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Sustainable finance: What is the role of central banks in managing climate change?

06 February, 2019Dr Paul Fisher
Sustainable-financeIn most countries, central banks are the monopoly supplier of the narrow money base. Their principal responsibility is therefore ‘sound money’ which leads to various functions: controlling inflation, making sure the payments system works and doing what they can to maintain financial stability, sometimes including prudential supervision of banks. In small countries, they often deal with market conduct issues as well. Should they also have a role in managing climate change or in other aspects of sustainability?

First, let us not argue with the primacy of the monetary policy responsibility. Sustainable growth and the ability to make long-term planning decisions in business and government both require stable monetary and financial conditions. But even beyond the core monetary task, central banks should be involved in climate issues. This is why: 

 

1. Supply-side shocks

As the planet continues to warm – in jumps, not smoothly – and/or a transition is made to a lower carbon-emitting economy, monetary policy will likely have to tackle more frequent and bigger supply-side shocks. These might be physical events (eg storms, droughts, floods) or transition effects such as structural change and abrupt policy shifts (eg cities banning fossil fuel engines). We could see sharp movements in energy and food prices. Such supply side shocks, which push inflation up and growth down, are the most difficult for monetary policy to address and to explain.

2. Movements in asset prices

If the transition is delayed and then abrupt, there could be substantial and sudden movements in asset prices causing systemic effects that trigger financial instability.  The need for an earlier and smoother transition is being addressed in part by changes in disclosure (eg as recommended by the Bloomberg-chaired Task Force on Climate-related Financial Disclosures). More information in the market should mean fewer, smaller surprises and more accurate, ongoing re-pricing.

3. Heightened risk

Banks currently finance many activities that are ultimately unsustainable. Meanwhile, the transition should create new profitable credit opportunities – but some will be risky. If banks and others do not factor climate change into their risk management and business models, they put their capital at heightened risk. For example, mortgage loans treat the property as security – but a climate-related event could wipe out both the borrower and their assets. Supervisors must help ensure that climate risks are properly considered. 

4. Spill-over effects

Central banks conduct balance sheet operations that implement certain policies, but also have spill-over effects on the financial sector.  The precise choice of assets purchased under quantitative easing, or the security taken when lending to banks, or even the haircuts charged on that collateral, do not necessarily affect either the quantity or price of money, nor impact financial stability. But such choices can affect the supply and demand for various asset types, including green finance. This is a live, controversial issue (especially for the ECB’s QE bond purchases). Whether central banks have the mandates or the skillsets to make decisions on sustainability grounds is debatable, and the impacts are uncertain.  

Taking climate change into account

Independence for central banks in both monetary policy and prudential supervision, accompanied by a clear legal remit, has proven to be highly effective. But ensuring financial stability requires a wider coalition of authorities.

Central banks need to take climate change into account to meet their primary objectives, and some of their actions can help promote and smooth the transition to a low carbon economy – especially through supervision and financial stability. This supports their secondary objectives. That is why the Bank of England, amongst others, has been playing a leading role and there is now a new Network for Greening the Financial System comprising some of the leading central banks and bank regulators globally.



Paul FisherDr Paul Fisher is a Fellow at the Cambridge Institute for Sustainability Leadership. He was previously a senior official and macroeconomist at the Bank of England for 26 years, including 5 years as a member of the Monetary Policy Committee and Executive Director for Markets and 2 years as Deputy Head of the PRA.  He is a member of the European Commission’s High Level Experts Group on Sustainable Finance and was a member of the UK Green Finance Task Force. He holds a portfolio of other roles in finance and academia.

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