Central banks, climate change, and economic efficiency
Philipp Hartmann, Agnese Leonello, Simone Manganelli, Melina Papoutsi, Isabel Schnabel, Jean-David Sigaux 10 June 2022
The discussion over whether and how central banks should contribute to climate policies has gathered pace. The ECB has adopted an ambitious climate action plan as part of its new monetary policy strategy (ECB 2021b, 2021c) and has also intensified its effort on the supervisory side. It has formulated its supervisory expectations for how banks should deal with climate-related risks (ECB 2020c), published a top-down climate stress test (De Guindos 2021, Alogoskoufis et al. 2021), and is phasing in climate-related supervisory stress tests (ECB 2020d, 2021d).
Cochrane (2020) and The Economist (2019, 2021) have argued that central banks should not enter into this policy area and suggest that they rather focus on their core mandates. In contrast, Honohan (2019), Papoutsi et al. (2022), and Schnabel (2020, 2021) stress that central banks may contribute to the carbon transition, while fully respecting their mandates. According to the latter view, they can mitigate potential biases in favour of high-carbon assets in their monetary policy operations, supervisory approaches, and other practices. Arguably, after initial scepticism, support for central banks considering well-defined contributions to climate policies has gained momentum (e.g. Bank of England 2021a, 2021b, NGFS 2021).
Even if fiscal climate policies, such as carbon taxes and emission trading schemes, are more effective than central bank tools and should take centre stage, a wide-ranging coalition of actors, including central banks, needs to contribute in order to achieve the carbon transition in a timely and orderly fashion (section 1).
In fact, we argue that a central bank neglecting the climate implications of its policies may foster market imperfections. This would create a dissonance with the European Treaty, according to which the ECB must act “in accordance with the principle of an open market economy with free competition, favouring an efficient allocation of resources” (section 2).
Climate-related central bank actions could include mitigating – or even removing – biases in asset portfolios, re-calibrating collateral policies, also based on enhanced disclosures, and enhancing prudential discipline over banks (section 3).
A historical challenge that no single authority can solve
Global warming and climate change are once-in-a-generation challenges to humanity. Figure 1 provides an illustration of the exposures of companies to climate-related physical risks in the euro area, such as floods, wildfires, or droughts. Last year’s floods in Germany and Belgium, as well as wildfires in Greece and Italy, are a vivid reminder that these risks are no longer a distant prospect.
Figure 1 Physical risk for euro area firms stemming from climate change
Sources: ECB (2021a, chart 1) with data from Four Twenty Seven (an affiliate of Moody’s).
Notes: The figure represents the exposure to climate-related physical risks for the 1.5 million largest firms in Europe. Each dot stands for one firm. The location of firms’ headquarters and that of their largest subsidiaries are used as proxies for firm location. The four exposure levels in the legend (distinguished with colours and corresponding to the level categories of the data provider) are derived for six different hazards (floods, wildfires, heat stress, water stress, sea-level rise and hurricanes), using scoring systems comprising a total of 21 sub-indicators. They combine current hazard frequencies and intensities as well as projected changes (until 2040). The figure shows for each firm covered only the (colour for the) maximum exposure across the six hazards. For details on the methodology and the data used, see the data supplement of ECB (2021a, notably sub-section 1.2.3).
The necessary decarbonisation of economic and social activities can only be achieved if everybody contributes – households, companies, governments, and various public authorities. Public policy is required because major market imperfections do not allow the market mechanism to attain the allocation of resources that is desirable from a social welfare perspective. These market imperfections are mainly of two types: externalities (as the individuals and companies causing carbon emissions do not fully internalise their costs); and informational frictions, including asymmetric information (as comprehensive data on carbon emissions and their sources, as well as the sustainability of economic behaviours are limited or not publicly available). A long-standing literature suggests that the central variable – the price of carbon – is likely to remain significantly below the social cost of carbon for an extended period of time (Nordhaus 2017), defying the hope that carbon pricing alone will achieve the transition to a carbon-neutral economy. The failure to impose efficient carbon pricing arises not only from imperfect information but also from the existence of an intergenerational coordination problem, whereby current generations do not fully internalise the benefit of climate policies for future generations (Kotlikoff et al. 2021).
A lot of time has been lost for attaining a more gradual decarbonisation. Going forward, some argue that it is not clear that political processes can achieve the ecologically and economically desirable carbon pricing, the optimal degree of transparency, and the necessary social cushioning of side effects on vulnerable parties at the same time (van der Ploeg 2021). At least equally challenging is achieving large and sufficiently impermeable international ‘climate clubs’ that would solve the problem of cross-border leakages and free-riding (Abbott and Snidal 1998, Nordhaus 2015, Battaglini and Harstad 2020), despite laudable efforts for a carbon border adjustment mechanism (European Commission 2021a). Against this background, a much broader approach will likely be necessary – one in which a multiplicity of parties contribute and catalyse progress in order to achieve an orderly transition even in the absence of optimally set standard climate policies. And this is where central banks come into the picture.
