Why should central banks focus on green finance?

Central banks have a key role to play in global efforts to reach net-zero targets and avert the climate crisis.

Using the tools already at their disposal, central banks can adjust monetary policy and capital requirements to move investments away from fossil fuels and other high-carbon industries, building a future based on green finance instead.

The science is unequivocal. Global emissions of greenhouse gases must end within years to avoid catastrophic climate instability. Through the Paris Agreement, countries have agreed on a target of limiting global heating to well below 2°C, and preferably to 1.5°C, and the International Panel on Climate Change, the International Energy Authority (IEA) and the Network for Greening the Financial System have outlined pathways for the emissions reductions necessary to reach this target.

Climate change falls within central bank mandates

The unique power and influence of central banks and regulatory institutions gives them unique responsibilities in helping the world to move along that pathway. Despite claims to the contrary, addressing the climate crisis falls within the mandates of central banks as maintaining long-term climate stability is essential for financial, economic and social stability.

The climate transition is also a necessary opportunity to support the dual or hierarchical mandates of central banks, whether the Federal Reserve’s employment mandate, the economic growth mandate of the People’s Bank of China, or the European Central Bank’s mandate to support the EU’s general economic policies.

According to the IEA, reaching net zero by 2050 requires a sharp decline in fossil fuel demand. This means that no new oil and gas fields or coal mines and mine extensions are needed. As a result, investment in new fossil fuel projects must end this year if global temperature targets are to be met, making such projects extremely vulnerable to stranding.

Meanwhile, clean energy transition-related investment must accelerate by USD$4tn annually by 2030, making clean energy a much smarter choice for mid-term portfolio growth.

Making green finance the standard model

Although meaningful progress has been slow, central banks and financial supervisors are now recognising their systemic and leadership roles in the transition to a post-carbon world. Significant work is being done to diagnose the problems faced by central banks, and the Green Central Banking Scorecard shows that many banks are doing well on research and advocacy.

Scenario analyses and disclosures are important, but the abundance of variables and radical uncertainty is contributing to analysis paralysis, and central banks risk missing their window of opportunity for action while complacently exploring options. Collected information is not being used to galvanise regulators into introducing effective policies that create disincentives or restrict financial flows to environmentally harmful activities.

High-impact policies that would achieve this include excluding fossil fuels from asset purchase programmes and collateral frameworks, and adjusting prudential tools such as risk weights to effectively integrate the risk of high-carbon lending. This would benefit low-carbon industries and technologies, and make green finance the standard model rather than an ethical option alongside traditional polluting ones.

Many governments have set targets for their economies to reach net-zero, so it is also within the mandates of central banks to support these ambitions. Redesigning the global financial system to favour green finance over high-carbon investments is essential for those net-zero targets to be reached and to build a secure, low-carbon future.

Looking directly up at the sun filtering through tall stems of bamboo