Once pandemic-related supply inflation begins to fade, there is another, less-discussed inflation looming not too far off: climate inflation.
There are several drivers for this: carbon pricing will be critical to delivering market-based decarbonisation, even while this likely leads to higher prices for everything in the medium and long term.
For example, from the middle of this decade the EU’s Fit for 55 program will implement a carbon border adjustment mechanism, which will result in carbon being priced into goods (across a range of industries) sold in Europe and may result in a decade of rising prices.
The greater demand for electricity will also be a key factor in rising inflation as grids are electrified, with electricity consumption set to double by 2050. Among renewables, project build costs are now starting to rise because of rising commodity costs (copper particularly).
Additionally, the nature of renewable energy generation will require significant additional electric transmission lines and additional generation to offset the interruptible nature of renewables.
Fossil fuel energy sources should have higher breakeven prices in the future as fossil fuel projects will likely have higher costs of capital associated with them (due to fewer sources of capital as banks move away from fossil fuel lending) and capital will likely need to be recovered over shorter time periods.
The dwindling supply of fossil fuel globally, due to several decades of underinvestment, will also increasingly put upward pressure on inflation and consumer bills.
Utilities are not without their climate-related expenses either: the New York City sewer system, for example, was built to handle 1.75 inches of rain per hour. In 2021, Hurricane Ida deluged the city with over three inches in an hour. While there are no immediate plans to upgrade the city’s aging sewers, reports indicate it could cost $100bn and take several decades to recalibrate the system. That cost will be recovered in utility bills or taxes.
Infrastructure is in a unique position among investable securities to support decarbonisation and combat inflation: it provides essential services to growing populations in emerging, developing and developed countries and thus will benefit from continued investment under regulatory or contractual frameworks that provide predictable future cash flows, often linked to inflation.
Among utilities, renewables are expected to grow substantially at the expense of coal and gas-fired generation: rail offers lower emissions per passenger/ton than other transport alternatives; toll roads facilitate lower-emissions travel, regulating traffic flow and evolving to allow electric vehicles; some energy infrastructure will be adapted to support hydrogen transportation and carbon capture in industrial processes; communication towers also allow technology to function as a mobility substitute, reducing travel emissions.
As climate inflation moves from an underdiscussed issue to front and-centre over the coming years, we expect infrastructure’s role as an inflation hedge — most revenues are linked to inflation —will also take on new meaning.
Shane Hurst and Nick Langley are portfolio managers on infrastructure strategies at ClearBridge Investments. The views expressed above should not be taken as investment advice.