An Evolution to Facilitate a Revolution

In the decades leading up to the Global Financial Crisis (GFC), a consensus emerged around central banking best practice: an independent monetary policy authority tasked with delivering price stability to optimise savings, investment, and production decisions while encouraging the labour market towards full employment. 

Calls in the post-GFC period for central banks to take action against the climate challenge were met with the traditional central banking view that doing so would be a distraction from core principles, dilute the focus on price stability, and ultimately erode hard-won independence.

These arguments weakened in the aftermath of the GFC and in response to the COVID-19 pandemic, as it emerged that central banks’ “market-neutral” asset purchase programmes resulted in an unintended bias towards carbon-intensive industries. For example, slightly more than 60% of the European Central Bank’s corporate bond purchases were in sectors responsible for approximately 60% of Euro area greenhouse gas emissions, but only contributed slightly more than 20% of the euro area economy’s gross value added. 

The unintended consequences of asset purchase schemes demonstrated that monetary policy was not just ignoring climate change, but running counter to Government objectives for net-zero emissions by underwriting securities from carbon-intensive issuers. 

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As such, it underscored the need for the policies of these technocratic institutions to be coherent and consistent with medium-term government objectives. Moreover, it highlighted the risk that ignoring reasonable public expectations threatened the independence of central banks through government intervention. 

Central Banks and Climate Change 

A body of frontier research indicates that climate change threatens the core functions of central banks, including price stability, financial stability as well as the safety and soundness of financial institutions. For example, rising agriculture and food prices could lift headline inflation rates, while climate vulnerability could affect asset valuations with implications for institution-specific and system-wide risks. Therefore, central banks need to monitor and understand the implications of climate change in the same way they approach other slow-burn issues outside of their normal purview, such as demographics, globalisation, and technological innovation. 

More importantly, institutions’ market pricing needs to reflect the risk of climate change in order to optimise their capital allocation decisions, and many significant global institutions have yet to price in these risks. For example, a recent European Central Bank (ECB) analysis finds that almost none of the institutions that it supervises meet the climate disclosure requirements set out by the Taskforce on Climate-related Financial Disclosures (TCFD). 

Efficient allocation of capital is of the utmost importance given the sheer amount of investment needed to achieve net zero emissions. The International Energy Agency (IEA) estimates that nearly US$150 trillion ($204 trillion) in cumulative investment is needed over the next 30 years to meet the Paris Agreement’s climate goals. And much of that investment needs to be frontloaded over the next decade. 

Not surprisingly, the woefully large ‘investment gap’ in the trillions of dollars indicates that capital is not flowing quickly enough to where it is needed the most. Given the scale of the climate challenge, alongside central banks’ primary objective of optimising the allocation of scarce resources, it seems difficult to argue that central banks have no role in addressing climate change. 

When put another way, in a free society, it would be considered intolerable for a respective central bank to remain unresponsive in the face of mass unemployment. Likewise, a view is coming into focus that it is similarly unacceptable for central banks to ignore the observation that capital is currently mispriced and, as a result, is not flowing to where it is needed most to meet societal objectives. 

This does not suggest a promotional role for central banks in the sphere of climate change. However, it highlights that central banks have a duty to ensure that their policy actions are aligned with medium-term Government objectives as they seek to maintain their legitimacy and independence. 

THE CHALLENGE FOR MODERN CENTRAL BANKING 

Among developed market central banks, a consensus has emerged that climate change poses risks to the macro financial system. Yet, in order for central banks to conduct monitoring and risk assessment and to ensure financial sector resilience (through stress testing, for example) a disclosure framework is required. The TCFD provides such a framework, but the UK is the only country to make the standard mandatory thus far. 

The topic of whether central banks should take an active role, particularly with the use of monetary instruments, to fight climate change is more controversial. For those central banks with secondary mandates to support government economic objectives and sustainable growth, such as the ECB and the Bank of England, many now agree that a change in mandate is neither desirable nor needed. 

In general, central banks requiring legislative measures to adjust their mandates face steeper hurdles in proactively addressing climate change, and those without legislative legitimacy risk their credibility if they appear to be freelancing on the issue. 

In instances where central bank mandates support addressing climate change, the subsequent challenge is to ensure that policy action is fit for purpose and not cycle dependent. For example, it would be counterproductive for central banks to limit themselves to climate change support when in an easing cycle. Moreover, studies have shown that skewing central bank purchases towards green assets would likely be too small to make a meaningful difference. 

More generally, central banks should avoid picking “winners and losers” in the green transition and instead ensure that market functioning delivers the desired outcome.

Similarly, it would be an inappropriate use of macroprudential policy, which is aimed at building balance sheet resilience, to actively direct financing towards sustainable investments. But there is a case to be made for central banks to “walk the talk” on managing and disclosing the climate change risks on their own balance sheets, as required by other financial institutions.

AN UPDATED APPROACH 

This essay argues that central bank action on climate change is wholly consistent with the traditional view that central banks should facilitate the efficient allocation of resources and are most effective when free from short-sighted political influence in an effort to achieve longer-term societal objectives. Moreover, those central banks with secondary objectives to support Government policy do not need a change in mandate to incorporate climate change, it simply requires a shift in policy emphasis.

Central banks have historically taken a leading role in setting financial regulation, such that prices reflect complete information to incentivise desired investment behaviour.

Disclosure of climate-related risks will similarly enable prices to drive investment behaviour towards a green transition. Central banks need to work together to develop and implement best practice as we have seen from the Financial Stability Board and the Network for the Greening of the Financial System. Further co-operation will help mitigate regulatory arbitrage, complexity, and greenwashing. 

Climate-related disclosures will subsequently enable central banks to effectively conduct surveillance of institution-specific and systemic risks. It would allow for scenario analysis and stress testing, such that capital buffers can be adjusted accordingly to ensure financial system resiliency across a breadth of scenarios. 

Central bank monitoring should also include the impact of climate change on the macroeconomic outlook, much in the way that central banks monitor employment trends relative to full employment, but leave the role of labour market policies to governments. Central banks can use their in-house expertise to incorporate climate change into macro models and develop scenario analysis to shed light on questions such as: is the economy on track to build a capital stock that will achieve its climate goals? Other issues of exploration could include conducting surveys to judge whether firms have sufficient access to financing avenues needed to support their green transition. 

A NEW PHASE 

The evolution in central banking that occurred over the course of two crises appears to be on the cusp of a new phase to address the existing crisis of climate change. For many institutions, the changes may be subtle at first. Rather than mandate changes, these central banks may shift policy emphasis to better align with medium-term government objectives. However, over time, the changes could become more pronounced as central banks’ core function of efficiently funnelling capital to where it is needed most requires greatly improved climate-risk disclosures—particularly as it pertains to their own policies and balance sheets. 

Central banks can act as role models in their own portfolio management by ensuring that their balance sheets account for climate change risks and are consistent with government targets. Moreover, central banks’ recognition of their unique position to influence capital formation can further enhance their legitimacy and protect their independence. 

Yet, mission creep will be a risk. Central banks will need to draw a clear distinction between their unique – but ultimately limited – role in facilitating the efficient flow of capital and proactive government climate policies. Institutions that are able to successfully navigate the fine line between core functions and activist policies may provide economies with much-needed support in their revolution to fight climate change.  

Katharine Neiss is chief European economist at PGIM Fixed Income.