Low Carbon Allocation in the Implementation of Monetary Policy

In this document, provided by the European Parliament’s Economic Governance and EMU Scrutiny Unit, Dirk Schoenmaker analyses how the European Central Bank (ECB) can implement low carbon allocation in its monetary policy.

In the paper Schoenmaker, professor of banking and finance at the Rotterdam School of Management, reviews the impact of climate shocks on inflation and suggests policy options for the ECB to decarbonise its asset and collateral portfolio. This, the author says, will “speed up the green transition and decrease the euro area’s fossil fuel dependency”.

The primary policies put forward are green targeted longer-term refinancing operations (TLTRO), changes to capital adequacy rules and capital add-ons, macroprudential exposure limits, and expanding green allocation policies to include bank bonds.

The paper begins by explaining that the “bulk of inflationary pressures” in recent years has come from the rise in energy prices linked to fossil fuels, or fossilflation. Price shocks caused by the physical effects of climate change, known as climateflation, have also had a substantial effect on inflation. However green investments were found to have only a minor effect on overall inflation.

Yet, as Schoemaker explains, the current high interest environment is having a disproportionate effect on renewables investments. Due to the high upfront costs needed for renewables, tighter monetary policy has led to a “sharp decline” in green investment, highlighting the importance of tailored policies to protect green investments.

The ECB’s guiding monetary principle of market neutrality has been shown to have a significant carbon bias, reinforcing the long-term lock-in of carbon in production processes and infrastructure. This exposes the financial system to significant instability with adverse consequences for inflation, and reduces the effective transmission of monetary policy.

However, the ECB has indicated in its strategic review that it is “ready to move away from a strict interpretation of market neutrality”. The paper explains that, to contain climate risks, an orderly green transition must be accelerated, even during a period of monetary policy tightening.

The author recommends a climate-informed risk based approach to allocation policy that fulfils the primary goal of maintaining price stability alongside greening the economy, and reviews four monetary policy options to implement this:

• green TLTROs – create a lower interest rate on green refinancing operations which will incentivise banks to lend to clean-energy and energy-efficiency renovations
• low-carbon allocation of collateral – extend corporate reporting requirements and tilting of collateral frameworks to include bank bonds and asset-backed securities, which form half of the collateral pool, rather than only covering corporate bonds and bank loans
• price stability – a stable investment climate without run-off costs is crucial for green investments
• low-carbon quantitative easing (QE) – future instances should be expanded to include all relevant asset categories, such as covered bank bonds, corporate bonds and asset-backed securities

He also proposes that the ECB adopt two financial policy instruments to bolster financial stability:

• capital adequacy rules – apply capital add-ons to banks with high climate exposures in the supervisory review and evaluation process, and advocate for higher capital requirements for climate risk in international standard setting bodies
• macroprudential exposure limits – set limits on a bank’s aggregate exposure to high-carbon companies to protect the system against banks that are overexposed to transition risk.