Green central banking: reorienting finance through a recalibration of monetary policy

ABSTRACT

This paper examines how monetary policy can be calibrated to promote a greening of finance. The paper reviews existing literature and notes a tendency to either focus narrowly on one policy instrument or provide a menu of options, without much depth or discrimination. This Perspective paper undertakes a theory-based analysis of green monetary policy options using an institutional approach to monetary economics. In so doing, it identifies a policy mix that would reorient finance by structurally modifying the relative incentives of financing green vs dirty assets. More specifically, the proposed green central banking strategy consists in the combined adoption of several, recalibrated monetary policy instruments. The two main ones are core elements of central banks’ collateral policies: making (more) green assets eligible in credit operations with central banks and using so-called ‘haircuts’ to give green assets preferential treatment over dirty assets in those credit operations. Combined, the adoption of the proposed, recalibrated instruments promises to reorder the collateral asset hierarchies that are the backbone of modern financial systems, providing strong financial incentives for enhanced financing of investment in green assets and divestment from dirty assets.

Key policy insights

• Monetary policy can help speed up a greening of the financial sector.

• Enhanced financing of green assets, as well as divestment from dirty assets, can be incentivized through a range of monetary policy tools.

• Among the most potent green monetary policy tools is differentiated treatment of green and dirty assets in credit operations, known as collateral policy.

• Several green monetary policy options can be pursued without compromising other monetary policy objectives (such as price stability).

• While most central banks currently remain reluctant to engage proactively with such policy tools, the increasing manifestation of climate change is likely to erode such resistance in coming years.

KEYWORDS:

• Climate change
• green central banking
• collateral-based finance
• monetary policy
• haircuts

Acknowledgements

Comments on a previous version of this paper from Perry Mehrling, Thomas Ferguson, Peter Gibbon, Louison Cahen-Fourot, Jan Corfee-Morlot and three anonymous reviewers are gratefully acknowledged.

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

1 D’Orazio and Popoyan note that ‘only the People’s Bank of China has a dedicated policy to promote green finance via monetary policy’ (D‘Orazio & Popoyan, 2022, p. 2), but the ECB recently launched a green monetary policy (see Dafermos et al., 2022b). On China, see Macaire and Naef (2022); on Japan, see D‘Orazio and Popoyan (2022).

2 The dichotomy of ‘defensive vs proactive’ is at times framed as ‘protective vs proactive’ (Boneva et al., 2021, p. 1) or ‘prudential vs promotional’ (Baer et al., 2021, p. 3).

3 ‘In a world where the impacts of climate change become ever larger […] the cost of not engaging the central bank in the promotion of sustainable finance may become prohibitively high’ (Dikau & Volz, 2021, p. 2).

4 The objective of deploying monetary policy instruments to mitigate climate change is what ‘interventionist’ approaches to the green role of central banks have in common, whether labelled promotional (Baer et al., 2021), precautionary (Chenet et al., 2021) or proactive (Boneva et al., 2021).

5 ‘Green’ signifies an objective to address a range of environmental issues, from biodiversity loss to climate change.

6 See Mehrling (2011, 2012, 2013, 2014, 2015, 2017, 2022) and Mehrling et al. (2013).

7 CMF has been developed by Daniela Gabor and colleagues, see Boy and Gabor (2019); Gabor (2016); Gabor and Ban (2016); Gabor and Vestergaard (2016, 2018); Vestergaard and Gabor (2022).

8 A key lesson of the global financial crisis was that in modern financial systems, crisis interventions must target collateral markets; central banks managed to tame the financial crisis only as they appreciated that backstopping the value of collateral assets was essential (Cœuré, 2016; Gabor & Ban, 2016; Gabor, 2016; Goodhart et al., 2014, Vestergaard and Gabor).

9 Borrowers often pledge government bonds as collateral because they usually exhibit a low degree of price-volatility and hence are considered ‘safe assets’.

10 Monnin (2018) provided the first comprehensive analysis of how collateral policies of central banks are biased toward carbon-intensive sectors. For recent work, see Dafermos et al. (2020, 2022a).

11 A broad mode of negative screening could also be detrimental to ongoing transition efforts of carbon-intensive companies by impeding their access to financing for those efforts.

12 All modes of preferential treatment of green assets in monetary policy should be pursued only against an authoritative standard for what counts as green assets (see section 4 for an example of how it could be done); otherwise, there is considerable risk of inadvertently boosting greenwashing.

13 Another advantage of differentiation over exclusion, is that the former much less than the latter risk short-circuiting ongoing transition efforts of carbon-intensive companies.

14 ‘Depending on the availability of aligned assets, counterparties may face challenges in flexibly constituting an aligned collateral pool and managing it over time’ and ‘the requirement may imply a significant decrease in corporate assets in the pledged collateral’ (NGFS, 2021, p. 40).

15 If several institutions fail to meet the reference value, the collateral pool approach could impede monetary policy effectiveness more generally.

16 This modality should not be binary but operate on a continuum constructed so as to ensure that even small increments in the share of green collateral are incentivized.

17 The full range of green monetary policy instruments is explicated in Annex 1 of the report by NGFS (2021, pp. 31–45). The instruments reviewed are: differentiated interest rates vis-à-vis counterparties’ climate-related lending or composition of pledged collateral; lending facilities that are contingent on counterparties’ disclosure of climate-related information; adjusted haircuts; negative and/or positive screening in collateral policy; alignment of collateral pools; tilted asset purchases; and negative screening in asset purchase programs. See also BIS (2020) and Dikau et al. (2020).

18 For early work on environmentally differentiated haircuts, see Schoenmaker (2019) and Gabor (2020). For a fourth model, see the proposal by Dafermos et al. (2021, p. 22) to adopt a ‘shades of dirty and green’ approach, whereby haircuts on corporate bonds are environmentally differentiated based on four factors: carbon intensity; share of non-renewable energy in total energy use; decarbonisation achieved; and alignment of decarbonisation plans with the Paris Agreement.

19 McConnell et al. (2021, p. 6) see brown collateral haircuts as the ‘most promising instrument for green monetary policy’. They also discuss an approach they label ‘green hairgrowth’, by which the collateral value of green assets would exceed their market value. Noting that this would be unprecedented, they dismiss the option since it ‘does not adhere to the market neutrality principle’ and is a ‘less favorable instrument than brown haircuts’ (McConnell et al. (2021, pp. 6–7).

20 Green taxonomies are being developed by multiple countries all over the world; the EU Taxonomy is used here for illustrative purposes. For a taxonomy of green taxonomies, see BIS (2021).

21 For another deployment of the EU Taxonomy in a green monetary policy proposal, see Van’t Klooster and van Tilburg’s (2020) work on green asset purchases.

22 Environmental differentiation of haircuts need not be applied only to corporate bonds; they can be relevant for other asset classes too, including government bonds.