Climate change and central banks: what role for monetary policy?

ABSTRACT

Climate change has profound effects not only on societies and economies, but also for the ability of central banks to deliver price stability in the future. Among others, climate change impacts the monetary transmission mechanism, the policy space available to central banks, and has implications for the design of the monetary policy framework. Thus, taking no action is not a viable option, even for central banks without an explicit sustainability mandate. This article establishes a framework for the integration of climate change objectives into monetary policy in the context of the existing central bank mandates. Currently, only in a few cases do such mandates refer explicitly to sustainable growth and development as a policy objective for the central bank. The article discusses several possible ways central banks can respond to climate change, ranging from protective actions to more proactive measures aimed at mitigating climate change by supporting green finance and the transition to a low carbon economy. It also focuses on understanding the constraints and opportunities for action in this arena.

Key policy insights

• Increasingly, central banks are being called upon to support an orderly transition to a low-carbon economy, not only in their financial stability capacity, but also with monetary policy measures.

• Independently of their specific mandate, central banks should consider protective and awareness raising actions, to ensure resilience vis-à-vis emerging climate-related risks and to safeguard the continued smooth conduct of monetary policy.

• Subject to their mandates, central banks should also consider designing monetary operations with green features to proactively support the environmental goals of their respective government.

• While proactive measures have the potential to be more impactful, they are also more controversial unless the central bank has a clear mandate to act on climate.

KEYWORDS:

• Climate change
• monetary policy
• environmental economics
• green finance

JEL classification:

• E52
• E58
• Q50
• Q54

Acknowledgements

The authors acknowledge all the suggestions, comments and contributions made to Boneva et al. (2021), on which this article is largely based. We are grateful to Jan Corfee-Morlot, Climate Policy editor, and two anonymous referees for very helpful comments and suggestions on this and earlier versions of this article. We are solely responsible for any remaining errors. The views expressed in this article are those of the authors and do not necessarily reflect those of the ECB or the Eurosystem.

Disclosure statement

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

Notes

1 Climate Action Tracker (2021), last accessed in November 2021.

2 See D’Orazio (2021), Brunnermeier and Landau (2020), Campiglio et al. (2018), and Campiglio (2016), among others.

3 Physical risk originates from extreme climate events (generating unanticipated shocks to components of demand and supply) and persistent global warming (impacting potential growth). Transition risk pertains to the shift to a low-carbon economy: this requires addressing the market failure propelling climate change and correctly pricing carbon emissions by means of climate policies, sustainable finance and clean technologies, amongst others (NGFS, 2020a).

4 There is now growing attention to the repercussions of physical risk for the banking sector, which plays a key role in the transmission of monetary policies. For example, Pagliari (2021) quantifies the reduction in the profitability of banks exposed to climate events leveraging on a locational database, which matches information about the frequency and severity of flood events in 19 European countries over the period 1980-2014, with balance sheet data of territorial banks, i.e. banks mainly operating in the areas where they are headquartered. Such findings shed light about the impact on central banks’ assets once adverse climate events materialise. D’Orazio and Popoyan (2019) examine the prudential approaches to incentivize the decarbonization of banks' balance sheets and promote green investments.

5 These include, for example, lower productivity and labour supply due to heat stress and higher morbidity (NGFS, 2020a; Laubach & Williams, 2015; Brand et al., 2018).

6 Empirical estimates of the potential economic damage from climate change vary widely. Hsiang et al. (2017) provide a quantification for the United States. The European Commission has funded an ambitious project to quantify the costs of climate change to Europe and estimates can be found in Feyen et al. (2020).

7 The vast majority of IT central banks (41 out of 43) currently base their targets on headline inflation, with only Sweden and Uganda targeting some kind of exclusion measures (see Table SM.1).

8 The pricing of climate risk into financial assets may have relevant implications for portfolio allocations, including for central banks. Multiple studies find evidence of investors requiring compensation for holding financial assets of high-carbon emitters – a carbon risk premium – albeit mainly in the wake of the Paris Agreement (Bolton & Kacperczyk, 2021). Alessi et al. (2021) find evidence of a negative risk premium linked to a firm’s greenness and environmental transparency, based on European individual stock returns. Benmir et al. (2021) discuss theoretically why environmental considerations matter for asset pricing.

9 Examples include the Magyar Nemzeti Bank and the Banco de México, see NGFS (2019).

10 The policy rate is the rate that is set by central banks to implement their monetary policy decision. Effectively, it is the price at which commercial banks can borrow from the central bank.

11 For example, the Bank of Japan has been purchasing Exchange Traded Funds (ETFs) since December 2010.

12 A carbon bias in bank lending is documented, for example, in Van ‘t Klooster and van Tilburg (2020). See also NGFS (2021); De Haas and Popov (2019); and Matikainen et al. (2017).

13 Ideally, actions to mitigate climate change should be anchored in a coherent and coordinated climate legislation: e.g., establishing clear policy mandates and setting shared long-term commitments by means of concerted climate policies conducive to decarbonisation. This might help ‘depoliticise climate action’, making it an overarching framework across electoral cycles. For an overview of such climate change legislation covering a diversity of geographical regions, theoretical approaches and methodologies see Special Issue: Climate Change Acts: Origins, Dynamics, and Consequences, Climate Policy, Vol 21, Issue 9, (2021).