Climate change presents two major types of risk. The first are physical risks or tangible risks from gradual global warming, such as the effects of temperature and rainfall changes or extreme weather events like floods, droughts and tsunamis.
These events can severely damage infrastructure, disrupt global supply chains and impact much else. The second are transition risks, which arise as the economy shifts away from fossil fuels toward a low-carbon economy.
This may involve carbon taxes, the adoption of renewable energy and carbon disclosure mandates, disproportionately affecting some industries and economies.
Both physical and transition risks can lead to supply and demand shocks, impacting price stability through multiple channels, often with opposing effects.
On the supply side, physical climate risks can hit agricultural productivity and food security, as well as energy production and distribution, while also hurting capital stock and infrastructure—all of which can mean shortages and price volatility.
Also vulnerable is labour productivity, while higher mortality may reduce labour supply. Short-term fluctuations in output can result in inflation and other forms of macroeconomic volatility. On the demand side, climate-related shocks reduce household wealth and private consumption.
The uncertainties of climate change can mean reduced consumer confidence and spending. Like wise for business confidence and investment. If additional investment must go into reconstruction, it may be at the cost of innovation.
In a country where climate-related losses are largely uninsured, extreme weather events are likely to have a net negative effect on consumption and investment. Physical climate risks can also hit aggregate demand by limiting the country’s export capacity.
India’s vulnerability to these climate risks is amplified by its reliance on imports of essentials such as crude oil and food products (including edible oils, oilseeds, pulses, fresh and dry fruits and spices), and climate-related import disruptions would result in price volatility.
Central banks need to assess impacts on both supply and demand to mitigate physical climate risks. Managing the growth-inflation trade-off will be harder with prices subject to climate uncertainty.
Transition risks arise when countries impose curbs on high-emission economic activities, such as through carbon pricing or regulations.
These policies act as negative supply-side shocks, as firms must allocate resources to reduce emissions, which can reduce profitability in the short-term and affect business growth.
On the demand side, transition risks include sharp reductions in investments in carbon-intensive sectors as economies try to decarbonize themselves. This shift can lead to a ‘crowding out’ of private investment as public funds are increasingly directed at low-carbon options.
There are other channels of impact too. Climate-related uncertainty may shift the demand for money by increasing the precautionary demand for cash and reducing the incentive to invest.
Lower investment demand could reduce the equilibrium real interest rate, limiting RBI’s capacity to use conventional monetary policy tools.
Further, climate risks could impair policy transmission by affecting the balance sheets of financial institutions with significant exposure to climate-related credit risks, thereby restricting credit flow to the real economy, hurting both consumption and investment.
India’s geography makes it particularly vulnerable to climate-change effects, including extreme heat, shifting rainfall patterns, droughts, falling groundwater levels, glacier melts and rising sea levels.
While these pose multiple threats, a World Bank estimate nearly a decade ago projected that, with just under 2° Celsius of warming by the 2050s, India’s foodgrain imports would need to double compared to its requirements without climate change.
Climate change, with its macroeconomic impacts on output and inflation through various channels, will require close coordination between the government and RBI.
The latter would need to explicitly incorporate climate-related risks into its mandate, enabling economic modelling to better anticipate and respond to climate-induced pressures on inflation and growth. This might also necessitate a greater reliance on unconventional central-bank policies, such as issuing forward guidance.
A joint effort by the government and RBI will be essential on multiple fronts: Planning urban environments to reduce ‘heat island’ effects, improving weather forecasting and flood planning, investing in agricultural R&D for drought-resistant crops and diversification, promoting efficient groundwater use, expanding water storage capacities, enforcing coastal regulation codes and strengthening health systems, especially in climate-vulnerable hotspots.
As climate-related risks increase, the growth-inflation trade-off will become more complex. Moving forward, a multi-pronged approach and close cooperation between the government and RBI will be crucial for effective planning and adaptation.
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