Central bank actions and economic efficiency
But how could central banks, within their mandates, contribute to the fight against climate change and to the green transition? One can distinguish three broad activities: analysis; disclosure and data; and monetary and financial policies. First, central banks can integrate climate change into their analytical frameworks in order to analyse the implications of climate change and the carbon transition for inflation, growth, and the functioning of the financial system. Second, they can adopt disclosure policies for their own operations and publish relevant statistics on the economy, while those with supervisory responsibilities can require banks to adequately report about their exposures to climate risks. Third, central banks can adjust monetary policy, financial market operations, and prudential policy, thereby influencing financial market prices, financial risks, and behavioural incentives even beyond the financial system and thus contribute to the fight against climate change.
By taking the carbon transition into account along these three dimensions, central banks can have a number of beneficial effects. First, they can act as thought leaders, helping to rationalise the economic debate and improving general knowledge. Second, adding data and information would contribute to improving the reflection of climate risks in asset prices and financial market participants’ assessments of those risks. Third, these efforts could mitigate distorted economic incentives, thereby contributing to the reduction of market imperfections and, hence, a swifter and smoother carbon transition.
Many of such activities are already required for central banks fulfilling their core mandates. Importantly, however, they also help to ensure that in pursuing their primary and secondary objectives central banks do not contribute to reinforcing the above market imperfections. For example, the ECB (2021c) says in its new climate action plan that it will take the implications for an efficient allocation of resources into account when considering changes to its monetary policy implementation framework. In fact, the legal framework for the European System of Central Banks (ESCB) postulates this efficiency orientation in general – a provision not found for other central banks.
The provision in the Treaty on the Functioning of the European Union in Article 127(1) that the “ESCB shall act in accordance with the principle of an open market economy with free competition, favouring an efficient allocation of resources” suggests that in pursuing its primary objective of price stability as well as its secondary objectives, the ECB should avoid reinforcing market imperfections, such as the ones caused by climate change. Moreover, if price stability can be achieved to the same degree with different combinations of instruments, the ECB should not be indifferent to varying efficiency implications of alternative combinations of instruments. This is even more so if the more efficient combination of instruments is better aligned with the general economic policies in the EU. One central bank that has recently gone in a similar direction is the Bank of England. The UK Treasury updated the remits of both its Monetary and Financial Policy Committees to reflect the government’s objective of achieving environmentally sustainable growth consistent with the transition to a net zero economy (Sunak 2021a, 2021b). Accordingly, the Bank of England has published a detailed plan to ‘green’ its Corporate Bond Purchase Scheme (Bank of England 2021b).
How central bank policies could contribute to the mitigation of market imperfections associated with carbon emissions
Various central bank policy instruments could make potential contributions to attenuating the market imperfections that hamper the socially desirable decarbonisation. Here, we focus primarily on monetary and financial instruments that directly influence market outcomes (i.e. asset purchases, the collateral framework and supervisory policies). Further indirect measures, such as research and data initiatives, are also included in the ECB’s climate action plan (ECB 2021c).
The greening of asset purchases and portfolios has received most of the attention so far. The starting point is that too low a price of carbon in the real economy, due to the above-mentioned market imperfections, implies that the cost of production of low-carbon (‘green’) companies is too high compared to high-carbon companies. Therefore, green companies are producing at a disadvantage. In line with an ‘efficiency principle’, as discussed in the previous section, central banks should be careful not to contribute to this production disadvantage by reinforcing the financing disadvantages of green firms.
Central bank corporate bond purchases have material effects on valuations and issuance activity. The impact of the ECB’s Corporate Sector Purchase Programme (CSPP) on corporate bond spreads and bond issuance has been documented in the empirical literature (Abidi and Miquel-Flores 2018, Arce et al. 2021, Bonfim and Capela 2020, De Santis and Zaghini 2019, Grosse-Rueschkamp et al. 2019, Todorov 2020, Zaghini 2019). The yields of eligible bonds are typically found to decline by around 15 to 40 basis points relative to non-eligible bonds upon announcement. Similarly, the issuance of eligible bonds has been found to be between 6% and 25% higher relative to non-eligible bonds. The impact of the CSPP on eligible bond yields is in line with the effect identified for the Bank of England’s Corporate Bond Purchase Scheme (Boneva et al. 2018, D’Amico and Kaminska 2019), the Bank of Japan’s corporate bond purchases (Suganuma and Ueno 2018), and the corporate credit facilities of the US Federal Reserve (Boyarchenko et al. 2020, D’Amicoe et al. 2020, Haddad et al. 2020).
