How central banks should react to climate change

Economic opinion

Climate change is altering the policy framework for central banks. Since climate-related economic shocks are similar to supply shocks, this will modify the nature of the typical shock that any economy will face in the future. As financial supervisors, central banks can play a role in facilitating correct and transparent pricing and reporting of climate-related risks, without creating undue additional costs for the sector. A proactive role for monetary policy in mitigating climate change is, however, controversial. A ‘first-best’ solution would be for fiscal policy to correct climate-related market failures, using carbon emission taxes and R&D subsidies. Explicit green quantitative easing programmes would come with the risk of creating additional market distortions and encouraging excessive fiscal deficit spending. Moreover, they should never compromise the ECB’s primary objective, which is, and should remain, medium term price stability.

At the Joint Annual Meeting of the World Bank and the IMF last week, climate change and the role of monetary policy featured prominently. This reflects growing attention to the issue among policy makers. In 2017, Mark Carney, the Governor of the Bank of England, launched the Network for Greening the Financial System (NGFS), which 46 central banks and regulators have joined so far. Next ECB president Lagarde also referred to mitigating climate change as one of her future policy priorities.

Climate-related events will impact conventional monetary policy in a number of ways. First, they make the identification of economic shocks more difficult for central banks by adding to overall volatility. Second, identifying the exact nature of a shock is all the more important since climate-related events tend to be supply shocks. As opposed to demand shocks, they create a policy trade-off for the central bank between stabilising inflation and stabilising output fluctuations. Third, climate-related shocks are likely to be relatively persistent. As opposed to temporary shocks, more permanent shocks give central banks less scope to ‘look through’ them, forcing them to act more frequently in the future. Fourth, extreme shocks become more likely. These ‘fat-tails’ are exacerbated by the fact that climate-related risks are likely to be more systemic and less country or sector specific. To hedge against this, central banks will need to make more sizeable policy rate changes in the future. Therefore, the scope for effective interest rate policy will be exhausted more often in the future, making nonconventional measures a much-needed item in the policy toolbox.

All these considerations fit into the traditional framework of central banks pursuing price stability, with climate change as another source of economic (supply) shocks. A conceptually different question is whether monetary policy can contribute more proactively to mitigating the consequences of climate change. The answer to this is balanced.

The case for economic policy intervention

The economic case for climate-related policy intervention is based on the presence of market failures. The impact of climate change can be seen as a negative externality of production and/or consumption of carbon-intensive goods and services. Not all costs of these activities are incorporated in market prices, which leads to an inefficient overproduction and overconsumption. Put differently, preventing climate change can be seen as a ‘public good’. Current market prices do not incorporate all the future benefits of preserving a sustainable climate. Mark Carney referred to this as ‘the tragedy of the horizon’: climate-related costs imposed on future generations are largely ignored in current market transactions.

This not only leads to mispriced goods and services, but also to misrepresented financial risks on firms’ balance sheets. More specifically, these risks include physical risks (e.g. the direct damage by a flood or a drought), transition risks (e.g. the declining value of coal mines and the cost of adjusting infrastructure to low-emission technology) and liability risks.

Central banks can potentially play a role in this respect in their supervising role. They can promote a better reflection of climate-related risk attached to financial securities in the calculation of Risk Weighted Assets, adjust the collateral requirements for refinancing operations accordingly and require more climate-related stress tests. However, this assumes that climate-related risks and costs, including those in the long term, can be quantified with an acceptable degree of accuracy. This cannot be taken for granted. It calls for caution when implementing new financial regulation and supervisory requirements, in particular when they are introduced quickly. They not only imply additional costs for the banking sector, but also risk destabilising the sector if the regulation is based on an incomplete knowledge of climate-related costs and risks.

Monetary versus fiscal policy

Apart from the general case for climate-related policy intervention and the supervisory role of central banks, there is no consensus about a broader role for central banks in this policy area. On the contrary, the common view among economists is that mitigating climate change is a task for fiscal, rather than monetary policy. The ‘first best’ policy response to climate change consists of taxes on carbon emission combined with subsidies to climate-friendly R&D.

Monetary policy can still step in if fiscal policy options are not available. In the case of the ECB, it could be argued that such a proactive role would be compatible with its mandate. Once price stability is achieved, the mandate requires the ECB to support the general economic policy objectives of the EU. Whether this includes climate change mitigation is part of the debate. In any case, there is room for interpretation, since the mandate also stipulates that the ECB will act in accordance with the principle of an open market economy with free competition.

The most explicit and controversial call for central banks to ‘step in’ is via the so-called ‘green Quantitative Easing’ (QE). Backed by theoretically unlimited financial resources, central banks would buy ‘green’ bonds issued by firms or e.g. the European Investment Bank.

However, if supporting climate change mitigation is an acceptable monetary policy objective, why not fighting poverty or speeding up economic convergence in the EU (see also the KBC Economic Opinion of 21 June 2019)? The point is that there is no free lunch, not even for central banks. Today, too high inflation is not a problem in the euro area. On the contrary. But at some point in the future, a trade-off between achieving the inflation target and conducting climate-related QE may well arise. When that happens, central bank independence will be at stake.

A climate-friendly bias in already existing QE-programmes was proposed in a recent Bruegel paper by Dirk Schoenmaker. He argued that corporate bond markets are biased towards capital and carbon intensive sectors, meaning that a market-neutral QE is not really carbon-neutral. A practical problem, however, is the insufficient liquidity of the European corporate bond market for a meaningful QE programme, once carbon-intensive sectors are excluded. A more fundamental objection by ECB Board Member Mersch is the absence of any agreed definition of what is ‘green’ and what is ‘sustainable’. He warned that a euphoria over green financial assets could lead to an inadequate pricing of their risks and eventually to a price bubble, referring to this as ‘the Ponzi risk of green finance’.

To sum up, climate change affects the way central banks conduct their conventional policies, and poses additional challenges. As banking supervisors, central banks can contribute to more transparent and efficient financial markets. A proactive role for monetary policy via QE comes with the risk of creating other market distortions and encouraging excessive fiscal deficit spending. And most of all, it should never compromise the ECB’s primary objective of medium term price stability.

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