The European Central Bank has announced a new plan to include climate change indicators in its inflation-reducing monetary policies; this stands to not only bolster the climate resilience of Europe’s financial systems, but also support the acceleration of its green transition
February 4, 2023
More often than not, conversations on the economy engender a somewhat inanimate, two-dimensional and transactional impression, but in truth, the economy is defined by more than just balance sheets, the stock exchange, trade, or investment.
The economy is in fact an ecosystem, a force of nature, and a constantly evolving entity affected by everything from war, scientific progress and changes in human behaviour, to the preferences of popular culture at any given moment.
It’s therefore no surprise that the global economy is also enormously affected by climate change.
In fact, the relationship works both ways; just as global warming has the power to influence the global economy, the latter also has a boundless capacity to impact the climate crisis in return, and central banks across the world must now begin taking steps to incorporate climate change considerations into their financial frameworks.
As such, a report released by the European Central Bank (ECB) last week as part of its climate action plan reveals the financial authority’s most recent efforts to do just that.
How? By starting to include climate indicators in its economic models, monetary policies and investment framework in an effort to make its mandate “climate change-proof.”
“Climate change poses risks to the economy and to the stability of the financial sector. At the same time, the financial sector will have to play a role in supporting the transition to a net-zero economy,” says the ECB.
Incorporation of such indicators in the policies that govern the European economy stands to not only bolster financial systems against the mounting risks of climate change, but also significantly shift the needle towards green finance and acceleration of the green transition.
“We need a better understanding of how climate change will affect the financial sector, and vice versa,” says Isabel Schnabel, a member of the ECB’s Executive Board, “The indicators are a first step to help narrow the climate data gap, which is crucial to make further progress towards a climate-neutral economy.”
How central banks regulate the economy – in simple terms
The primary function of central banks is to maintain balance within the economy so that wealth can accumulate, debt can be reduced, the standard of living can be raised, thus fueling economic growth.
To do this, central banks must ensure that both daily life and trade are affordable, and they achieve this by controlling inflation.
Inflation can be caused by a myriad of stimuli, but one of the major triggers is often a surge in demand. When this happens, one of the methods central banks employ to bring the inflated prices back down again is decreasing the liquidity of the market – i.e., the amount of money in circulation and therefore being spent.
They regulate liquidity in three main ways: buying and selling bonds, raising or decreasing interest rates, and adjusting the amount of money banks must keep in reserve.
All three of these factors directly affect how much money is available to move around within the market. For example, if central banks raise interest rates, the higher cost of repayment will decentivise borrowing and incentivise saving, therefore less money will be spent and demand will go down.
As demand goes down, so will inflation, and vice versa.
We’ve witnessed this exact scenario recently, where an unprecedented surge in demand has sent inflation through the roof. But what this has also shed light on, is that the strategies employed by central banks to recalibrate market prices are possibly also stymying the green transition in parallel.
Curbing inflation is also curbing the green transition
After the past few years of pandemic-induced inactivity and the fallout of Russia’s war in Ukraine, the market has seen an explosion in demand caused by a delayed consumer build-up and disruption to supply chains.
As a result, the price of food and energy has skyrocketed internationally, bringing with it an increase in inflation across the board.
To address this price-hike, central banks tried to stem the cash flow and decrease demand by tightening their monetary policies; for example, the ECB reacted to the rise in inflation by raising interest rates by 2.5% and halting their purchasing of corporate bonds in parallel.
Strategies such as this have historically proven effective in the short-term by bringing inflation down, but, as recent analysis shows, they are potentially detrimental to climate action in the long-term.
The problem lies in the fact that higher interest rates disproportionately affect the renewable sector in comparison with non-renewable industries, because the upfront costs of getting clean energy projects off the ground is comparably larger than those involved in the running of already established fossil fuel power plants.
As a result, decarbonisation efforts risk being decentivised, and rising inflation is often used as a scapegoat for delays incurred in the green transition.
Widespread debate has therefore ensued around whether the tightening of monetary policy may in fact be misaligned with the Paris Agreement in directly curbing the green transition, and whether climate considerations should therefore play a more prominent role in defining how and when such policies are exacted.
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However, given that increasing interest rates is one of the essential tools used by central banks in stabilising the economy, many economists conversely claim that overly accounting for climate change is in fact misaligned with the primary mandate of central banksentirely.
This brings us back to the ECB’s latest climate indicator report, which may provide one possible solution out of this paradoxical mire.
The European Central Bank’s climate action plan
In July 2021, the ECB announced a new action plan to include climate change metrics within its macroeconomic models and monetary policy strategies.
Since then it has started making measurable changes to its operations and framework at the public and private sector levels, ensuring both are aligned with EU climate targets.
