Climate change adds another layer of uncertainties to the high inflation and geopolitical conflict that are obscuring the macroeconomic outlook. And it will continue to do so even in the absence of these shocks because of the variety of paths global warming can take. Macroclimate scenario analysis tells us climate risk will come from two sources--transition risk and physical risk. The two extremes--accepting global warming will continue unchecked (a "hot house" earth in which physical risks prevail and worsen) or engineering a quick transition to net zero, where transition risks are high and with anticipated significant mitigation of physical risk from midcentury--have different implications for the nature of climate-related macroeconomic shocks. While transition risk shocks are more likely to initially affect the demand side, and therefore the flow of GDP, physical risk shocks will likely be felt predominantly through the supply side by damaging physical capital and lowering productivity.

A faster transition to net zero could create short-term price pressures but also bring long-term efficiency gains

With transition risk, a mix of demand- and supply-side shocks are at play. Policies (such as carbon pricing), changes in consumer and investor preferences (the repricing of higher environmental footprints), and technological disruption could all create a more environmentally sustainable growth equilibrium. Getting there implies structural and systemic changes originating mostly from relative price changes and demand shifts, forcing the supply side to allocate resources differently.

While a very gradual transition--seen to date--may not have visible effects on the economy, a more abrupt shift could add short-term inflationary pressures and therefore reduce consumer purchasing power. This could either be because current consumption patterns become more expensive, say from widespread carbon pricing, or because cleaner production capacities are not yet sufficient to meet the sudden change in demand. Nonetheless, the Network for Greening the Financial System (NGFS) scenario results for net zero suggest price pressures would remain relatively muted, adding around 0.5-2.0 percentage points to inflation rates in the first decade of the transition depending on the country, compared with 2022 inflation rates of close to 10% in many advanced economies (chart 1).

Chart 1

The current energy crisis is an example of such inflationary dynamics. The sudden constraint on the energy supply (that is, its Russian origin) could not be alleviated quickly because it takes time to source energy from elsewhere or build new supply capacities. Higher energy prices have ensued, underscoring that abrupt demand shifts can be inflationary when substitutes are not immediately available--though these effects will likely fade as decoupling from Russian fossil fuels becomes more pronounced. A key difference with today's price impacts, compared with a policy-driven energy transition, is that revenues from higher fossil fuel prices are unevenly distributed (aside from the related taxes, they are mostly captured by fossil fuel producers), while carbon pricing revenues would be collected by the country seeking to speed up the transition--for as long as carbon offsets from voluntary carbon markets are not recognized as emissions abatement by carbon taxing schemes. In that sense, higher prices would lower consumption, like today, but also redirect spending toward public investment if carbon tax revenues are recycled to speed up the transition.

Today's crisis also shows that not only inflationary dynamics are at play when a structural shift is underway; other dynamics can be self-reinforcing and amplified. For example, several governments have increased their spending commitments to renewables as a result of supply-side pressures and energy security concerns. The IEA (2022b) now expects renewable capacity addition in 2022-2027 will be 30% higher than it had initially forecast in 2021--an 85% acceleration from the previous five years. There is also some evidence that consumers and companies in the EU have reduced their energy consumption beyond what milder weather and economic activity would suggest (chart 2). This hints at energy efficiency and related productivity gains resulting from the current shock. In the longer term, once the supply shock has been absorbed, there is a risk that Russian energy and related processing facilities will become obsolete and potentially create stranded assets. All these changes--more green spending, energy efficiency, productivity gains, and stranded assets--are also likely to take place amid the climate transition.

Chart 2

A more rapid transition to net zero is likely to be bumpy, with some inflationary pressures and relative wealth losses in the short-to-medium term. This would result from stranded assets and the need to redirect funds away from consumption and toward investment. All these dynamics would likely dent an economy's production capacity at the start. That said, the longer-term net impacts are less clear. A green transition could push an economy onto a more productive growth path, if the move to more environmentally friendly production also triggers a more efficient use of resources (for example with improvements in energy efficiency or cheaper technologies to produce electricity; see chart 3 and Panetta 2022). In that vein, another less inflationary scenario could also materialize if the supply side is quicker to adjust than demand. If companies are able to offer cleaner alternative and potentially cheaper goods before climate policy becomes stricter or consumers change their preferences (as has been the case for electric vehicles until now), supply may actually create its own demand and therefore not be inflationary.

Chart 3

Physical risks are likely to increase the volatility of output

Positive impacts on growth from physical risks are unlikely. Chronic changes in weather patterns will increasingly disturb economic activity as temperatures rise, predominantly through supply-side shocks. Two types of disturbances are occurring: chronic risks are more gradual and include long-term shifts in temperatures, precipitation patterns, and higher sea levels, while acute risks describe more frequent and severe event-driven shocks (such as storms, floods, and wildfires).

