The UK is not exactly known for its warm weather. In July 2022, however, temperatures in some regions climbed to around 38 degrees at times. And in France, in the municipality of Beaulieu-sur-Layon, it hit almost 43 degrees. According to climate researchers, the 2022 heatwave, which affected almost all of Europe, might have been the hottest summer for 500 years. What is certain is that it has never been warmer in Europe since temperature records began in 1881.

The high temperatures were not without consequences. There were droughts and forest fires in large parts of Europe. Some regions also ran out of drinking water. And some rivers, such as the Rhine, became impassable for shipping in some places due to low water levels. In addition, according to a study, over 60,000 people in Europe died as a result of the heat between 30 May and 4 September 2022. With very few exceptions, scientists agree that the heatwave was triggered by man-made climate change. There is also a scientific consensus that climate change is having a huge impact on economic development and that this will intensify in the future.

In a working paper by the Potsdam Institute for Climate Impact Research (PIK) and the ECB, the scientists conclude that climate-related crop failures increased food inflation in the eurozone by 0.67 percentage points in the summer of 2022. As food expenditure accounts for around a fifth of the total basket of goods used to calculate euro inflation, this was actually a very relevant driver of inflation. However, the effect was overshadowed by the two even greater effects on prices: the Russian invasion of Ukraine, and the impact of the coronavirus pandemic on global supply chains. As a result, the climate-related inflation effect hardly received any attention in 2022.

In the future, however, debates are likely to focus more often on the impact of climate change, since the effects will become stronger over time. The International Monetary Fund (IMF) assumes that if current policies are maintained, economic output in Europe will fall by almost 5% by the end of this decade as a result of climate change. By 2050, this would already be almost 10%. If humanity actually succeeds in emitting zero greenhouse gases globally by then, European economic output would be 3.4% lower by 2050 than without climate change.

„It is unclear whether the economic impacts of climate change will increase linearly or exponentially over time,“ Maximilian Kotz, who researches the consequences of climate change for inflation and economic growth at PIK, said in an interview with Börsen-Zeitung. „Most current work assumes more of a linear approach.“

If it does turn out to be exponential, the economic damage would be far greater than predicted by the IMF in its modelling. „Climate change causes costs and makes us all poorer in any case,“ Almut Balleer, Professor of Empirical Macroeconomics at the Technical University of Dortmund, told Börsen-Zeitung.

A look at the impact on inflation shows that central banks cannot afford to ignore climate change in their monetary policy. In a study by the PIK and the ECB, the authors, including Kotz, come to the conclusion that higher average temperatures could increase global food inflation by between 0.9% and 3.2% running up to 2035. As a result, overall inflation would be 0.3% to 1.2% higher. „The price-driving effects of climate change and the resulting greater fluctuations in inflation are likely to make it more difficult for central banks to achieve their inflation target in the future,“ says Kotz.

It will be crucial for central banks to understand what effects climate change will have on the economy and how monetary policy should respond to this. „The ECB must keep an eye on the price effects of climate change, and analyse whether they are only temporary in nature or only affect relative prices,“ says Balleer, who works on monetary policy at the RWI – Leibniz Institute for Economic Research. „Monetary policy should react to widespread, more persistent price changes.“

If food prices rise yet there are signs that the situation is easing, central banks should not react by raising interest rates. This is simply because monetary policy always has a delayed effect on the real economy. On the other hand, a central bank should take structurally higher food prices, for example due to recurring crop failures, into account in its monetary policy. If it fails to do so, it risks missing its inflation target permanently. However, distinguishing the structural components from the temporary ones is no easy task.

Kotz acknowledges that the European Central Bank has been working intensively on the topic of climate change and its consequences for monetary policy for several years. „The ECB is currently doing a good job of closing this gap," he says. "An example of this is the Network for Greening the Financial System (NGFS).“ The NGFS is a global network of central banks and supervisory authorities. The aim of the organisation is to analyse the consequences of climate change for the financial system and to promote a sustainable economy.

Climate change was also a topic at this year's ECB Forum in Sintra. Theresa Kuchler, Associate Professor of Finance at the Stern School of Business at New York University, presented a study on the economic consequences of the loss of biodiversity. Together with the other authors of the study, she came to the conclusion that at a certain point, species extinction reaches a tipping point at which the economic damage increases significantly. This occurs when the remaining species are no longer sufficient to fill the gap in the ecosystem left by the extinct species.

Climate change affects economic development in a variety of ways. „It destroys capital, lowers crop yields and, according to initial studies, also reduces labour productivity,“ says Balleer. Kotz has also observed this. According to him, even office work is less productive at high temperatures. However, this applies to an even greater extent to people who work outdoors.

While climate-induced food inflation is clearly recognisable in the data, it has so far not been possible to provide unequivocal evidence of higher inflation due to lower productivity.

As challenging as climate change will be for Europe, other regions of the world will suffer even more. Climate researchers agree on this. The hotter a region already is, the more damaging the additional rise in temperature will be. What's more, rich countries are better able to deal with the consequences of climate change. For example, they can rebuild destroyed areas more quickly after a flood. „Global inequality is therefore increasing due to climate change,“ Kotz concludes.

Scientists' forecasts on the long-term global economic consequences of climate change vary greatly. „Depending on estimates, global GDP per capita by the end of the century in a worst case scenario is expected to be 10% to 50% lower than it would be without climate change,“ says Kotz. The „worst-case scenario“ means that countries and companies fail to implement a sustainable economic policy.

The green transformation could also initially inhibit economic growth. Many sustainable companies are not yet as productive as „brown“ companies, says Balleer. However, this is likely to change over time. The economist also emphasises that "the faster the green transformation succeeds, the lower the costs. Fiscal policy is therefore required to stimulate investment in greater sustainability.“