Central banks wrestle with a green dilemma

“Central banks are rushing headlong into climate policy. This is a mistake. It will destroy central banks’ independence, their ability to fulfil their main missions to control inflation and stem financial crises, and people’s faith in their impartiality and technical competence. And it won’t help the climate.” So said the renowned American economist, John Cochrane, at a recent European Central Bank (ECB) conference.

The move by central banks into this area has been contentious. It can be traced back to a speech given by the then Governor of the Bank of England, Mark Carney in September 2015. Titled “Breaking the Tragedy of the Horizon”, the address covered the role of regulators in helping the market to price climate related risk. It was followed, two years later, by the establishment of the Network for Greening the Financial System (NGFS). Initially comprised of eight central banks, the network now numbers 89 organisations, including numerous regulatory authorities. Perhaps most significantly, the US Federal Reserve (Fed) joined the club last December.

There is broad agreement across the financial sector on the need to ensure full disclosure of environmental risks associated with asset portfolios. Full disclosure is not without its challenges – both in respect of the modelling and valuing of physical and transitional risks, and the recognition of a workable global standard. Nonetheless, this consensus includes even those central bankers who remain less than wholly keen to fully embrace climate policy as part of their remit.

Opinions are, though, divided on the question of how far the green agenda should guide central banks’ operational targets and, by extension, monetary policy. Most explicitly, this might be visible in the bond purchases that currently constitute an integral element of COVID-19 stimulus measures. Recovery strategies that favour green industries will have the direct effect of lowering the cost of capital in the sector – doing so at the expense of ‘brown’ industries.

Recent comments by Fed Chair Jay Powell, hint at his reluctance to push fully down this route. The Fed, says Powell, “has historically shied away strongly from taking a role in credit allocation." More fundamentally, he has questioned whether any mandate has been granted by Congress to pursue actions specifically designed to combat climate change.

By way of contrast, UK Chancellor Rishi Sunak used his budget address last month to provide just such a mandate for the Bank of England (BoE). The BoE can now provide active support for government efforts to green the economy and achieve zero greenhouse gas emissions by 2050. The bank has since committed “to allow for the climate impact of the issuers” in any future corporate bond purchases.

The European Central Bank (ECB) is currently grappling with the same issue as part of a broader strategy review. In one camp are those who take the view that climate change is a matter for governments to address through carbon pricing and other levers. This group, perhaps best described as traditionalist, believes that the ECB ought to maintain a focus on price stability. Among their ranks is Bundesbank President Jens Weidmann, who warned against central bank “mission creep” towards the back end of last year.

Set against them are those who coalesce around ECB President, Christine Lagarde. Lagarde has previous in this field, having used her time as Managing Director of the IMF to drag the fund into greener territory. She, and they, argue that the climate emergency necessitates a divergence from market neutrality in the management of monetary policy. The President of the Bank de France, François Villeroy de Galhau, has advocated for the “pragmatic, gradual and targeted” decarbonisation of the ECB’s balance sheet.

While it is still unclear which side will win out, my sense is that there will be some shift in approach – even if it is relatively gradual. Critically, on the question of price stability, the persistent threat of natural disasters and increased volatility of crop yields suggests that climate change presents a real and pronounced threat. Indeed, the NGFS has highlighted the potential impact of the latter on inflation and inflation expectations. Furthermore, the failure of the market to capture externalities linked to greenhouse gas emissions, combined with the severity of the threat posed, could be said to justify intervention.

That said, it would be foolish to dismiss the concerns of the traditionalist faction. Should central banks find themselves pulled in different directions in their efforts to hit multiple, perhaps even incoherent, objectives, their overall credibility will be damaged. The debate around a shift in behaviour in the management of monetary policy also needs to be set in a wider context. De Nederlandsche Bank, the central bank of the Netherlands, published a report on economic stresses related to the green energy transition late last year. The Bank de France recently assessed the resilience of the French banking and insurance sectors to climate risk, while the BoE has committed to doing likewise in 2021. There are, then, means other than monetary policy by which central banks can influence the climate agenda.

But even here, there is much discussion around the right and wrong approaches. Joe Biden’s administration may have made some high-profile early moves on climate policy, but US Treasury Secretary Janet Yellen has issued a somewhat mixed message. She is, she says, willing to submit American banks and insurers to a new round of climate stress testing. But she has also denied that the tests will grant the White House powers to limit pay outs and capital requirements.

At the core of the debate is whether it is the sole role of governments to drive climate policy, or if there is a supporting part to be played by central banks. The mood music does appear to be signalling a gradual shift towards the latter. Nonetheless, a significant number of policymakers evidently remain unconvinced.