Being more incremental, chronic risks are likely to result in a gradual erosion of economic productive capacity. For example, higher average temperatures affect the labor force, reducing workers' productivity and increasing mortality rates, but also increase the likelihood of conflict (Carlton and Hsiang 2016). Agricultural output is also affected, with some crops yielding less in warmer climates (according to Roson and Sartori's research; see chart 4). As for rising sea levels, the impact is more concentrated on capital stock with productive land located on coastlines disappearing. But it can also lead to a geographical reallocation of resources and human migration away from the coast; the effects may be much greater for a local economy, while less visible at the aggregate country level. Rigaud et al. (2018) estimates that by 2050 around 3% of the populations in South Asia, Latin America, and sub-Saharan Africa could be forced to move within their own countries as a result of climate change.

Chart 4

By contrast, acute physical risks could manifest as more sudden supply-side shocks that increase output volatility as well as reduce long-term potential GDP. Long-term losses can occur through damage to capital caused by weather events (for storms see Hsiang and Jina 2014). Short-term GDP losses may also be visible when extreme weather events or acute physical risks affect an economy's productive capacity. As such, heat waves tend to lower the productivity of outside workers, while droughts impair agricultural production, energy production (hydropower generation decreased despite higher capacity; IEA 2022a) or trade flows (low Rhine levels significantly reduced German trade in 2022 and 2018). These can generate short-run inflationary pressures because supply is not able to meet demand (Faccia et al. 2021), not to mention second-order effects in a world of highly integrated supply chains.

Taken together, we believe physical risks--both acute and chronic--are likely to lower potential output, relative to a no-climate-change scenario, and increase the volatility of output, with the distribution of shocks likely to be fat-tailed. We estimate that climate physical risks could expose 4% of global GDP to losses by 2050 under the current pledge in which emissions peak in 2040 then decline (known as RCP 4.5; see "Weather Warning: Assessing Countries' Vulnerability To Economic Losses From Physical Climate Risks," April 27, 2022).

That said, beyond the uncertainty surrounding climate and hazard projections, the longer term losses linked to global warming remain difficult to quantify. Much depends on how swiftly economies can recover from shocks. Research so far suggests that economies with greater financial means and more flexible labor and product markets will tend to see less long-term scarring than lower-to-middle-income peers (see IMF 2017). And as physical risks become more pronounced, the global economy is likely to adapt to these risks (for example by changing crops cultivated to adapt to hotter climates). But adaptation may not entirely offset all weather-related losses, especially because of the substantial adaptation gap. For developing countries, the UN Environment Program estimates annual adaptation investment needs at 5x-10x higher than 2022 finance flows, bringing the figure to $340 billion per year by 2030 (see UNEP 2022).

Chart 5

Future economic impacts from climate-related risks are intrinsically entwined with policies, consumer and investor preferences, and technological progress. A mix of transition and physical risk shocks are likely to materialize. Globally, current government policies to lower carbon emissions are not at a level that would limit warming to 1.5C (see our carbon pricing and climate risk reports, links in Related Research below). If the transition to net zero gains more traction, we could see some limited inflationary pressures as the supply side adjusts. By contrast, for as long as a net zero is not achieved, we anticipate that physical risk shocks will continue to rise and drag increasingly on potential output, with more frequent extreme weather events adding volatility to output. That said, income impacts highlighted above don't account for consumers' likely preference for a cleaner and more stable environment--another likely benefit of transitioning faster.

Related Research

S&P Global Ratings

• Carbon Pricing, In Various Forms, Is Likely To Spread In The Move To Net Zero, Aug. 9, 2022
• Weather Warning: Assessing Countries' Vulnerability To Economic Losses From Physical Climate Risks, April 27, 2022
• Climate Risk: What are the short- to medium-term costs of climate change? Global Credit Outlook 2023: No Easy Way Out, Dec. 1, 2022

External research

• Carleton, T. and Hsiang, S. (2016), Social and economic impacts of climate, Science 353
• Faccia, D., Parker, M. and Stracca, L. (2021), Feeling the heat: extreme temperatures and price stability, ECB Working Paper No 2626
• Hsiang S., and Jina, A. (2014), The causal effect of environmental catastrophe on long-run economic growth: evidence from 6,700 cyclones, NBER, Working Paper 20352
• IEA (2022a), Hydroelectricity, IEA, Paris https://www.iea.org/reports/hydroelectricity, License: CC BY 4.0
• IEA (2022b), Renewables 2022, IEA, Paris https://www.iea.org/reports/renewables-2022, License: CC BY 4
• IMF (2017), The effects of weather shocks on economic activity: how can low income countries cope?, Chapter 3, WEO
• Panetta, F. (2022), Greener and cheaper: could the transition away from fossil fuels generate a divine coincidence?, ECB speech, Nov. 16, 2022
• Parker, M. (2016), The impact of disasters on inflation, ECB Working Paper 1982
• Rigaud, K., de Sherbinin, A., Jones, B., Bergmann, J., Clement, V., Ober, K., Schewe, J, Adamo, S., McCusker, B., Heuser, S., Midgley, A (2018). Groundswell: Preparing for Internal Climate Migration. World Bank, Washington, DC.
• Roson, R. and Sartori, M. (2016). Estimation of Climate Change Damage Functions for 140 Regions in the GTAP9 Database. Policy Research Working Paper; No. 7728. World Bank
• UNEP (2022), Adaptation Gap Report 2022: Too Little, Too Slow – Climate adaptation failure puts world at risk