Central banks: the tools to fight climate change

The Covid pan­dem­ic, the cri­sis linked to the war in Ukraine and the chal­lenges posed by cli­mate change present cen­tral banks with a com­plex chal­lenge: to steer and con­trol infla­tion that is con­stant­ly ris­ing. The Euro­pean Cen­tral Bank’s (ECB) objec­tive is to achieve 2% infla­tion in the medi­um term – com­pared with 3% in Europe today – but with­out curb­ing the invest­ments need­ed for the ener­gy transition.

On the one hand, the scale of the invest­ments required to meet cli­mate objec­tives is colossal.

Our remain­ing glob­al car­bon bud­get, which rep­re­sents the CO₂ emis­sions com­pat­i­ble with the Paris Agree­ment, would be 580 GtCO₂ for a 50% prob­a­bil­i­ty of keep­ing warm­ing below 1.5°C accord­ing to the esti­mates of the IPCC report². On aver­age, annu­al glob­al anthro­pogenic emis­sions are around 40GtCO₂ (Glob­al Car­bon Project, 2022). At this rate, this car­bon bud­get would be exhaust­ed in less than 15 years. On the oth­er hand, the sources of infla­tion today are mul­ti­ple, from the dis­or­gan­i­sa­tion of val­ue chains dur­ing the pan­dem­ic to the imbal­ance between sup­ply and demand at the end of the cri­sis. In addi­tion, the rise in ener­gy prices linked to the war in Ukraine and ener­gy tran­si­tion poli­cies are fuelling “green infla­tion”³.

Is it legit­i­mate for cen­tral banks to take up the issue of com­bat­ing cli­mate change? This ques­tion was already raised by Mil­ton Fried­man in 1970 regard­ing the envi­ron­men­tal and social respon­si­bil­i­ty of com­pa­nies, when he ques­tioned the polit­i­cal legit­i­ma­cy of com­pa­ny direc­tors to pro­vide pub­lic goods⁵. How­ev­er, in terms of the fight against cli­mate change, we are faced with a dou­ble fail­ure to inte­grate cli­mate risk: the fail­ure of mar­kets but also the fail­ure of gov­ern­ments⁶.

The expec­ta­tions of eco­nom­ic and finan­cial actors and reg­u­la­tors are legit­i­mate. But this does not mean that cen­tral banks should replace governments.

The need for cen­tral banks to mobilise in the fight against cli­mate change is twofold: cli­mate change is a threat both to eco­nom­ic activ­i­ty and to finan­cial sta­bil­i­ty. It is there­fore an inte­gral part of the cen­tral bank’s man­date. Indeed, the TCFD report⁹ by the Banque de France and the ACPR in 2022 begins:

“Con­tribut­ing to assess­ing, reduc­ing, and man­ag­ing the impact of cli­mate risks on the real econ­o­my and the finan­cial sys­tem is in our view an inte­gral part of the man­date of cen­tral banks and super­vi­sors, both in terms of mon­e­tary strat­e­gy and finan­cial sta­bil­i­ty. The Banque de France has there­fore been an ear­ly advo­cate for the com­mu­ni­ty of cen­tral bankers and super­vi­sors to take cli­mate change issues into account. Inter­na­tion­al­ly, it was one of the found­ing mem­bers of the Net­work of Cen­tral Banks and Super­vi­sors for the Green­ing of the Finan­cial Sys­tem (NGFS)¹⁰ in 2017, which now has 121 mem­bers and for which it pro­vides the glob­al secretariat.”

Cli­mate risk in finance is defined in terms of two main com­po­nents: phys­i­cal risk and tran­si­tion risk (Car­ney, 2015). Phys­i­cal risk rep­re­sents the eco­nom­ic and finan­cial costs incurred because of the increas­ing sever­i­ty and fre­quen­cy of phys­i­cal cli­mate haz­ards. Tran­si­tion risk, on the oth­er hand, results from changes in gov­ern­ment poli­cies, tech­no­log­i­cal changes and changes in investor and con­sumer behaviour.

The tran­si­tion to a low-GHG econ­o­my requires rapid and far-reach­ing tran­si­tions in ener­gy, land use, urban plan­ning, infra­struc­ture, and indus­tri­al sys­tems. €830 bil­lion per year would be need­ed to make this tran­si­tion¹¹.

€830 bil­lion per year would be need­ed to ensure the tran­si­tion to a low-GHG economy.