Hence, if one tilted purchase programmes towards bonds issued by greener firms, while leaving the overall monetary policy stance unchanged, this would improve funding conditions for these companies relative to less sustainable companies. One possible objection is that such a policy could entail side effects, as it might amplify other types of market imperfections. First, the policy may require buying a large amount of green bonds in an initially relatively small market, which could cause market disruptions or encumbrance phenomena, at least in the short run. But as green bond markets grow, liquidity and resilience are likely to increase. Second, the policy could also lead to an overvaluation of green bonds (a ‘green bubble’), over and beyond the socially optimal prices.
However, these objections as such do not provide a justification for refraining from tilting asset purchases altogether. Indeed, the theory of the second best (Lipsey and Lancaster 1956) states that, in the presence of many market imperfections, addressing a particular imperfection (e.g. one of the environmental ones mentioned above) has the potential to improve the overall allocation of resources, even if it worsens some other market imperfections.
An important consideration is that composing purchase programmes in proportion to the sector decomposition of outstanding bonds – in accordance with one notion of a ‘market neutrality’ principle – is not ‘neutral’ (Schnabel 2020). Bonds tend to be issued by large firms (e.g. Didier et al. 2014) with sizeable tangible assets, such as machines or commodities. These are often ‘old economy’ firms with relatively high greenhouse gas emissions relative to ‘new economy’ firms in information and communication technology, education, research and development, hospitality and leisure or other services. Therefore, ‘buying the market’ would imply some funding advantages for polluting firms – those creating the largest climate externalities – relative to more innovative and greener firms.
Papoutsi et al. (2022) illustrate this for the ECB’s CSPP. Figure 2 shows that the sector composition of the ECB’s corporate bond portfolio (red bars) correlates strongly with outstanding amounts in the bond market (yellow bars) but less with economic relevance – as measured by sectoral capital income (blue bars). This induces a bias towards high carbon emissions (grey bars). Based on this study, when market frictions are present and an optimal carbon tax is not available, it may be beneficial for a central bank to tilt its portfolio towards greener sectors and companies, even if the availability of bonds may be constrained by different issuance behaviours (e.g. companies operating in the services sector tend to issue fewer bonds relative to companies in the manufacturing sector). In the detailed roadmap for its climate action plan, the ECB announced it would assess during 2021 and 2022 potential biases in the allocation of corporate sector purchases, consider alternative allocations, and make concrete proposals for alternative benchmarks (see the annex of ECB 2021c).
Figure 2 Comparison of different corporate bond market portfolios and carbon emissions by sector
(bond market and ECB holdings end 2019 stock data, economic relevance based on total 2019 capital income flows, emissions total 2019 flows)
Sources: Papoutsi et al. (2022, figures 2 and 4) with data from the ECB, Eurostat and Orbis.
Notes: Columns of the same colour add up to 1. Sectoral economic relevance is derived from capital income (value-added minus wages) full-year flows. Emissions are measured with scope 1 air emissions. “Automobile” refers to the manufacturing of automobile vehicles; “High-carbon Manufacturing” includes oil & coke, chemicals, basic metals, nonmetallic minerals; “Other Manufacturing” food, beverages, tobacco, textiles, leather, wood, paper, pharmaceuticals, electronics, electrical equipment, machinery, furniture, construction, and other manufacturing. To assess the relative emission intensity across sectors, one has to compare the grey bars relative to the blue bars (a measure of the relative size of sectors).
While a ‘market efficiency benchmark’ may not be feasible due to legal and practical hurdles, the use of a ‘Paris-aligned benchmark’, whereby the portfolio composition reflects the long-term temperature target of the Paris Climate Agreement (European Union Regulation 2019/2089), may be able to mimic the underlying economic principle. Importantly, this would go well beyond considerations purely based on climate-related financial risk. Such a benchmark could not only be applied to new flows of asset purchases, it could also be used to gradually adjust the existing stock. This is particularly relevant at a time when central banks have discontinued their net asset purchases and start reducing their balance sheets at some point.
A second relevant area concerns amendments to the collateral framework that is underlying all of the ECB’s credit operations, such as the longer-term refinancing operations. The available literature suggests, for example, that assets eligible for central bank operations have lower yields and higher values relative to comparable ineligible assets (Ashcraft et al. 2011, Corradin and Rodriguez-Moreno 2016, Pelizzon et al. 2020). This direct eligibility premium has been estimated at between 11 and 24 basis points, an economically meaningful magnitude. In addition, there are further benefits for issuers and holders of these securities, such as enhanced usability in repo and securities lending transactions.
