Climate change an increasing priority for central banks

Central banks are becoming increasingly aware of the importance of climate change mitigation. The trend of integrating climate change risks in central bank policy is likely to continue and even intensify in the years to come. This will fundamentally change how the financial sector deals with climate change.

Bank of England as the frontrunner

Back in 2015, Bank of England Governor Mark Carney spoke about the impact of climate risks for the financial sector. He has since taken a leading role in the world of central bankers on this subject, in spite of allegations that he is exceeding his mandate. To this day, the Bank of England is still the frontrunner in integrating climate risks into policy. Recently, the bank ramped up its efforts and announced the introduction in 2021 of climate-related stress tests for the banking and insurance sector in the UK. The central bank will test the resilience of the UK financial system to physical risks and transition risks. The first category includes risks associated with the increased frequency and severity of extreme weather as well as risks due to gradual warming and associated issues like rising sea levels that diminish the value of sea-side properties. The second category includes risks that stem from the transition to a carbon-neutral economy. Because of the transition, financial institutions could see their balance sheets depleted by the depreciation of assets linked to carbon-intensive activities and industries.

Others are following suit

Although the bank of England is still in the lead, it is no longer the only central bank that is thinking about integrating climate change in its policy. During the One Planet Summit in December 2017, eight central banks decided to establish the Network for Greening the Financial System (NGFS). The goal of this network is to share best practices and contribute to the development of environment and climate risk management in the financial sector and to mobilise finance to support the transition towards a sustainable economy.

Currently, the network consists of 48 members and 10 observers, including institutions like the Bank for International Settlements, the International Monetary Fund, the Organisation for Economic Cooperation and Development and central and national banks from around the world. The most notable absentees are the Bank of Japan and the US Federal Reserve.

How far can and will they go?

There are two broad areas of agreement within the network according to Kristalina Georgieva, the new managing director of the IMF. The first one is that central banks will increasingly have to take climate change risks into consideration in economic forecasts and monetary policy. This makes sense as events like floods, droughts and storms can have a significant impact on GDP growth and inflation. Secondly, central banks are determined to make sure the private sector, and more specifically the financial sector, is prepared for the impact of shocks related to climate change.

On other possible policies linked to climate change, minds are less aligned. One example is whether central banks should try and influence financial market flows and investor behaviour, for instance by introducing tiered capital charges for assets, depending on how green they are. Or if central banks should encourage environmentally friendly behaviour by only investing in green assets. There is much debate around the extent to which central banks should actively steer the market. Some state that, by doing so, central banks would move beyond the boundaries of their mandate. There is also fear that by making their quantitative easing greener, central banks could distort markets and derail government budgets. On top of that, quantifying how green certain activities or assets are is not an easy exercise.

Changes ahead

2020 will likely be an interesting year for integrating climate change measures into central bank policy. This is especially true for the euro area because the newly instated European Central Bank president, Christine Lagarde, has vowed to put climate change on the ECB’s agenda. In the past, the ECB has been criticised for buying so-called dirty bonds from companies in high polluting industries. Time will tell if the ECB will change its course under Lagarde’s reign.

This year could also be an important pivotal year for the US Fed as signs are emerging that minds are shifting on the importance of climate change. During its first-ever conference on climate change and economics in November 2019, Fed Governor Brainard said the Fed will need to study the implications of climate change for the economy and the financial system and to adapt work accordingly. If and how this could translate into action will become clear in the years to come.

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