Climate change and monetary policy


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Central banks must do their part in the fight against global warming

The devastating effects of climate change are becoming increasingly evident. Temperature records are broken again this year in Canada, the United States, Arctic Russia and Central Asia. Globally, the past six years have been the warmest on record, and temperatures in 2020 topped the 1850-1900 average by 1.25 ° C (2.25 ° F).

It is not clear exactly how climate change will affect the economy and the financial system. The European Central Bank (ECB) is currently trying to quantify the consequences of climate change on businesses and banks through an economy-wide stress test. The exercise, the results of which will be published shortly, is based on a series of climate scenarios developed by the Network for Greening the Financial System (NGFS), a global association of central banks and supervisors advocating a more financial system. sustainable. These scenarios make it possible to assess the potential impact of climate change on around 4 million businesses around the world and around 2,000 banks in the euro area.

Preliminary results show that without new mitigation policies, the physical risks associated with climate change – heat waves, windstorms, floods, droughts, etc. – will probably increase considerably (Alogoskoufis et al. 2021). The average probability of default of the credit portfolios of the 10% of euro area banks most vulnerable to climate risks could increase significantly – up to 30% by 2050. Businesses across Europe are exposed to physical risks climate change, although the risks are unevenly distributed (see graph).

Faced with these risks, the costs of transition to a carbon neutral economy appear relatively contained (from Guindos 2021). There are obvious advantages to acting early. The transition can be costly in the short term, but the initial investment will likely be more than compensated for in the long term, as companies avoid the increased physical risk and reap the economic benefits of the mitigation. Based on a range of different models, recent IMF research echoes these findings (IMF 2020). The resulting message is simple: now is the time to take ambitious and broad actions to ensure an orderly transition and mitigate the effects of climate change.

The existential threat posed by climate change means that all policy makers must think about how to contribute to the fight against global warming. While governments are the main players, a consensus is forming that central banks cannot sit on the sidelines. The NGFS, made up of eight members in 2017, now has 95 members and 15 observers, including all the major central banks. In 2019, the IMF joined as an observer.

The main reason central banks should increase their attention to climate change is the likelihood that it affects their ability to fulfill their mandates. The main mandate of the ECB is price stability, a goal shared by most central banks. Evidence suggests that climate change has crucial implications for price stability and also affects other areas of central bank competence, such as financial stability and banking supervision.

Climate change affects price stability through at least three channels.

The main reason central banks should increase their attention to climate change is the likelihood that it affects their ability to fulfill their mandates.

First, the consequences of climate change could hinder the transmission of monetary policy measures from central banks the financing conditions of households and businesses, and therefore consumption and investment. Losses resulting from the materialization of physical risks or stranded assets (such as oil reserves that will not be tapped as the world moves away from fossil fuels) could strain the balance sheets of financial institutions, reducing the flow of credit. towards the real economy. In addition, the more insufficient account is taken of climate change, the greater the risks of policy transmission associated with a sharp and sudden increase in credit risk premiums. Central banks themselves are exposed to potential losses – on securities acquired under asset purchase programs and on collateral provided by counterparties in monetary policy operations.

Second, climate change could further reduce the room for maneuver of conventional monetary policy by lowering the equilibrium real interest rate, which balances savings and investment. For example, higher temperatures could adversely affect labor productivity or increase morbidity and mortality rates. Productive resources could be reallocated to support adaptation measures, while climate-related uncertainty could increase precautionary savings and reduce incentives to invest. Collectively, these factors can reduce the equilibrium real interest rate and therefore increase the likelihood that a central bank’s policy rate will be constrained. But it is far from certain; equilibrium rates could instead rise due to green innovation and investment and chart a way out of the current environment of low inflation and low interest rates.

Third, climate change and policies to mitigate its effects may have a direct impact on the dynamics of inflation. Recent history confirms that a greater incidence of physical risk can lead to short-term fluctuations in output and inflation that amplify longer-term macroeconomic volatility. Unless mitigation policies are more aggressive, the risk of even larger climate shocks increases, with more lingering consequences for prices and wages. In addition, even mitigation policies, such as carbon pricing programs, can affect price stability, potentially precipitating large and lasting trends in relative prices and creating a gap between aggregate and baseline measures. inflation.

