Central banks weigh in on carbon transition

Instead, they advocate a role marshalling different opinions and initiatives into a more cohesive body of action.

“To envisage a miraculous white knight such as a central bank appearing on the scene to solve climate change would be naïve. We should contribute to solving the problem through coordination. The way [climate change] policies are constructed is primarily the responsibility of government”, says Luiz Pereira da Silva, Deputy General Manager at the Bank of International Settlements in Switzerland, one of the authors of a new paper on central banking and financial stability in the age of climate change.

Released in January 2020 and entitled ‘The Green Swan’, it contributes alongside the NGFS to efforts to redefine the role of central banks while denouncing the “procrastination” of governments. The bankers publishing the remarks, who include both da Silva and Banque de France Deputy Head of Financial Stability Morgan Despres, say the pressure exerted on central banks to address climate change is “excessive and unfair”.

Such comments are a rebuffal to nonprofits urging central banks to intervene as they did during the 2008-10 financial crash. This would mean using policy instruments with the power to drive greener investment, such as purchasing green bonds, an activity dubbed ‘green quantitative easing’ by advocacy groups and media, to help move the economy away from fossil fuels.

To counter such views, da Silva and Despres assert that it is the role of government to establish the right conditions for greener investment. The policy instruments at the disposal of central banks, they say, cannot substitute for the many areas of interventions necessary from regulatory authorities for a global transition to a low-carbon economy. Examples include carbon pricing and taxation, or designating assets green or brown. Meanwhile, they suggest that central banks can adopt a more coordinating role between governments, the private sector, civil society and international organisations “to encourage other players to set the right mechanisms for making sure their policies are consistent”, says da Silva.

Organisations ranging from the European Commission to NGO the Climate Bonds Initiative, who are examining more direct action on financial markets, consider several possibilities. Alongside ‘green quantitative easing’, they visualise the use of the ‘green supporting factor’ by central banks to green the financial system. This means setting easier lending conditions for green investments and lowering capital risk requirements for green assets. It reduces the amount of capital banks set aside when lending to green projects, and could be accompanied by a corresponding ‘brown penalising factor’.

However, investigations into that approach by advocacy groups such as Positive Money have met with opposition because it would require evidence to prove green assets have a lower level of default. Thus, there are concerns in the European Central Bank, for example, that the ‘green supporting factor’ could undermine general rules for lending and itself add risk to economic stability.

Another option proposed by advocates of a more interventionist central banking approach, such as Positive Money, includes explicit targets or discounts to interest rates to guide bank lending to preferred sectors such as greener transportation. However, fears that this preferential treatment could undermine markets have prompted calls for more consensus. “Central banks are not the only game in town and can’t play the same role as in the financial crash in relation to climate change. This requires collective action by everyone”, states da Silva.

The flux in opinion is visible not just among NGOs, policy makers and financial organisations but also among NGFS members as they attempt to mould a common view. For instance, Jens Weidmann, President of the Deutsche Bundesbank (Central Bank of Germany) warned in October 2019 against ‘green quantitative easing’. By contrast, new European Central Bank (ECB) president Christine Lagarde stated at the launch of a wide-ranging ECB policy review in January 2020 that the bank could consider increasing the share of green investment in its portfolio.

Previously, both the Bank of England governor Mark Carney and the NGFS had drawn attention to the changing role of central banks and the need to disclose climate risk. As a follow-up, the Bank of England initiated its first stress test on climate in line with the more conventional tasks carried out by central banks. The test will measure whether climate change could create a financial crisis by, for example, causing sudden loss of productivity in a heat wave. Currently under consultation, its findings will be published in 2021.

De Nederlandsche Bank (Central Bank of the Netherlands), another NGFS member, has already conducted an energy transition stress test, while many more of the 50+ members globally are also reviewing this possibility. Most of these supervise both commercial banks and insurers, as well as making their own investments. However, the consortium lacks a key player, the Federal Reserve (central bank) of the US.

The initial aim of the NGFS is to incorporate climate change into economic models of financial stability, and improve the information that helps evaluate climate risk. Thus, even if central banks do not take direct action to influence the transition to a greener economy, they can still make use of other options alongside the coordination role proposed in ‘The Green Swan.’

For instance, they can compel climate disclosure by the financial organisations they supervise. In many countries this does not require separate government legislation.  But before this is made mandatory, pioneers in the field such as members of the Taskforce on Climate-related Financial Disclosures (TCFD) – a global high-level group promoting better reporting, have been advocating voluntary climate scenario analysis. This requires assessing risks experienced by banks at various degrees of global warming.

That means obtaining appropriate data through meticulous investigations that central banks have never conducted, such as understanding the potential impact of floods or hurricanes on cities they have never examined. At this early stage, data ambiguities have become apparent, according to Morgan Despres.

For example, no two approaches to modelling physical risk to real estate are identical. The extent of flood risk is not visible to the central banks, who have no information on the exposure of mortgage lending by a particular commercial bank. In addition, each segment in the chain is reliant on other segments. “If the financial sector is working on climate risk disclosure but clients are not, we’re hampered in terms of inputting our own disclosures”, points out Simon Connell, sustainability strategy head at the commercial bank Standard Chartered.

Agreement on effective and standardised reporting techniques is one solution under scrutiny by the TCFD to help chart a pathway through the data required.  This could take several years to develop for both physical and transition risk (financial risk from adjusting towards a lower-carbon economy). Transition risk depends on views of the development of fossil fuel policy, for example. These are forward-looking and thus more subjective than historic reporting on the year’s activities

Another more conventional activity under discussion is the integration of sustainable investment criteria into central bank portfolio management (pension funds, their own accounts and foreign reserves).

For instance, Banque de France in 2019 stated in its first Responsible Investment Report that it would now include environment, social and governance (ESG) criteria in its asset management and apply a best-in-class approach based on firms’ ESG scores and climate performance. It will also adopt a voting policy that includes provisions on non-financial transparency and also increase its general meeting attendance rate.

Of all these possibilities, the most widely expected among the majority of the banks is mandatory reporting. Mark Carney already signalled this in autumn 2019, calling for a two-year timeframe to agree rules on climate risk reporting or expect them to become compulsory.

But shortcuts may be available anyway, as Simon Connell explains: “It is critical for TCFD to develop detailed disclosure models for financial participants and the clients we serve. But they are not available yet so we may have to more quickly arrive at a rough answer”, he says.

Clearly, the divergence between policy makers, banks and financial organisations is a risk in itself to both climate and economy as conflict obstructs global cooling and could generate unpredictable events. By offering to coordinate between them, the authors of ‘The Green Swan’ show central banks themselves can diminish that transitional risk.

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