Climate Change and Monetary Policy in the Euro Area

This report from the European Central Bank (ECB) analyses the implications of climate change for the conduct of monetary policy in the euro area. It is one of a number of background papers to the 2021 strategy review, which incorporated climate change considerations for the first time.

The paper covers the macroeconomic and financial impacts of climate change and the adaptation of macroeconomic models to reflect these impacts. It also reviews the potential monetary policy measures the ECB can take within its mandate to manage and ameliorate climate risk.

A number of potential monetary policy measures are identified which the ECB could use to address climate risks. These include incorporating climate change criteria in the allocation of corporate bond purchases, requiring disclosures as an eligibility requirement for collateral and asset purchases, and considering climate-related factors in the methodologies employed to calibrate the bank’s risk control framework and valuation methodologies.

Climate stress tests of the Eurosystem balance sheet, the incorporation of climate-related risks in credit ratings, and “green targeted longer-term refinancing operations” are also included as possible monetary policy responses.

The paper shows that as shocks from more frequent and extreme weather events increase, the euro area and global economy will be subject to greater volatility in output and prices. This increased volatility can also result in the effective lower bound interest rate being hit more frequently, particularly if the equilibrium interest rate is also lower.

It also finds that a disorderly transition to a low-carbon economy is “likely to have substantial effects on economic and financial activities, relative prices and inflation, output growth and productivity, and hence on the optimal response of monetary policy”.