Why green lending facilities can solve the ECB’s monetary tightening dilemma

In a speech earlier this month, European Central Bank (ECB) board member Isabel Schnabel confirmed that the green transition was important to fulfil the ECB’s mandate, and signaled the central bank’s willingness to go beyond previously announced climate-related measures.

However, she also seemed to push back on the proposal to implement a green lending facility in order to directly contribute to the energy transition, opposing it to the current cycle of monetary tightening. Such a stance could prevent the bank from delivering on its mandate, while a targeted green lending facility could enable the ECB to both contribute to the EU transition and pursue a counter-inflationary stance.

Even though it marked a shift in the way the central banks consider climate-related matters, the ECB’s “climate roadmap” fell short of aligning the its operations with climate goals. The roadmap failed to fully consider the impact of climate change on the bank’s primary mandate of price stability. As highlighted by a coalition of climate groups, it did not include measures that would cut support to big polluters, nor actively support the EU’s ecological transition.

But times are changing. In recent months, ECB leaders and staff have acknowledged that the green transition would contribute to price stability and, reciprocally, a failure to transition could jeopardise that stability. The logical consequence of this statement should be for the ECB to use its operations to support the transition, and notably to set up lending facilities to help fund green activities. However, this is not yet  the case.

Why? The answer was given to us in Schnabel’s speech.

As Christine Lagarde and ECB researchers have done previously, Schnabel emphasised the relevance of the green transition to ECB’s mandate. She recognises that higher rates could have a negative effect on renewable energy deployment, as well as the potential effectiveness of green lending facilities as a policy tool. Schnabel also goes as far as to lay out priorities to substantially strengthen the ECB climate roadmap, particularly in corporate and public asset purchases, and collateral frameworks. And the board member rightly points out that greater purchases of supranational green bonds (such as those of the European Investment Bank) and tilting ECB’s sovereign bond holdings towards greener bonds could support green investment.

Nonetheless, in an effort to justify the ECB’s monetary tightening at all costs, Schnabel also stresses that green lending facilities should not be deployed under the current restrictive monetary stance. This opposition between tightening and green lending is puzzling as it is possible to combine rate rises with a  lending facility that would provide preferential rates to predefined activities.

Presenting the current tightening policy stance as an argument against setting up a green lending facility could lead the ECB to fail to deliver on its mandate for two reasons.

First, the ECB must ensure both short and longer-term price stability, but Schnabel’s argument prioritises a restrictive policy aimed at suppressing second round inflationary effects in the near term, but at the cost of leaving the EU more exposed to future inflationary shocks due to climate change and new episodes of fossil fuel-induced inflation (otherwise known as fossilflation).

However, the price stability mandate defined by EU treaties is not bound to a specific time horizon. The ECB must ensure price stability in both the short and long term, and therefore must consider the need to support the green transition even when facing an inflationary period.

Secondly, the ECB must not work against EU objectives, and must not implement a policy that hinders key EU objectives if there is an alternative way to achieve the same price stability effects without such negative side effects. Using a dual-rate policy based on a targeted green lending facility would effectively protect the activities needed to achieve the EU transition from the effects of monetary tightening while preserving the impact of this policy for the rest of the economy.

To ensure this, the ECB could start with a green lending facility specifically targeted at energy-efficient building renovations, as suggested by the Unlock coalition of NGOs. Indeed, the ECB has itself underlined that improving building energy performance “will make households and companies more resilient to energy price surges” and “help reduce price sensitivity to volatility in fossil fuel prices”.

Schnabel is right about the legality and legitimacy of green lending facilities and differentiated rates. Newly discovered archival documents show that, when the ECB’s mandate was being drafted, the question of whether ECB instruments should include interest rate differentiation was discussed. It was decided to allow for “rediscounting at a preferential rate with ceilings by bank or for certain types of credit” – in other words, exactly what a green lending facility would require.

Schnabel’s stance reveals a clear contradiction between the fact that the ECB acknowledges the green transition is necessary to achieving price stability, and its refusal to differentiate between polluting and “clean” activities. The central bank’s reluctance to support the transition in the current tightening context could contradict its own mandate. A targeted green lending facility could enable the ECB to contribute to the EU transition while maintaining its monetary tightening stance, thus solving the dilemma.