The climate in monetary policy

Climate issues are becoming an important part of the considerations and activities of many central banks, and the European Central Bank (ECB) may soon become the first central bank to take environmental matters into account in the pursuit of its monetary policy objectives.
The climate in monetary policy


Monetary policy supports actions aimed at protecting the economy against unexpected and adverse disruptions or shocks. However, it is more difficult for monetary policy to protect the economy against supply-side shocks than demand-side shocks. Meanwhile, the disruptions associated with the consequences of climate change usually belong to the category of supply-side shocks.

In the assessment of institutions affiliated at the Network of Central Banks and Supervisors for Greening the Financial System (NGFS), central banks should take into consideration the impact that climate change will have on the economy, because it may also affect monetary policy even if it materializes beyond its traditional time horizon which ranges from three to five years. One additional argument here is that climate change is already a part of the context in which monetary policy is implemented.

Central banks are able to take environmental issues into account, among other things, in the development of their own climate risk assessments, and also by appropriately reflecting this risk in their policies relating to collateral or the creation of asset portfolios.

The central bank’s monetary policy instruments supporting the objectives of environmental protection include, for example, better access to central bank funding for banks investing in low-carbon projects, purchases of low-carbon bonds issued by development banks, appropriate management of asset portfolios, and the adaptation of the monetary policy framework.

A green approach to quantitative easing

One of the areas of central banks’ activities through which these institutions could directly and positively affect the environment are the purchases of securities as part of the quantitative easing programs. These programs have been used by many central banks for a number of years, especially in conditions of crisis, including right now — during the pandemic crisis.

Recently, the central banks’ asset purchase programs have become the subject of debate among economists and policymakers who are exploring the possibility of utilizing them to reduce the impact of climate change. This could be achieved, in particular, by applying an appropriate key for the selection of the purchased assets, that is, by avoiding the purchases of assets related to the so-called dirty sectors (e.g. fossil fuels) and environmental pollution.

Some central banks are now starting to notice this problem and the associated opportunities. For example, in June 2020, the Bank of England published a report in which it informed about its own exposures to the risk of climate change. This relates both to its physical activities (e.g. the production of banknotes, the carbon footprint of the buildings and business travels), as well as its financial activities (including the activity concerning its asset portfolios, which are held in connection with the conduct of monetary policy).

The report indicated that the current composition of the Bank of England’s investment portfolio is incompatible with the objectives of the Paris Agreement, as it supports an average temperature increase of 3.5 degrees Celsius above pre-industrial levels by 2100. This is especially due to the fact that the investment portfolio of the Bank of England includes corporate bonds with a high carbon footprint, which were purchased as part of its quantitative easing programs.

In early July 2020, the Governor of the Bank of England, Andrew Bailey, announced that after the end of the current pandemic-related crisis management he will consider including climate change as a factor in determining corporate bond purchases as part of the monetary policy pursued by the UK’s central bank.

The ECB’s QE program is tilted towards high-carbon sectors

The issue of the possible use of monetary policy to achieve environmental objectives also applies to the ECB. According to Christine Lagarde, the President of the ECB, the current review of the bank’s monetary policy strategy, which has been going on since the beginning of this year, provides a good opportunity to examine the possibility of including climate change in the implemented monetary policy. The review covers all aspects of the monetary policy implemented within the ECBs mandate, which is to maintain price stability.

In a recent public statement Ms. Lagarde promised to examine the possibility of introducing more environmentally friendly changes in all the central bank’s operations, including asset purchases. As a result, the ECB could become the world’s first major central bank which takes environmental concerns into consideration in the pursuit of its monetary policy objectives.

This declaration was inspired, among other things, by an open letter to Ms. Lagarde, signed by more than 160 scientists, economists and environmental protection activists. The authors called on the ECB to commit to gradually eliminating carbon-intensive assets from its portfolios. The signatories include, among others, Adair Turner, the Former Chairman of the United Kingdom’s Financial Services Authority, and Francesco Papadia, the former Director General for Market Operations at the ECB.

The criticism of the ECB’s activities concerns in particular its decisions to buy corporate bonds issued by companies from carbon-intensive sectors — such as manufacturing and utilities — as part of its EUR2.8 trillion asset purchase scheme. Environmental protection activists have urged the ECB to introduce changes in its asset purchase program by selling “brown” bonds issued by carbon-intensive companies and those linked to fossil fuels, and by increasing purchases of “green” bonds.

The ECB is able to pursue climate friendly policies

On the one hand, there are some opinions that the ECB is able and is obliged to pursue environmentally friendly policies. The Treaty on the Functioning of the European Union states that “without prejudice to the objective of price stability, the ECB shall support the general economic policies in the Union with a view to contributing to the achievement of the objectives of the Union as laid down in Article 3 of the Treaty on European Union”. These objectives include, among other, “a high level of protection and improvement of the quality of the environment”. Consequently, the ECB is obliged to also support the EU policies and activities relating to the protection of the environment, such as the European Green Deal.

In addition to the legal basis, there are also economic justifications for such measures. For example, due to the increase in energy prices and the reduction in the rate of economic growth, global warming could cause a supply-side stagflation shock which requires an adequate response from monetary policy. Looking from this perspective, this means that the impact of climate change falls within the scope of the central bank’s mandate to maintain price stability.

On the other hand, it is emphasized that the main role in the fight against climate change should be played by fiscal measures which are amplified by appropriate financial regulation, policies aimed at improving the infrastructure of financial markets, as well as monetary policy.

Protection of the environment is not the only objective assigned to the European Union’s institutions, including the ECB. In addition, the Treaty on the Functioning of the European Union confers considerable independence to the ECB, which gives it flexibility in the implementation of its policies. It will therefore be important to determine the rules of the game, whose objective will be to actively support the transition to a low-carbon economy — without interfering with the main objective of the ECB’s monetary policy under the Treaty, that is, maintaining price stability.

The strategic review of the ECB’s monetary policy is supposed to last until mid-2021 and until then we should definitely expect various signals, especially since not all of the Eurozone central banks agree that monetary policy should serve the purposes of environmental protection (this includes, for example, the German central bank).

The opinions expressed by the author do not represent the official position of Poland’s central bank, NBP.



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