As a result of these factors, central banks are beginning to integrate climate-related risks into their monetary policy operations.

Towards carbon neutrality

Climate change considerations were an integral part of the ECB’s Monetary Policy Strategy Review which concluded in July 2021. We published an ambitious action plan and detailed roadmap confirming our strong commitment to further integrate climate change considerations into our monetary policy framework. Our comprehensive review of the strategy has shown that there are many areas in which central banks can help in the fight against global warming, and that more may open up in the future.

By analyzing in depth the potential actions and developing the means to make them operational, for example with regard to the classification of more or less “green” activities, the ECB and other central banks can act as catalysts of a system. more sustainable financial. In addition, by announcing changes to our operational framework in advance, we can encourage market players to accelerate the transition to carbon neutrality.

As part of its action plan, the ECB will integrate climate change considerations into its monitoring of the economy, for example by strengthening analytical capacity in climate-related macroeconomic modeling and forecasting.

As part of its statistical function, the ECB will develop new climate-related statistical indicators, for example concerning the classification of green instruments, the carbon footprint of financial institution portfolios and their exposure to physical climate-related risks.

In addition, the ECB advocates consistent and verifiable climate disclosures at international level. The ECB will introduce disclosure requirements for private sector assets, either as a new eligibility criterion or as a basis for differential treatment for collateral and asset purchase purposes, which could help speed up the process. disclosure in the corporate sector. The ECB will start disclosing climate-related information on its non-monetary policy portfolios and its corporate sector purchasing program (CSPP) by the first quarter of 2023.

From 2022, the ECB will carry out weather stress tests of the Eurosystem’s balance sheet, using the methodology of its ongoing economy-wide weather stress test. The ECB will also conduct a review to assess the extent to which credit ratings and asset valuations under our collateral framework reflect exposures to climate-related risks.

The ECB will also incorporate climate-related criteria in its purchases of corporate bonds. In the past, private sector bond allocations were generally guided by the principle of market neutrality, whereby purchases reflect the composition of the overall market, in order to avoid relative price distortions.

However, emission-intensive sectors tend to have large fixed long-term capital investment needs and generally issue bonds more frequently. As a result, the debt eligible for the CSPP and the ECB’s portfolio have a high issuance intensity. (Papoutsi, Piazzesi and Schneider 2021). In other words, upholding the principle of market neutrality is likely to perpetuate pre-existing market failures or even exacerbate market inefficiencies that result in sub-optimal allocation of resources.

It therefore seems appropriate to replace the principle of market neutrality with a principle of market efficiency that more fully integrates the societal risks and costs linked to climate change (Schnabel 2021), taking into account the alignment of issuers with the EU legislation implementing the Paris Agreement.

With its new strategy and new action plan, the ECB recognizes that climate change is a global challenge that requires an urgent political response, including from central banks. As part of our mandate, we are determined to help accelerate the transition to a carbon neutral economy.


ISABEL SCHNABEL is a member of the management board of the European Central Bank.

The references:

Alogoskoufis, S., and others. 2021. “Climate risks to financial stability”. Financial Stability Review, European Central Bank, Frankfurt.

de Guindos, L. 2021. “Shining a Light on Climate Risks: The ECB’s Economy-wide Climate Stress Test. »ECB blog, March 18.

International Monetary Fund (IMF). 2020. “Mitigating Climate Change – Strategies for Growth and Distribution”.
friendly strategies ”, Global economic outlook, Chapter 3, Washington, DC, October.

Papoutsi, M., M. Piazzesi and M. Schneider. 2021. “How unconventional is green monetary policy? Stanford University Working Paper, Stanford, California.

Schnabel, I.. 2021., “From Market Neutrality to Market Efficiency”. Welcome speech to the ECB DG Research Symposium “Climate change, financial markets and green growth”. Frankfurt, June 14.

The opinions expressed in articles and other materials are those of the authors; they do not necessarily represent the views of the IMF and its Executive Board, or the policy of the IMF.

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