On Inflation, Climate and Compromise – Energy Institute Blog

Can the Lower Inflation Act address both climate change and inflation?

18 months ago, Larry Summers wrote an important article The Washington Post warns of two things. First, he warned that Biden’s stimulus could “trigger inflationary pressures like we haven’t seen in a generation.” Second, he worries that an overheated economy will struggle to find “political and economic space” to push the Democrats’ progressive agenda.

Three weeks ago, both predictions seemed to have come true. first, Inflation data released on July 13 Show consumer prices rose 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 increased federal funding for climate and clean energy investments. His reason: “We can’t add fuel to this inflationary fire any more.”

Senator Manchin is right to make fighting inflation a top policy priority. But declaring inflation public enemy No. 1 doesn’t rule out all federal climate policy options. This does mean that we need to choose our policy tools carefully.

Yesterday, after an intense week in Washington, Democrats in the Senate rallied to pass the Inflation Reduction Act (IRA). The bill includes the largest and most impactful climate and energy package ever to make it through the U.S. Senate. This is not done yet. I’m not ready to fully unwrap this bill until I sign and stamp it. So as we watch and wait, this week’s blog raises the question: What does climate spending have to do with the fight against inflation?

Energy prices are driving inflation (some more than others)

Before diving into the details of an IRA, it’s worth reviewing some inflation basics. Basically, households are affected by inflation through the prices they pay for the things they consume. To measure and monitor inflation, nerdy economists track the cost of a basket of goods and services (also known as the Consumer Price Index or CPI) that represents the consumption of a typical American household.

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

The key here is that inflation, measured as a percent change in CPI, depends not only on the prices we pay, but also on the mix of goods and services we buy.

Energy prices have played a huge role in driving the headline inflation rate we are experiencing. To illustrate this, the graph below plots the relationship between the “relative importance” of different consumption categories (a measure of how consumer spending is allocated) and the contribution to inflation we have seen over the past year. Energy spending (blue dots) accounts for less than 9% of consumer spending (compared to car purchases and medical bills), but they account for more than 30% of inflation over the past year.

Note: These figures are taken from the dismal July CPI report (Table 7).

You may have noticed that some of your energy costs (such as gas) are growing faster than others (such as electricity). Break down this energy consumption category into components, and the effect of gasoline prices on inflation really jumps out.

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

One implication of these pictures: If more households drove electric vehicles than gasoline-powered vehicles, the gasoline price shock would have less of an impact on headline U.S. inflation because natural gas would account for a smaller share of household operating costs.

Another punchline: There is more than one way to control these energy-related inflation drivers. We can try to lower energy prices. And/or we could try to keep American households away from relatively expensive energy. The Inflation Reduction Act (IRA) does both.

Climate Action in the Lower Inflation Act

Given the frenetic pace of the past few days, trying to keep up with the ins and outs of the IRA isn’t easy.The diagram below breaks down the basic structure using the reported numbers here. The bars on the left represent taxes.The right column represents government spending

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

The first thing to note is that the IRA raises more revenue than it spends. This is the most critical inflation reduction driver in the IRA. I’ll leave it to macroeconomists to forecast in detail the net impact of this deficit reduction. We are energy economists here. So I want to focus on the green part that represents climate and energy-related terms.

Energy and climate regulations fall into one of three categories:

1. Consumer incentives: There are a lot of regulations that can make life cheaper with electrification at home. This includes a $36 billion tax credit for new and used “clean” vehicles. The IRA also uses billions of dollars in credits and rebates to reduce the cost of purchasing heat pumps, electric water heaters and other building electrification investments.

Source: Heat Pump

In my opinion, the most promising avenues for deep decarbonization include greening the grid and electrifying many things, including transportation and buildings. Therefore, accelerating the pace of electrification is good for the climate. It could also help control inflation, as the “relative importance” of gasoline and natural gas prices will fall as more and more households have electricity. On the other hand, these demand-side subsidies could raise the price of electric vehicles and electricity. This highlights the importance of supply-side measures…

2. Producer incentives: If we are going to increase the demand for electricity (accelerating electrification), we need to increase the supply of electricity. The IRA distributes more than $160 billion in clean energy tax credits over the next ten years. The bill includes incentives to simplify the permitting process and loans to provide loans for transmission projects. The IRA also includes measures to promote the growth of domestic electric vehicle manufacturing, battery supply chains, and other clean technologies.

New renewable energy projects, new energy storage projects and new transmission projects come online will lower wholesale electricity prices.but affects retail The price of electricity will depend on how these investment costs are paid. We have previously blogged about the efficiency and equity implications of using retail electricity prices to cover these capital investment costs. The IRA shifted most of the cost burden from households to a more progressive tax tool. In other words, tax credits provide a way to accelerate the decarbonization of the grid without adding capital costs to electricity consumers.

3. Targeted taxation: If you squint at my bar graph above, you’ll see a thin green line on that income bar. This represents a smart, targeted taxation of a particularly important greenhouse gas, methane.

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In terms of warming potential (in the short term), methane emissions are far stronger than carbon dioxide.and most of the methane emissions in the U.S. From a handful of “super leaks” usually caused by maintenance failures. Methane charges included in IRAs apply specifically to emissions from the oil and gas sector TonExceeding facility-specific thresholds. This provides a strong incentive for oil and gas producers to comply with EPA regulations. This is a relatively small part of the IRA. But it could have a relatively large impact on U.S. greenhouse gas emissions.

Compromise and commitment (more needed)

The Reducing Inflation Act is an important shot in the arm for federal climate action. It should be structured to reduce consumers’ overall energy bills. The IRA is not the perfect policy package for anyone. But it’s nothing short of miraculous that Democratic lawmakers have managed to thread the needle amid growing concerns about inflation and resentment in Washington.

Climate measures included in IRAs clearly have Potential Promote massive reductions in greenhouse gas emissions.but accomplish The economic and emission impacts depend to a large extent on the design and implementation of the various options. In the weeks and months leading up to yesterday’s vote, we have seen (among other things) a refreshing amount of cooperation, commitment and compromise. To take full advantage of the opportunities offered by the IRA, more funding is needed.

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

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

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