Central banks are being forced to rethink their roles in light of climate and nature risk, and the transition to a net-zero, nature-positive economy. They’ve made enormous progress in the last decade, with Eurosystem central banks and others in the Network for Greening the Financial System taking a leading role.
But the paradigm shift is incomplete. Although the risks are well understood, the next step is to further embed these into the policy response. The European Central Bank’s (ECB) on-going strategy review – only its third ever – is a rare opportunity to take stock of this progress and plan a way forward. Here’s what needs to happen next.
No backsliding on addressing climate and nature risk
The Eurosystem (of which the ECB and other Eurozone central banks are members) has led global efforts to understand climate- and nature-related financial risk. We now have supervisory frameworks with clear sanctions, innovative stress testing exercises underpinned by internationally-recognised scenarios and a robust debate on climate change’s impact on monetary policy.
This is as it should be and yet sustainability is under attack from both outside and within the EU, seen as a distraction from serious issues like geopolitics, defence and competitiveness. Against this challenging backdrop, there is no room for complacency. Central banks mustn’t dodge their duty to take all risk seriously and protect the financial system, regardless of the politics of climate change, nature loss and the net-zero transition.
Backtracking on progress made so far would amount to central banks burying their heads in the sand when confronted with the evidence. We’ve seen regulators do that before (most notably ahead of the great financial crisis of 2007-2008) and, having suffered the consequences, they have rightly resolved to do better in future. Playing ostrich is not a good look for watchdogs.
Climate and nature risk are part and parcel of central banks’ primary mandate, not a nice-to-have. The European Banking Authority (EBA) confirmed this with its recent ESG guidance: climate and nature risk drive financial risk in all its forms, so firms and regulators should act accordingly to guard against it. This creates a solid legal basis for this agenda – backsliding would mean breaching the obligation to act.
Further embedding climate and nature risk in policy tools
Phase 1 in addressing climate and nature risk has been getting the right data and understanding it – phase 2 is actually doing something with that information.
The Eurosystem has tackled phase 1 admirably, although of course it will never be finished. Progress on phase 2 has been slower and much more work is needed in the medium and long term.
For example, European supervisors’ climate stress tests are laudable but the standard tests don’t include climate and nature. These issues don’t exist in a bubble – the Basel Committee considers them to be part and parcel of existing risk types. There are also no dedicated macroprudential tools to tackle how climate and nature risk might manifest in the financial system as a whole, and there has been limited work done to factor it into existing tools.
And while European central banks have done plenty on supervising climate and nature risk in individual firms, they are only just beginning to impose prudential consequences for poor risk management and mitigation. More work is also needed on understanding how these risks should feed into regulatory capital requirements.
On the monetary policy side, existing frameworks are designed to tackle demand-side shocks and tools. But climate change and nature loss are causing increasing supply-side shocks, which current toolkits can address only indirectly.
This could result in poorly targeted and overly restrictive monetary policies, potentially hampering both their effectiveness and the economic growth that central banks should support as part of their secondary mandates. Luiz Awazu Pereira da Silva, a former deputy general manager at the Bank for International Settlements, recently co-authored a paper in which he suggested a re-think of inflation targeting to better reflect this new reality.
To address these points, the Eurosystem should follow the spirit of the ECB’s climate and nature action plan to its logical conclusion, making sure that existing toolkits are fit for purpose and reforming them where they fall short. It should also embed climate and nature risk into everything it does at a structural level, as the EBA recommends firms should do.
To do this, the Eurosystem central banks must work on three critical areas, aiming in time to:
- protect the financial system with a revised macroprudential toolkit and strengthened microprudential supervision. This should include more realistic stress testing, adequate capital requirements and credible transition plans, all supported by supervisory action;
- protect the economy by re-thinking monetary policy frameworks and macro-economic modelling to ensure it can withstand the sustained supply-side shocks that climate change will inevitably bring;
- protect their balance sheets with solid collateral frameworks that reflect the fact that fossil fuel assets are riskier, as the European Insurance and Occupational Pensions Authority recently concluded.
Thinking systemically and outside the box
Central banks can be rather siloed, specialised organisations. But in continuing to act on climate and nature risk, the Eurosystem should be careful not to become trapped in existing ways of thinking.
As landmark book The Green Swan – co-authored by one of this article’s authors, Morgan Després – laid out: radical climate uncertainty and the risk of a chaotic transition call for a holistic approach. That means thinking about the causes of climate and nature risk rather than just the symptoms, and about the upstream and downstream effects of individual policies.
Proper coordination between policies and tools is key. Monetary, macroprudential, microprudential and fiscal policies all have a role to play but are all interconnected. The Eurosystem should also look to other climate and nature policies beyond its own, for example considering how its supervisory and collateral frameworks depend on data gleaned from mandatory sustainability disclosures.
As with other central banks, Eurosystem members are juggling action on changes already underway while at the same time anticipating future headwinds. Climate change and nature loss are already causing losses for firms and will likely increasingly unsettle the financial system.
This also creates trade-offs between mitigation and adaptation. Although central banks will inevitably feel the consequences of this, it remains a relative blind spot for them. And this is a dynamic exercise: geopolitics and technological advances such as artificial intelligence may drastically change the transition’s cost and change curves.
The Eurosystem should assess some elements as both upstream and downstream considerations. For example, we need better modelling on the monetary and financial stability impacts of financing gaps for mitigation and adaptation. But central bankers should be aware of how monetary and prudential policy may also contribute to those financing gaps.
In the long term, the Eurosystem might explore how to mitigate monetary policy’s potentially distortionary impacts on the transition by repurposing existing policies and adapting them to support green assets.
In a world where global co-ordination will be increasingly challenging, the Eurosystem’s leadership is more important than ever. The Eurosystem should continue leading the way and using its influence to foster other countries’ ambition, levelling the playing field for European actors and limiting global risk contagion.
Central bankers are by nature reluctant to rock the boat, but a reluctance to adopt new ways of thinking may steer us into choppy waters by default. Instead, they must think big and adopt what were previously considered radical ideas to address climate and nature risk in an uncertain world.
This page was last updated April 2, 2025
Written by
Daphné McRae leads on central banking work at the European Climate Foundation. She is a former climate analyst at the Bank of England, where she represented the UK at the Network for Greening the Financial System and the Basel Committee's Task Force on Climate-related Financial Risks. She later led on green finance strategy at the UK Treasury, working on G7 negotiations and co-founding the Transition Plan Taskforce.
Morgan Després is executive director for international climate finance at the European Climate Foundation. Previously, he worked in the French official sector on financial stability, and international and European financial regulation issues. He was the founding head of the Network for Greening the Financial System, and is co-author of The Green Swan: Central Banking and Financial Stability in the Age of Climate Change.
