Central banks are financial institutions with authority over the production and distribution of an economy’s money and credit. Typically, they are responsible for creating monetary policies and regulating member banks by keeping inflation low and GDP growth steady. Financial stability refers to the capability of a financial system to withstand shocks and imbalances. Central banks work to minimise disruptions that can cause economic activity to contract.
Climate change can have different impacts on the economy, and central banks need to recognise them. Typically they can be classified into physical risks and transition risks. Physical risks include natural disasters, rising sea levels, drought etc. and can cause severe damage to infrastructure and private property. Agriculture is also affected by the devastation of crops, and that impacts food prices. Furthermore, there is the disruption to economic activity, global supply chains and trade, which can create a shortage in resources and divert essential capital from productive uses to repairing damages. It also brings transition risks as certain actions need to be carried out when moving towards a low carbon economy – these can have a significant effect. This includes the risk of technological change or consumer sentiment when certain products see a decline in demand (diesel cars being a prime example with the introduction of electric cars). Transition risks also need to be carefully managed through strong and effective policymaking.
Climate change is one of the biggest challenges facing economies around the world. It’s relevant to central banks because unlike many other issues, it has a pervasive effect on sectors of the economy, and it is irreversible, which makes it incredibly urgent for banks to take action. In 2017, at the Paris “One Planet Summit”, the Network of Central Banks and Supervisors for Greening the Financial System (NGFS) was established. As of December 2020, it consists of 83 members and 13 observers, including the Bank of England, Swiss National Bank, European Central Bank and (most recently) U.S. Federal Reserve. A report published by the NGFS made six recommendations for greening the financial system, four of which were addressed to central banks. This included “integrating sustainability factors into own-portfolio management [and] climate-related risks into financial stability and monitoring”. Of course, there is the matter implementation and whether this alone can sufficiently solve climate change; that is unlikely. But the material impact the coalition is capable of shouldn’t be underestimated either, given the trillions of euro under supervision.
Some might wonder what fighting climate change has to do with price stability or the stability of the financial system. Perhaps an important consideration regarding this is whether central banks can have a real influence beyond the types of assets they choose to purchase, e.g. opting for low-emission companies. From an economic standpoint, are they able to (or should they) tackle climate change? Maybe it is only a concern as it pertains to the risk posed to specific sectors and the impact on economic development. Although realistically, such risks would be taken into consideration regardless and major structural shifts (whether as a result of climate change or otherwise) will always be a concern for central banks. So it might not even be necessary to use monetary policy to fight climate change, especially when other instruments might be better suited to addressing this issue. For instance, pricing carbon emissions by taxing companies could be more effective, particularly in the worst offending sectors. After all, economists generally agree that increasing the market price of carbon is key in tackling global warming. However, such substantial movements in relative prices should ideally be carried out in the context of central banks meeting their inflation targets, since prices typically fluctuate and big adjustments can be difficult. So this challenges the notion that central banks have a small role in tackling climate change when in fact, it could be necessary to deliver their core mandates. It is about mitigating the risk to financial institutions and monitoring the economy and attempting to predict inflation. There could very well be an adjustment in household spending as people fit their homes to be more energy-efficient. Similarly, many companies will move to greener technologies and energy-producing sectors will eventually have to change to low emission sources. It is worth noting that while this isn’t solely their responsibility, they can play a crucial role in setting standards and ensuring climate risk is properly assessed across sectors. Currently, many companies hold assets that sit in-between as they gradually become greener. Central banks need to be more willing to introduce various risk weightings like incentivising holding green assets and penalties for holding brown assets.
Climate change is a global issue that requires global solutions. In terms of resources and expertise, central banks are in the position to take charge in this matter. In addition to their expertise on the economy, they can add significant value by understanding new concepts and ideas surrounding the research into green technologies. This data can be used to develop new economic models and gain more insight into the long-term impact of climate change on factors such as employment and the price of goods/services. It could be essential for determining monetary policies and securing financial systems.