Some argue that central banks could intervene in the financial system to avert risks from climate change, as markets fail to price them in sufficiently.
Specifically, some believe that they could help rectify the mispricing of carbon and climate-related risks.
As early as 2015, Mark Carney, the governor of the Bank of England, pointed out that the cost conundrum lies in the “tragedy of the horizon” that climate change causes, as it “imposes a cost on future generations that the current one has no direct incentive to fix”.
Frank Elderson, the chair of the Network for Greening the Financial System (NGFS), a group of central banks and supervisors, said that it “recognises that there is a strong risk that climate-related financial risks are not fully reflected in asset valuations”.
Less than 5% of global emissions covered under carbon pricing initiatives are priced at a level consistent with achieving the goals of the Paris Agreement; ie $40/tCO2 (€36.2/tCO2) to $80/tCO2 by 2020 and $50/tCO2 to $100/tCO2 by 2030, according to a 2019 report by the World Bank Group.
This raises doubts whether enough political willpower can be found to achieve them.
The International Monetary Fund (IMF) said in a 2019 working paper: “Market failures, unaddressed and exacerbated by government failures, prevent an appropriate market response to the challenge of mitigating climate change.”
It concluded that while fiscal tools, such as carbon pricing, are first in line and central, they may need to be complemented by financial and monetary policy instruments.
The role of central banks
Yet, whether central banks should apply monetary policies to mitigate climate-related risks in the financial market is controversial.
Opponents say that this would counteract the mandate of central banks to preserve price stability and follow the principle of “market neutrality”, and could lead to a distortion.
Jens Weidman, the president of the Deutsche Bundesbank, argued in a recent speech that central banks lack the democratic legitimacy of politicians to intervene.
His comments came shortly before Christine Lagarde, the previous head of the IMF, replaced Mario Draghi as president of the European Central Bank (ECB).
Lagarde suggested earlier that the ECB could apply green criteria to its asset purchase programme once the EU’s taxonomy for sustainable activities, a classification system for green activities, is completed.
Christine Lagarde, president of the ECB
Proponents of central bank intervention believe that their primary objective is to protect financial stability.
The NGFS stated at the end of 2018 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,” it said.
Climate risks redefine central banks’ mandate
Benoît Cœuré, member of the executive board of the ECB, said in a speech at the end of 2018 that mitigating climate risks can fall within the mandate of central banks.
“If left unchecked, [climate change] may increase the likelihood of extreme events and hence erode central banks’ conventional policy space more often, and it may raise the number of occasions on which central banks face a trade-off forcing them to prioritise stable prices over output.
“Put simply, the longer the risks of climate change are ignored, the higher the risks of catastrophic events, possibly with irreversible consequences for the economy,” he concluded.
Ulrich Volz, founding director of the SOAS Centre for Sustainable Finance, a research hub part of the SOAS University of London, goes as far as calling the principle of market neutrality a myth.
He argues that central banks have in the past, and will continue to, influence markets via conventional or unconventional policies.
“The problem that we have with quantitative easing (QE) policies over the past years, which the main central banks have conducted, is that these asset purchases have been very heavily-tilted towards high carbon,” Volz says, in spite of the declared climate goals of the Paris Agreement.
A policy paper by the London School of Economics and Political Science in 2017 confirmed this.
It found that the QE programmes of the ECB and the Bank of England were disproportionately skewed towards high-carbon sectors, despite the central banks’ intent to be neutral.
Central banks implement climate policies
Meanwhile, central banks have begun to adapt to the transition.
The NGFS found in a recent member survey that 25 out of total 27 respondents have adopted socially responsible investing principles in their investment approaches, or are planning to do so.
In 2019, the De Nederlandsche Bank (DNB) became the first one to sign the Principles for Responsible Investment.
The DNB has also started to stress test its financial system against energy transition risks, while the Bank of England announced that it will stress-test the UK financial system for climate resilience.
In 2020, the NGFS plans to publish a manual for supervisors that sets out how climate risk can be integrated in supervisory frameworks, according to Aerdt Houben, director financial markets at the DNB.
The power of green QE
While green QE is just one of several tools that central banks can apply, it has received attention because of the immense magnitude that QE asset purchases could have on the financial market.
Yet, given the small size of the current green bond market, making up less than 1% of the total bond market, it is unrealistic as of today, explains Volz.
“Green QE would basically mean that central banks would suck up the entire green bond market and they still wouldn’t find enough assets,” he says.
Cédric Merle, sustainable finance expert
at Natixis CIB Green & Sustainable Hub
Cédric Merle, sustainable finance expert at Natixis CIB Green & Sustainable Hub, believes that it could be implemented by 2025.
He says: “If there is a political consensus, if the taxonomy is adopted and strongly supported, and there is a sufficiently large pipeline of assets that meet the taxonomy criteria, then it would be possible to implement green QE.”
The call for a brown taxonomy
Merle argues that the effects of green QE in terms of decarbonising carbon-intensive industries will be limited as long as a “brown” taxonomy is missing.
So far, the EU has focused its efforts on establishing a “green” taxonomy to spur such investments and avoid greenwashing. Discussions on the need to establish a “brown” taxonomy, or classification of carbon-intensive activities, are still ongoing.
DNB’s Houben concurs: “From a risk perspective, it would be helpful if the European Commission broadens the taxonomy to also include a classification of brown activities, as these may be more prone to transition risks,” he notes.
Merle explains: “We cannot extrapolate the green taxonomy and conclude what falls outside should be considered as brown and requires higher capital requirements.
“We need data to monitor and track the risk profile of the underlying assets. We need to monitor the non-performance ratio and the risk of those brown assets,” he adds.
Central banks as safety net
Investors can be put off investing in green assets because of the difficulty to assess the likelihood and timing of sustainable transition scenarios, Dutch asset manager PGGM wrote in an article.
“When probabilities and their impact become clearer, pension funds will commit more capital to the sustainable economy,” the article states.
Climate-related policies by central banks, which can help to fast track the low-carbon transition, could thus carry an important signaling effect to investors.
Merle explains that “if we continue to fail on those conventional policies, we might need to consider unconventional policies, mainly central bank policies”.
Green QE, he believes, would be a strong incentive for companies and issuers and lead to an increase of green assets. “There might be a pricing benefit for issuers because it will grow the demand for this kind of debt, ie green bonds that are EU Green Bond Standard compatible,” he suggests.
Brenda Kramer, senior advisor responsible investment at PGGM, agrees that a green QE programme “could, theoretically, decrease the cost of capital for green companies eventually, and more importantly increase the cost of capital for polluting companies”.
Volz emphasises that central banks have a duty to act and price in climate-related risks.
“Markets may speculate, governments may or may not act on it, but I would argue that central banks as public bodies should assume that the [Paris] policy targets, that have been announced, will be implemented sooner or later,” he says.
