The Covid-19 pandemic has shown just how quickly and creatively central banks can respond to existential threats. By the end of March 2020, the Federal Reserve, European Central Bank and Bank of England had all created new programmes designed to support the economy and restore normal market functioning.
There is however another immediate global existential threat that central banks are responding to much more slowly: climate change. Central banks can and should do more, and the Federal Reserve should embrace the opportunity to not only catch up but to leapfrog and lead on this initiative.
The Federal Reserve has made some big steps towards addressing climate change over the past year. In November 2020, the biannual Financial Stability Report was the first of its kind to discuss climate change as a near-term risk to the financial system. Later that year, the Fed was the last major central bank to join the Network of Central Banks and Supervisors for Greening the Financial System (NGFS), an international consortium aiming to address climate risk in the financial sector.
This year, the Fed established the Supervision Climate Committee (SCC) to assess the micro-prudential readiness of financial institutions and the Financial Stability Climate Committee (FSCC) to evaluate the macroprudential risk of climate change to the financial system.
These are exciting and important shifts in the Fed’s engagement with climate change, but it still lags behind many of its peers.
The Bank of England (through the Prudential Regulation Authority), Financial Conduct Authority (FCA) and Department for Work and Pensions (DWP) have led the way in encouraging corporate disclosure of climate risk. In 2020, 33% of UK firms were fully compliant with TCFD guidelines and another 45% were partially compliant. Disclosures will be mandatory for all publicly listed firms in the UK by 2022 and will be mandatory for all private companies, asset managers, pension schemes, banks, and insurers by 2025.
The Bank of England (BoE) recently set out its first comprehensive stress test of the UK’s biggest banking and insurance companies to evaluate their resiliency to physical and transition risk in three different climate scenarios: early action by governments to cut carbon emissions over the next 30 years, late action and no additional action. The results, which will be released in the spring of 2022, will be reported in aggregate rather than firm-by-firm and will not be used to determine capital requirements for now.
It is uncontroversial to assert that central banks have a supervisory role to play in assessing the risk from climate change. But the BoE is the only central bank to take this one step further to also include supporting the government’s net-zero emissions target in its official mandate.
The European Central Bank (ECB) is not far behind the BoE in combating climate change. While the ECB hasn’t included climate change in its mandate, it is currently undergoing a strategic review of its monetary policy strategy. It may turn out that its mandate to support the economic policies of the Eurozone already allows it to consider climate when determining monetary policy. ECB President Christine Lagarde has highlighted that markets misprice climate risk and thus by insisting on maintaining market neutrality with asset purchases, the ECB is just exacerbating this market failure.
The ECB does not try to manage climate-related financial disclosures for European firms, but does monitor the progress of member countries in meeting TCFD guidelines. Later this summer, it will publish the final results of a stress test conducted at the beginning of the year to gauge the impact of climate change on 4 million firms and 2,000 banks over the next thirty years. Some senior officials at the ECB have suggested that banks with high levels of climate risk may have to raise more capital as early as this year.
The ECB also allows banks to post as collateral bonds that link their interest payments to compliance with the EU’s taxonomy regulation for green investments. Green bonds have also been included in the ECB’s asset purchase schemes.
The Swiss National Bank (SNB), like the Fed, has been relatively behind on climate change action, but is catching up. In December 2020, SNB Chair Thomas Jordan announced the central bank would expand its exclusion criteria for firms it invests in to take climate change into account. SNB and the Financial Market Supervisory Authority (FINMA) are also engaged in a joint project to evaluate transition risks for UBS and Credit Suisse.
Relative to these European counterparts, the Fed has a long way to go. In March 2021, Chair Jerome Powell told the House Financial Services Committee that the central bank is in the “very early stages” of considering climate stress testing. Any regulation of disclosure is likely to be carried out by the US Securities and Exchange Commission (SEC). Following the confirmation of Gary Gensler as SEC chair, this has become more likely.
There remains some concern among the Fed, the Bank of England, the ECB and the SNB that central bank involvement in climate change is a slippery slope, which could seriously threaten central bank independence. Monetary policy officials also argue that they are unelected officials and so have no business choosing winners and losers with their decisions.
The reality is that all central bank decisions—even the simplest act of hiking or cutting rates–creates winners and losers. Since central bankers are already involved in asset allocation decisions, they might as well be thoughtful about addressing one of the most pressing, existential crises of our time.
While some central banks have done more to address climate change than the Fed, none can rest on their laurels. In particular, all central banks should use dual interest rates to incentivize and subsidise green lending and facilitate the transition. The BoE and ECB have already implemented dual interest rates; the former with the Funding for Lending Scheme that was redeployed during the pandemic, and the latter with targeted longer-term refinancing operations. Rather than use these schemes to encourage lending to the private sector, central banks should offer banks preferential (negative) rates if they use the funds to lend for green investment.
The Fed has yet to establish an explicit scheme like this, but the plumbing for it is all there. The central bank could cut the discount rate into negative territory and offer banks this rate if they deploy the funds for green lending. To determine green taxonomy, the Fed can work with other bodies such as the Federal Housing Finance Agency (FHFA), which regulates Freddie Mac and Fannie Mae—two government-sponsored enterprises that already offer green loans for the US housing and commercial real estate industries.
The Fed may be coming from behind on climate change, but it should embrace the opportunity to leapfrog its counterparts and become a leader with bold and creative initiatives to encourage sustainability.
This page was last updated April 27, 2022
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