Born after the global financial crisis and before the Covid crisis, central banks’ agenda on climate emerged at a time when – at least in developed economies – these institutions were ‘the only game in town’, and often criticised for taking on what should have been tasks for elected politicians.
This profoundly shaped the way they understood and publicly defined their role, viewing climate through a limited risk lens. But times have changed, and central banks must now step up.
In the wake of the financial crisis and the subsequent euro area sovereign debt crisis, monetary policy tools, particularly quantitative easing, were overly-relied upon to generate a recovery. One just needs to look at how often a call for governments to take stronger action on structural reforms was made in any of the speeches by then-president of the European Central bank Mario Draghi. Fiscal policy levers were not moving, with governments across Europe and the UK worrying about fiscal responsibility. These were the years of deeply damaging austerity policies and underinvestment.
And the relations among central banks, politicians and the public were not always smooth. The ECB was regularly questioned over potential political motives behind key decisions, with crises in Greece and Italy in the spotlight. During a two-hour hearing at the Dutch parliament in May 2017, Draghi was grilled over whether quantitative easing was “within the ECB’s framework” that prohibits monetary financing. German tabloids were regularly attacking the Frankfurt-based central bank in their front covers.
These were deeply polarised times, and the central banks were genuinely worried. As the chief economist at the Official Monetary and Financial Institutions Forum at the time, I remember discussing the future of central bank independence in virtually every central bank gathering we hosted.
Climate-related risks as financial risks
Against this background, central banks’ understanding of their roles in the climate agenda was based on concepts of risk.
“Climate-related risks are a source of financial risk. It is therefore within the mandates of central banks and supervisors to ensure the financial system is resilient to these risks.” So read the first progress report of the Network for Greening the Financial System (NGFS) in October 2018. At the time made up of around 20 institutions, this ‘coalition of the committed’ now counts 100 central banks and supervisors as members.
The risk lens is straightforward and now widely accepted. There is no question that climate change is macrocritical. Disruptions to economic activity from rising temperatures, extreme weather, natural disasters, and biodiversity loss are materialising at greater speed, scale and intensity than anticipated.
These so-called physical risks are already materialising. Global losses from natural disasters in 2020 came to $210bn. They are hitting labour productivity and long-term economic capacity: in 2019, over 300bn of potential work hours were lost globally due to high temperatures.
Transition risks are also already crystallising through policy shifts. The Paris commitments have spurred additional regulations and carbon-related taxes and subsidies. Unless properly managed, these could constrain short-term economic output.
There will be consequences for price stability and financial stability, as effects cascade through the system and hinder monetary policy transmission. The response of central banks, while grounded on a narrow interpretation of their mandates viewed exclusively through a risk-lens, has invited scepticism and concern. Some have focused on the political elements of these choices and the potential conflict with the notion of central bank independence. Others have warned about “the perils of asking central banks to do too much”.
Where we are: climate action through a risk lens
The actions of central banks have spanned their functions across monetary policy, regulation and supervision, and their own operations. As monetary policy-makers, they have begun incorporating climate variables in macro modelling and forecasting. Those engaging in quantitative easing have begun exploring how to green their portfolios, or accepting sustainability-linked bonds as collateral. Others have begun upgrading the toolbox of lending facilities by introducing green-targeted lending programmes.
As regulators and supervisors, they have initiated climate stress tests for regulated institutions, which are quickly becoming mainstream. Some have gone even further in adjusting capital requirements by introducing green supporting factors or considering brown penalising factors.
Central banks have also begun leading by example: by integrating environmental, social and governance considerations into the management of their non-monetary portfolios including their foreign exchange reserves and pensions portfolios; by disclosing the climate-related risks of their own operations; and by upgrading their buildings’ energy efficiency.
Where we should go: central banks actively supporting the transition
But as the latest Green Central Banking Scorecard shows, they have much further to go. The times of questioning their independence and the political risks of engaging on climate are not fully behind us. But the scale and urgency of the climate problem and the need for all actors to do ‘whatever it takes’ within their mandate are becoming harder to ignore.
As I write from Glasgow today, countries representing the vast majority of the global economy have committed to net zero, as have financial institutions representing more than $130tn in assets under management under the Glasgow Financial Alliance for Net Zero. The momentum is there. So what more can central banks do?
Central banks have already recognised that climate risks are underappreciated in market prices, which systematically underestimate damages and overestimate the costs of action. They must now act to address this.
They could start by developing an alternative benchmark to replace the ‘market neutrality’ principle for guiding asset purchases. This principle, when narrowly interpreted, induces a carbon bias in central bank operations. Taxonomy efforts – both green and ‘dirty’ – would be a key ingredient to enable this. While not directly central banks’ responsibility, they can support governments in developing these. And they should ensure these reflect the principle of double materiality.
Central banks could then seek to implement a more decisive tilting approach in asset purchases, by penalising dirty as well as supporting green. This could be done through using internal ratings in addition to ratings agencies, or through developing their own minimum standards.
Innovation is also needed to update the toolkit with new and enhanced instruments. Green-targeted lending instruments, such as the ECB’s targeted longer-term refinancing operations, should become mainstream and used beyond the recovery. Deploying macroprudential policy tools for climate action through adjusting capital requirements has not been explored sufficiently. Incorporating sustainability considerations beyond climate to include biodiversity should also be explored further.
In seeking to build on their achievements, central banks should resist excuses to delay action. Imperfections around data are often used as one, as radical uncertainty means that risks are inherently challenging to measure. The NGFS has warned that “when balancing the need for robust and comprehensive data against the opportunity cost of inaction, central banks should be cognisant of the risk that acting early with imperfect information could be less costly than acting only once stronger data standards have emerged”.’
An alternative proactive response could minimise disruption. Taking direction from governments’ commitments embodied in the Paris Agreement and now confirmed in Glasgow, central banks should begin putting guardrails in place, then asking how to keep within them.
The risk of doing too little is much higher than the risk of doing too much.
This page was last updated April 27, 2022
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