Expensive climate fight will boost interest rates

Funding Australia’s climate transition will be challenging – and expensive. That means higher interest rates are likely to be with us for some time.

While critical, funding Australia’s climate transition will be challenging – and expensive. That means higher interest rates are likely to be with us for some time.

The October and May federal budgets contain $29.5bn in climate-related spending measures, a fourfold increase from the 2021-22 budget. The Safeguard Mechanism reforms of 2023 cover about 30 per cent of Australia’s total emissions. Australia is a signatory to the “30 by 30” target – an aim to protect at least 30 per cent of the world’s land and oceans by 2030.

At the same time, the demand for resources at a global level is intensifying. The US Inflation Reduction Act was pitched as a $US391bn ($592bn) package over 10 years, but Brookings Institution research suggests it is likely to be closer to $US900bn. Europe has offered its own Green Industrial Plan in response but is under domestic pressure to do still more.

The EU’s Carbon Border Adjustment Mechanism (CBAM) will begin administrative operation in October 2023, and in 2026 begin collecting tax on the carbon emissions embedded in imports from sectors including steel and aluminium. The US is expected to respond with its own CBAM.

In an economy already struggling with excess demand, climate-related efforts are likely to sustain inflationary pressure, which crowds out other forms of economic activity. That rise is also prompting a monetary policy response to return inflation to the 2-3 per cent target.

If private balance sheets were less robust, that crowding out might be able to occur at more modest levels of interest rates. But in aggregate, private balance sheets in Australia are the strongest in two decades.

In 2022 the Reserve Bank suggested the proportion of mortgages to those households living pay cheque to pay cheque had nearly halved in the last 15 years.

It may be that those most vulnerable to cost-of-living pressures don’t carry as much debt as they perhaps used to.

The net asset position of the household sector has deteriorated over the past two years, but it is still higher than at any time before 2020. The corporate sector in aggregate is also in strong shape, with corporate debt as a share of GDP the lowest since 2005.

The strength of the demand of recent years has been beneficial in some areas. This year, for instance, there have been a sweep of female labour market records: the highest participation rate, share of hours worked, share of full-time employment, and lowest female unemployment rate. There are more gains to be had. Immigrants, for instance, often struggle to have their qualifications appropriately recognised.

The resources required for history’s largest infrastructure swap, in other words, are competing with resilient consumer and business demand.

In response to economic challenges again Australia is looking to immigration to add to the economy’s inputs, but constraints are emerging. Housing supply hasn’t kept pace.

The March ANZ/Property Council of Australia Survey found housing supply and affordability as critical issues for the federal government. Yet, in the current year immigration is expected to contribute to the strongest population growth since 2009, and before that 1974.

The natural environment transition is likely to worsen this constraint, both through the competition for resources and perhaps also from the application of more stringent environmental standards to the construction sector.

While this isn’t yet a widespread discussion in Australia, a recent study in the Journal of Building and Environment examining Germany might give a sense of the orders of magnitude involved. The study finds the cost of retrofitting existing dwellings for Germany’s environmental standards to be between $96,000 and $155,000 (at current exchange rates). Bear in mind Australia has an average house size 38 per cent larger than Germany and the largest in the world.

Productivity growth can help ameliorate these challenges to some degree, but the Productivity Commission’s recent five-year stocktake gives a sense of how much more difficult raising service sector productivity is, relative to the goods sector efforts of past decades.

Natural environment spending, as well as housing, defence, ageing and other imperatives, faces resilient private balance sheets in a tussle for resources. This has implications for interest rates. While much of the debate concerns how many more hikes are coming, the real story is the likely absence of substantial easing on the other side.

Richard Yetsenga is the chief economist of ANZ.