On Inflation, Climate, and Tradeoffs – Energy Institute Blog


Can the Inflation Reduction Act fight both climate change and inflation?

18 months ago, Larry Summers wrote an important article in the Washington Post warning of two things. First, he warned that Biden’s stimulus could “trigger inflationary pressures of the kind we haven’t seen in a generation.” Second, he worried that an overheated economy would make it difficult to find “the political and economic space” to advance the Democrats’ progressive agenda.

Three weeks ago, it looked like both of those projections were coming true. First, inflation figures published on July 13 showed that consumer prices increased by 9.1%. This is the largest annual increase we have seen since 1981.

Source: Bloomberg

Then, after seeing those inflation numbers, Senator Manchin announced that he could not support increasing federal funding for climate and clean energy investments. His reason: “We can’t add any more fuel to this inflation fire.”

Senator Manchin is right to make the fight against inflation a top political priority. But declaring inflation public enemy number one doesn’t take all federal climate policy options off the table. This means that we must choose our policy instruments carefully.

Yesterday, after a week of bullying in Washington, Senate Democrats rallied to pass the Inflation Reduction Act (IRA). This bill includes the largest and most important climate and energy package ever to come out of the US Senate. It’s not done yet. I am not ready to fully unpack this bill until it is signed and sealed. As we watch and wait, this week’s blog addresses the question: what does climate spending have to do with fighting inflation?

Energy prices drive inflation (some more than others)

Before diving into the specifics of the IRA, it’s worth reviewing some inflation basics. Basically, households are affected by inflation through the prices they pay for what they consume. To measure and monitor the rate of inflation, corny economists track the cost of a set of goods and services (aka the Consumer Price Index or CPI) representative of typical US household consumption.

Source: https://www.wallstreetmojo.com/price-inflation/

The key here is that the rate of inflation, measured as the percentage change in the CPI, is determined not only by the prices we pay, but also by the mix of goods and services we buy.

Energy prices have played an outsized role in driving the overall rate of inflation that we are experiencing. To illustrate this point, the chart below plots the relationship between the “relative importance” of different consumption categories (a measure of the distribution of consumer spending) and the contribution to the rate of inflation that we have seen over the of the last year. Energy expenditure (blue dot) represents less than 9% of consumer spending (comparable to car purchases and medical costs), but it is responsible for more than 30% of inflation over the past year.

Notes: These figures are taken from this dismal July Consumer Price Index report (Table 7).

You’ve probably noticed that some of your energy costs (eg, gasoline) have increased faster than others (eg, electricity). Breaking this category of energy consumption down into its component parts, the impact of gasoline prices on inflation really becomes apparent.

Notes: These figures are taken from the same BLS report.

One implication of these images: if more households drove electric cars than gasoline-powered cars, gasoline price shocks would have less of an impact on US inflation overall, because gasoline would account for a lower household operating costs.

Another punch: there’s more than one way to get these energy-related inflationary factors under control. We can try to reduce energy prices. And/or we can try to divert American households away from relatively expensive energy sources. The Inflation Reduction Act (IRA) is part of both.

Climate action in the Inflation Reduction Act

Trying to keep up with what’s inside and outside the IRA hasn’t been easy given the hectic pace of the past few days. The chart below breaks down the basic structure using the numbers reported here. The left bar represents tax revenue. The right bar represents government spending

Source: https://www.crfb.org/blogs/whats-inflation-reduction-act. Note that these numbers do not reflect the most recent changes, including those negotiated by Senator Sinema.

The first thing to notice is that the IRA generates more income than it spends. This is the most critical inflation reducing engine in the IRA. I will leave it to macroeconomists to project the net effects of this deficit reduction in detail. We are energy economists here. So I want to focus on the green parts that represent climate and energy related provisions.

Energy and climate provisions fall into one of three categories:

1. Consumer Incentives: There are many provisions that will allow households to electrify their lives at a lower cost. This includes $36 billion in tax credits for new and used “clean” cars. The IRA also directs billions of dollars in credits and rebates towards reducing the cost of purchasing heat pumps, electric water heaters and other investments in building electrification.

Source: heat pump

In my view, the most promising path to deep decarbonization is to green the grid and electrify many things (including transport and buildings). So accelerating the pace of electrification is good for the climate. It could also help keep inflation in check, because as more households become electrified, the “materiality” of gasoline and natural gas prices will decline. On the other hand, these demand-side subsidies could increase the price of electric cars and electricity. Which highlights the importance of supply-side measures…

2. Producer Incentives: If we want to increase the demand for electricity (with accelerated electrification), we will have to increase the supply of electricity. The IRA is allocating over $160 billion in clean energy tax credits over the next decade. The law includes incentives to streamline the permitting process and loans to grease the wheels of transmission projects. The ERI also includes measures to promote the growth of domestic manufacturing of electric vehicles, battery supply chains and other clean technologies.

Bringing new renewable energy projects, new storage projects, and new transmission projects online will reduce wholesale electricity prices. But the impact on detail electricity prices will depend on how these investment costs are covered. We have previously blogged about the efficiency and equity implications of using retail electricity tariffs to cover these capital investment costs. The IRA shifts much of this cost burden from households to more progressive tax vehicles. In other words, tax credits offer a way to accelerate grid decarbonization without increasing investment costs for electricity consumers.

3. A well-targeted tax: If you squint at my bar chart above, you can see a thin green line at the top of this revenue bar. This is a judiciously targeted tax on a particularly important greenhouse gas: methane.

Source

Methane emissions are far more potent than CO2 in terms of (short-term) warming potential. And the majority of methane emissions in the United States come from a small number of “super leaks” which are usually caused by maintenance failures. The methane charge included in the IRA applies specifically to emissions from the oil and gas sector youthat exceed facility-specific thresholds. This is a strong incentive for oil and gas producers to comply with EPA regulations. It’s a relatively small piece of the IRA. But it could have a relatively large impact on US GHG emissions.

Compromise and Commitment (no longer needed)

The Cut Inflation Act is a major boost for federal climate action. And it’s structured to reduce consumers’ energy expenditures overall. The IRA is not anyone’s perfect policy package. But it’s nothing short of miraculous that Democratic lawmakers have managed to thread that needle at a time when concerns about inflation loom large and resentment in Washington runs deep.

The climate measures contained in the IRA clearly have the potential to drive significant GHG reductions. But realized the economic and emissions impacts will depend to a large extent on how the various programs are designed and implemented. In the weeks and months leading up to yesterday’s vote, we have seen (among other things) a refreshing display of collaboration, commitment and compromise. It will take a lot more to make the most of the opportunities offered by the IRA.

Follow Energy Institute blog posts, research and events on Twitter @energyathaas.

Suggested citation: Fowlie, Meredith. “On Inflation, Climate, and Tradeoffs” Energy Institute Blog, UC Berkeley, August 8, 2022, https://energyathaas.wordpress.com/2022/08/08/on-inflation-climate-and-compromise/

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