The ECB has already added innovative financial instruments related to sustainability to the eligible collateral (ECB 2020a). Its new climate action plan also envisions to link eligibility to adequate green disclosure, based, for example, on the Corporate Sustainability Reporting Directive (CSRD, European Commission 2021b). This could also be done for corporate purchases (annex of ECB 2021c). As the CSRD covers only a relatively small part of the eligible collateral, disclosure initiatives for additional asset classes would be desirable.
Another lever could be valuations and haircuts in the collateral framework. These are based on available market prices and short-run liquidity as well as market and credit risk considerations. Therefore, they only take into account potential climate risks to the extent that those are incorporated in market prices and credit ratings, which are affected by climate change-related disclosures. The ECB is reviewing the collateral valuation and risk control framework to explicitly account for climate-related financial risks (including the consideration of climate risks in the external and internal ratings used) as part of its action plan. However, climate risks typically do not materialise during the relatively short liquidation horizon, yielding little scope for adjustments. Central banks could also require the composition of collateral pools to be in line with the temperature objective laid out in the Paris Agreement. This would constrain banks’ use of assets associated with high carbon emissions, increasing the funding costs of the entities issuing them. It would reflect efficiency considerations over and above risk aspects.
An open question is still the greening of the ECB’s credit operations, such as ‘green TLTROs’ providing direct incentives for more sustainable lending. This would affect – via banks – a wider range of firms, notably small and medium-sized enterprises. As a first step, it would first require progress on the measurement of climate-related risks in banks’ loan portfolios.
These and other amendments in the implementation of monetary policy are currently subject to discussion and analyses in the ECB. Challenges include, for example,
- the lack of reliable sustainability metrics, including indirect emissions (scope 3) as well as forward-looking indicators;
- the limited availability of green bonds in the market and potential asset encumbrance,
- their distribution between corporate and sovereign bonds, with only a negligible share of the much larger sovereign market being categorised as green;
- the preservation of appropriate price discovery in the bond market; and
- the desirability of considering the corporate activity level rather than the company level, in order to set transition incentives for carbon-intensive companies.
In any case, it may be wise to prioritise measures that are most effective and compare and coordinate them with measures of other authorities (see also NGFS 2021).
Finally, for central banks with supervisory responsibilities, like the ECB, disciplining banks to adequately assess, manage, and disclose their climate-related exposures and risks will support a smooth carbon transition and its financing (Elderson 2021). This would, in turn, induce non-financial companies and households to take those risks properly into account. It will also contribute to the creation of better data and more accurate pricing of climate risks in financial markets. The ECB (2020c) has put out its supervisory expectations for climate-related risks, covering business models, strategy, governance, risk appetite, risk management, and disclosures, after having found out that banks were still lagging behind with their practices (ECB 2020b). Now, banks have the task to conduct self-assessments against these expectations and draw up action plans how to meet them.
Over time, climate-related risks will be integrated in the standard Supervisory Review and Evaluation Process (SREP) and therefore in supervisory capital assessments and demands. Consistent with existing empirical evidence (e.g. Cortés et al. 2020, Acharya et al. 2018), these policies are expected to induce banks to tighten lending conditions for borrowers more exposed to climate risks. This year, bottom-up climate-related stress tests of individual banks will be conducted for the first time (ECB 2020d, 2021d), complementing the top-down stress test of long-term climate scenarios and events on the European banking and non-financial corporate sectors published in September 2021 (de Guindos 2021, Alogoskoufis et al. 2021).
Within their mandates, central banks can make valuable contributions to climate policies. While governments should remain the leaders in climate policies, the carbon transition requires central banks to act in concert with a coalition of other parties. The ECB will contribute to this concerted effort, among other things, via monetary policy operations and supervisory policies. Mitigating or even removing biases in asset portfolios, re-calibrating collateral policies, also based on enhanced disclosures, and enhancing prudential discipline over banks can help to avoid contributing to the market imperfections that hamper the socially desirable transition to a carbon-neutral economy. This resonates with the Treaty provision that in pursuing its primary and secondary objectives the ECB should favour an efficient allocation of resources. Such an ‘efficiency principle’, which could be operationalised through a Paris alignment of all central bank actions, can ensure that central banks pay due attention to the climate implications of their policies and their responsibility to contribute to the transition to a carbon-free economy.
Authors’ note: All views expressed are those of the authors and should not be regarded as the views of the ECB or the Eurosystem.
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