However, some central banks (such as in the Eurosystem) are also subject to secondary mandates to support the economic policies of the states in which they operate. In those cases, central banks could have a legal responsibility to go beyond the risk lens – without prejudice to their core objectives – and actively support the transition. This means focusing not just on how climate change affects the financial system but also, reflecting a double materiality principle, how the actions of actor in the financial system contribute to the acceleration of the climate crisis, or to its solution.
In practice, this involves as a first step developing new tools and using existing ones to correct market failures and internalise mispriced risk. For example, central banks could look to revisit the ‘market neutrality’ principle guiding asset purchases as it has been shown that this can lead to a carbon bias that stands in contrast to their government’s net-zero transition plans. Following this, central banks can direct capital by deploying a ‘tilting approach’ to asset purchases that penalises assets that contribute to the climate crisis and supports those that contribute to its solution. Other options, already employed by some central banks, include green targeted-lending programme or adjusting macroprudential tools such as capital requirements.
KPP: How do you see the role central banks actually play in the fight against climate change? Are these actions appropriate taking into considerations the legal mandates of central banks?
DK: Central banks have come a long way in recognising the role they can play in the biggest challenge that faces humanity today. This has happened in a gradual and cautious way, and has always been presented in relation to their mandates. This is partly explained by the circumstances in which the central banks’ climate agenda emerged.
The critical period spans across 2015 with Mark Carney’s ‘tragedy of the horizon’ speech, to 2017 with the creation of the NGFS, to 2019 when the NGFS reached ‘critical mass’ with its members covering the majority of the global economy and carbon emitters. That period, after the global financial and euro area crisis and before the Covid crisis, was also a time when central banks were at the spotlight for taking on too much in relation to their operations to generate a recovery, particularly asset purchases in developed economies.
This profoundly shaped the way they understood and publicly defined their role in the climate agenda, being very careful to link any action and argument to their mandates, and grounding the agenda on concepts of risk. The first progress report of the NGFS in October 2018 for example was careful to state that “Climate-related risks are a source of financial risk. It is therefore within the mandates of central banks and supervisors to ensure the financial system is resilient to these risks.”
Addressing climate change is thus primarily about enabling central banks to achieve these core price (financial and macro-) stability objectives. It is clear that addressing these objectives is no longer possible without understanding the implications of climate change for the financial system and preparing it for them. While the primary responsibility is of course with governments, the financial system that central banks oversee will have to fund the transitions. There should be no doubt that they will have to play a core role in ensuring risks are acknowledged and priced in – especially in the face of market failures. And, depending on mandates and their interpretations, some might be tasked to do even more.
To date, I would argue that there haven’t been instances where central banks have braved to take on actions that would be remotely questionable in relation to their mandates. This is not necessarily a positive thing – given the scale of the climate challenge central banks can afford to push further and be bolder in their actions. Looking back at the history of central banking, institutions have often been able to rapidly rethink their approaches in the face of emergencies so we know that this is possible.
KPP: The growing activity of central banks concerning environmental sustainability can put into question the independence of central banks which is considered crucial related to their price stability mandate. What is your opinion about that potential conflict?
DK: In many jurisdictions, central banks are often ranked among the most trusted public institutions. This level of trust is an important asset, but also bestows on them the responsibility to continue to protect it by continuing to be seen as independent institutions removed from the temptations to act without consideration for the long run that come with being subject to a political cycle.
Climate change entered most central banks’ agenda at a time when their independence was under attack over their unconventional monetary policies. This generated scepticism among some in relation to the climate agenda, and an unwillingness to engage in an issue that may be interpreted as political. For example, in a speech on climate change and central banking in November 2018, Yves Mersch, executive board member at the ECB at the time, warned that ‘The bigger threat to price stability over the long run does not lie in relative price changes [caused by climate change], but rather in a loss of independence by central banks following a situation in which they have ventured far into a political agenda with distributional consequences.’
However, times are now changing. As more evidence becomes available about the scale of the climate challenge and its potential impacts on the economy and the financial system, the more relevant question today is not whether central banks are doing too much to the extent that it would damage their independence, but whether they are doing enough.
The rationale for central bank independence is rooted in the ability of central banks to deliver stable prices in the face of short-term temptations that politically elected institutions may face. As I have argued previously, this ability is preserved by pursuing the right policy options and delivering good results, not by refraining from doing so to defend a reputation for independence for independence’s sake. If fear of losing independence ends up preventing central banks from pursuing the right policies and using the tools appropriate for the conditions they face, this can risk being the very reason why they end up losing their independence.
KPP: In the short run, what would be your most important advice to central banks? Some are focusing more on prudential regulation, some on integrating green aspects into monetary policy, and others on making reporting concerning climate impact mandatory. What is your position on that?
DK: Overall, all central banks that have not done so already will have to acknowledge the far-reaching implications of climate change, expand their analytical frameworks and assess the broader economic stability implications. In terms of responding by creating the financial architecture to address these realities, appropriate next steps will be different for different central banks and will depend on four broad factors.
First, their specific mandates. Central banks with a secondary mandate to support the transition can take bolder action than those with just a price stability or a price and financial stability mandate. In the case of the latter, central banks may focus on liaising with governments to explore ways in which their mandates can be updated to reflect new realities. For example, the Bank of England’s remit was updated in 2021 to explicitly include reference to its obligations in relation to the climate agenda. Central banks in emerging markets and developing economies also often have much broader mandates and are involved in their countries’ broader sustainable development policies.
Second, the climate circumstances in their jurisdictions. Some countries, particularly in the Global South, will be more exposed to natural disasters, or will struggle more with raising the funding and resources needed to address them. Appropriate action in those cases may involve scaling up sustainable capital markets with products such as catastrophe bonds, or strengthening the insurance market. Others may expect to be hit harder by gradual changes in temperatures, which may require directing capital towards renovating and building climate-resilient infrastructure.
Third, the economic circumstances. Oil-exporting economies, for example, will be more exposed to transition risks. Economies where the financial sector does not play a major role or where the informal economy is big, may face lower risks of financial instability but may still see their economies hurt by climate change. Focusing on the potential impacts on financial stability will in such cases not be the most appropriate course of action as it may distract from the bigger picture.
Fourth, at which point of their ‘climate journey’ they are. Central banks who started their journey later than others do not have the luxury to take the same steady, slow path. They must accelerate action now and catch up. Climate change is not going to wait.
Kolozsi Pál Péter
Danae Kyriakopoulou is Senior Policy Fellow at the Grantham Research Institute on Climate Change and the Environment at the LSE where she leads the policy work on climate and economic development. From 2016 to 2021, she was the Chief Economist and Director of Research of the Official Monetary and Financial Institution Forum (OMFIF). As part of this, she set up the Sustainable Policy Institute and served as its Managing Director and Chair of its Advisory Council, of which she is now a member. Previously she was Managing Economist at the Centre for Economics and Business Research. She holds a BA in Philosophy, Politics and Economics and an MSc in Economics for Development from the University of Oxford.
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