When central banks go green

Central banks confronted with the issue of climate change face a number of questions. Should monetary policymakers (and other financial regulators and supervisors) focus on the implications of climate change for financial stability? Should they treat climate change as a potential threat to their ability to pursue their macroeconomic mandates of full employment and/or price stability? Should mitigating the adverse consequences of climate change become an explicit monetary-policy objective?

In considering such questions, it is important to remember that two distinct types of financial risks are associated with climate change. The first includes the transition or mitigation risks that come with a successful shift to a lower-carbon future. For example, climate-mitigation and green-energy policies could result in stranded assets – namely, fossil-fuel reserves – that would sharply decline in value, owing to a fundamental change in demand wrought by legislation, regulation, taxation, technology, tastes, and so forth.

The second class of financial risk concerns a failure to address climate change effectively. There are physical risks associated with adaptation to a higher-carbon future, including the destruction of real commercial and natural assets as well as human capital. A wide range of natural disasters would threaten infrastructure, other privately and publicly owned structures, land, and water resources. And the heightened risks to people of injury, death, or lost earning potential could have adverse financial consequences not just for those directly affected, but also for insurance providers and other parties.

At least since the signing of the 2015 Paris climate agreement, financial regulators and supervisors have been aware of the risks that climate change poses to financial stability. The United Kingdom's Prudential Regulation Authority now pays close attention to the potential impact of climate change on the insurance and banking sectors, and, along with the UK Financial Conduct Authority, it has modified supervisory and regulatory frameworks accordingly.

Likewise, the Financial Stability Board's Task Force on Climate-related Financial Disclosures has developed recommendations for building climate resilience that now enjoy wide support. And the Central Banks and Supervisors Network for Greening the Financial System, created in 2017, offers regular recommendations for how banks and other financial institutions can address climate-related financial risks.

As this proliferation of regulatory and advisory initiatives suggests, climate risks could have a first-order impact on monetary authorities' ability to pursue their traditional macroeconomic objectives. Extreme manifestations of climate change could depress aggregate demand and potential output significantly, unpredictably, and over extended periods of time.

In recent decades, central banks have faced few significant stagflationary challenges (low economic growth coupled with high inflation) beyond the familiar case of oil-price shocks. But that could change if the adverse supply- and demand-side effects of climate change become more frequent and severe. Moreover, the broader climate risk could mean that the monetary-policy time horizon (typically 2-3 years) will have to be extended to allow for low-frequency, high-impact, and persistent climate shocks.

Neither the US Federal Reserve nor the Bank of Japan has a mandate to pursue climate-change mitigation. The Bank of England, however, is required "to maintain price stability, and … subject to that, to support the economic policy of Her Majesty's Government," which could include support for climate policies. And in Europe, the camel's nose of climate policy is firmly in the monetary-policy tent. The European Central Bank's primary objective is "to maintain price stability and, without prejudice to this objective, to support the general economic policies in the Union," which includes providing "a high level of environmental protection and improvement of the quality of the environment," and contributing "to peace, security, and the sustainable development of the Earth."

In recent statements to the European Parliament and the media, ECB President Christine Lagarde has indicated that climate risks are indeed a concern of the ECB, and she has hinted that climate mitigation could be added as an ECB monetary-policy goal, following an ongoing review of the bank's policy framework. If so, this would have to be implemented though the ECB's lending and borrowing operations and any asset-purchase programs it pursues.

For example, the ECB could favor purchases of financial instruments that meet certain "green" objectives, turning quantitative easing (QE) into "quantitative greening." And its targeted longer-term refinancing operations could offer better terms and collateral conditions to firms whose behavior is supportive of climate objectives. As long as such financial interventions are made "without prejudice" to the price-stability objective, climate mitigation could become a legitimate secondary objective of the ECB. While the size of QE operations would be dictated by the price-stability objective, the composition could be skewed toward green bonds and other securities that meet "environment, social, governance" or "socially responsible investment" standards.

To be sure, Bundesbank President Jens Weidmann has objected to the practice of skewing asset purchases toward green bonds, arguing that this would run counter to the principle of market neutrality, as outlined in Article 127 of the Consolidated version of the Treaty on the Functioning of the European Union. Yet given that neither Article 127 nor the rest of the treaty contains any reference to such a principle, Weidmann's objection seems vacuous.

Thus, we should expect to see "green QE" in the not-too-distant future in both the eurozone and the UK. As for the United States and Japan, however, there would need to be changes to the Fed and the BOJ's mandates before such a move is possible.

Willem H Buiter, a former chief economist at Citigroup, is an adjunct professor at Columbia University.