Some sec­tors may lose much of their val­ue or even dis­ap­pear in the com­ing decades (referred to as strand­ed assets). Stud­ies¹² esti­mate that a pol­i­cy to lim­it glob­al warm­ing to 2°C would mean that 35% of oil reserves, 52% of gas reserves and 88% of coal reserves would become unus­able. In this con­text, should we then con­tin­ue to invest cap­i­tal in the search for and exploita­tion of these reserves? These invest­ments risk becom­ing unus­able, very expen­sive, and pos­si­bly total­ly depreciated.

All these changes can gen­er­ate loss­es iden­ti­fi­able through tra­di­tion­al finan­cial risks: cred­it (sub­ject-sen­si­tive bor­row­ers), mar­ket (asset val­u­a­tion), liq­uid­i­ty (access to bank finance) or oper­a­tional (com­pli­ance and reg­u­la­to­ry risk).

In terms of infla­tion – a core man­date of the Cen­tral Bank – the phys­i­cal risks of cli­mate change lead to neg­a­tive sup­ply shocks (cap­i­tal destruc­tion, reduced labour sup­ply, pro­duc­tiv­i­ty uncer­tain­ties) that reduce poten­tial out­put, increase out­put gaps and infla­tion­ary pres­sures. An increase in the fre­quen­cy and sever­i­ty of these neg­a­tive sup­ply shocks could lead to increased volatil­i­ty in head­line infla­tion and, under cer­tain cir­cum­stances, could affect infla­tion expec­ta­tions¹³. 

The ACPR (Autorité de con­trôle pru­den­tiel et de régu­la­tion), con­duct­ed a pilot cli­mate stress test in 2021 that high­lights the expo­sure to cli­mate risk in France of 9 bank­ing groups and 15 insur­ance groups, which togeth­er account for 85% of the total bal­ance sheet of banks and 75% of the total bal­ance sheet of insur­ers in France. This exer­cise shows that, for the insur­ance sec­tor, the cost of cli­mate-relat­ed claims should be mul­ti­plied by 5 or 6 between 2020 and 2050 in cer­tain depart­ments (par­tic­u­lar­ly in the west of France).

The cost of weath­er-relat­ed claims should be mul­ti­plied by 5 or 6 between 2020 and 2050.

The main haz­ards con­tribut­ing to this increase in claims are relat­ed to the risk of drought and flood­ing, and the increased risk of cyclonic storms in the over­seas ter­ri­to­ries. If this risk were to be off­set by an increase in pre­mi­ums, insur­ance pre­mi­ums would have to increase by 130 to 200% over 30 years, i.e. 3 to 3.7% per year¹⁴.

• To inte­grate cli­mate risk into finan­cial sta­bil­i­ty mon­i­tor­ing, pru­den­tial super­vi­sion and port­fo­lio man­age­ment, the cen­tral bank has sev­er­al tools at its dis­pos­al (see for exam­ple the rec­om­men­da­tions of NGFS, 2019¹⁵):
• Eco­nom­ic and finan­cial analy­sis (tak­ing cli­mate change into account in its mod­els, macro­eco­nom­ic pro­jec­tions, and risk assessment).
• Bank­ing and insur­ance super­vi­sion (rais­ing aware­ness and ensur­ing that banks and insur­ers man­age cli­mate risk adequately).
• Mon­e­tary pol­i­cy and invest­ment port­fo­lios (cen­tral banks can invest in green bonds, for example).
• Pru­den­tial and finan­cial sta­bil­i­ty mea­sures (e.g. on cap­i­tal require­ments and sec­toral lever­age ratios).

The cli­mate strat­e­gy of the Banque de France and the ACPR is thus embod­ied in all of the institution’s mis­sions (mon­e­tary strat­e­gy, finan­cial sta­bil­i­ty, ser­vices to the econ­o­my and soci­ety and sus­tain­able per­for­mance). Five strate­gic cli­mate actions are ded­i­cat­ed to pri­or­i­ty areas: adapt­ing mon­e­tary pol­i­cy oper­a­tions to cli­mate risks, increas­ing the finan­cial sec­tor’s con­sid­er­a­tion of cli­mate risk, assess­ing the inte­gra­tion of cli­mate risks into com­pa­ny rat­ings, active­ly com­mit­ting to car­bon neu­tral­i­ty, and aim­ing for dig­i­tal sobri­ety in all uses¹⁶.