The latest installment in the ECB’s green finance roadmap was revealed just last week in the form of three new climate indicators that are set to be incorporated into the policies that govern Europe’s financial systems and the projects they fund.
The three new climate indicators developed by the ECB are:
- Sustainable finance indicators (e.g., how sustainable the projects being funded are in any given financial portfolio).
- Carbon emissions indicators (e.g., what the relative carbon-intensity is of any given financial portfolio).
- Physical risk indicators (e.g., what the climate-related risks associated with any given financial portfolio are).
By incorporating climate-related data into its policy, the ECB hope to be able to mitigate risks posed on the European economy by the escalating climate crisis, as well as better assess which stakeholders are demonstrating greater decarbonisation efforts in alignment with the Paris Agreement, and therefore which to prioritise for inclusion in their public and private bond portfolios.
In turn, this will incentivise the decarbonisation of both governments and corporations and result in the acceleration of the green transition.
What’s more, through bolstering the resilience of the economy against climate risk and providing better energy security through the scale-up of renewable technologies, this development could also stand to prevent future anomalies in demand and therefore potentially reduce the risk of inflation and subsequent need to increase interest rates.
What’s more, the ECB is not the only central bank making this shift.
Other central banks’ climate commitments
Off the back of the UN and World Bank’s “One Planet Summit” in Paris in 2017, eight central banks came together to form the “Network of Central Banks and Supervisors for Greening the Financial System (NGFS),” with the aim of enhancing the financial sector’s role in accelerating the green transition in line with the UN’s Paris Agreement.
Since then, the network has grown to over 120 members, with many embarking on their own initiatives to transition to a net-zero economy and share best practices in green finance.
In 2021, one of the network’s most prominent members, the Bank of England, announced it would be incorporating climate considerations into its operations and framework to support the green transition and climate resilience of its financial systems.
The US Federal Reserve, also a member of the NGFS and historically on the receiving end of widespread climate blindness criticism, announced in September last year the commencement of a new pilot climate scenario analysis for six of its biggest banks.
Both of the major central banks in Asia, the Bank of Japan and the People’s Bank of China, have also shown commitment to shifting their economies towards net-zero through climate-focused monetary policies and prioritisation of green lending, although China in particular has faced widespread accusations of greenwashing in their parallel push for coal power plant investment.
However, for those nations whose economies rely heavily on fossil fuel sectors, transitioning to a green economy incurs a comparably higher cost, and so directly conflicts with the mandate of central banks in maintaining a monetary policy that encourages stability. The Bank of Canada, for example, has been widely criticised for climate inaction in this regard.
The path ahead
Though the release of these climate indicators marks a significant step forward in the transition to a net-zero economy, the ECB has stated that there are also many limitationsassociated with their design.
For example, the data that the carbon emissions indicator is based on is largely still reliant on corporate and government emissions disclosures; reports which – although are soon to be made mandatory by the ECB for bonds to remain eligible – are notoriously inaccurate, if not deliberately misleading.
Furthermore, the physical risks indicator is based on an inexhaustive list of natural hazards. For example, heatwaves – the extreme phenomena which wreaked havoc across Europe last summer causing as much as a 0.5% drop in Germany’s economic growth – are not incorporated.
As a result of such limitations, the ECB have openly disclosed that their intention in releasing this report was to open dialogue on how to “better assess the impact of climate-related risks on the financial sector” and to “monitor the development of sustainable and green finance,” rather than as a complete solution.
There are however four areas that these indicators could help the ECB to incentivise decarbonisation and spark a cascade of downstream implications within Europe’s broader financial sector.
These four areas are:
- Encouraging use of fiscal policy to accelerate the green transition, e.g., raising fossil fuel taxes, providing renewable subsidies, or raising carbon prices.
- Greening the ECB’s private sector bond portfolio, e.g., by prioritising investment in low-carbon intensity corporations or those with strong decarbonisation plans.
- Greening the ECB’s public sector bond portfolio, e.g., by prioritising investment in government schemes that support the green transition.
- Greening the ECB’s lending operations, e.g., by helping identify which bonds meet climate criteria for reinvestment.
By using climate indicators to help identify which government projects and corporations are most aligned with the Paris Agreement, the ECB will be able to attribute them with a “climate score” to help guide decisions on which public and private sector bonds to prioritise the purchase of.
In turn, the use of this framework will incentivise stakeholders to reduce emissions and decrease reliance on fossil fuels if they are to meet climate-related criteria and receive investment.
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However, along with incorporating climate considerations in monetary policies to encourage decarbonisation and support the green transition in this way, if we are to actually facilitate the successful and timely rollout of renewable technologies that will accelerate this at a pace aligned with UN climate targets, the bureaucratic red tape that surrounds such processes must also be reduced, if not removed entirely.
This article was originally published on IMPAKTER. Read the original article.