The discussion of the monetary policy response to climate change has typically focused on whether central banks should take action and what types of adjustments they could make, with comparably less focus on the practical challenges in making such adjustments. This final column in a three-part series reviews some prominent examples of central banks having adjusted their monetary policy operations to account for climate factors, examining why the actions were taken, exploring which types of measures were implemented, and identifying the operational challenges and how they were overcome.
Climate change is affecting weather and climate extremes in every region across the globe, with the adverse economic impacts becoming increasingly clear (IPCC 2023). So it is not surprising that academics, think tanks, and central bankers continue to discuss how central banks could adjust monetary policy operations in light of climate change (e.g. Landau and Brunnermeier 2020, Van’t Klooster and van Tilburg 2020, Schoenmaker 2021, Dafermos et al. 2022, Schnabel 2023).
This discussion has typically focused on whether central banks should take action and what types of adjustments they could make. There has been comparably less focus on the practical challenges in making such adjustments – including questions around prioritisation, calibration, or data.
In a recent report (NGFS 2024), the Network for Greening the Financial System (NGFS), a group of over 140 central banks and supervisors, reviewed eight prominent examples of central banks having adjusted their monetary policy operations to account for climate factors (complementing its earlier, conceptual work on this topic, see NGFS 2021). This analysis, set out below, focuses on the practical aspects of those actions and shines a light on three areas:
First, it examines why central banks have taken action. Some central banks have adjusted their monetary policy operations to support the economy-wide transition to a low-carbon world, while others have taken action to protect their own balance sheet.
Second, it explores which types of measures have been implemented. The diversity of approaches we see suggests that central banks are willing to experiment with new measures, and that operational challenges can often be overcome.
Third, it identifies cross-cutting operational challenges and discusses how central banks have addressed these. This allows policymakers to learn from peers.
Why have central banks decided to take action?
Every central bank needs to manage financial risks to their own balance sheet – which includes climate-related financial risks. For example, if a central bank is concerned that fossil fuel-related assets might lose value in the transition to a low-carbon economy, it may want to reduce its exposure to such assets. We refer to this as the ‘risk protection’ objective of climate action.
Some central banks have legal mandates that go further and that require (or allow) them to take measures that are intended to support the economy’s transition towards a low-carbon economy. For example, a central bank may try to increase the relative funding cost of coal companies to discourage investment in this sector. We refer to this as the ‘climate change mitigation’ objective.
Figure 1 Central bank objectives in connection with climate change
Six of the eight case studies the NGFS identified were motivated by a ‘climate change mitigation’ objective and did not appear to be accompanied by any risk-based measures. This may reflect several factors.
First, relevant central banks may have chosen not to highlight any risk-based actions publicly. This would not be particularly unusual – central banks rarely discuss all aspects of their internal risk management processes publicly. But it would explain why the NGFS failed to identify these actions.
Second, the relevant central banks may have judged that they did not have to take additional action to protect their balance sheets. As part of their regular monetary policy operations, central banks already take measures that protect their balance sheets against a wide range of tail risks. For example, they only lend against high-quality collateral and apply conservative haircuts to this collateral. Central banks may have judged that these measures were sufficient to protect them from any climate-related risks.
Third, methodological challenges may have stopped these central banks from also adjusting their risk management frameworks. Accurately measuring and quantifying climate-related financial risks in a comprehensive manner and integrating these findings into traditional risk management tools is difficult and can take time. This is particularly true for central banks, which typically want to limit the role of purely qualitative assessments in their risk management frameworks. However, we would expect this to change over time.
Which elements of their monetary policy operations have central banks adjusted?
The assets that central banks hold for monetary policy purposes typically involve collateralised lending to eligible financial institutions, and outright purchases of financial assets (‘quantitative easing’). Hence, adjustments can focus on three broad areas shown in Table 1.
Table 1 A taxonomy of actions that central banks have taken, and number of case studies that fall into each category
Note: “Credit operations” include measures taken by the Magyar Nemzeti Bank, the People’s Bank of China, and the Bank of Japan; “collateral” includes measures taken by the Magyar Nemzeti Bank and European Central Bank; “asset purchases” includes measures taken by the Magyar Nemzeti Bank, the European Central Bank, and the Bank of England.
First, central banks can adjust the terms under which they are willing to lend. This includes (i) adjusting pricing to reflect counterparties’ climate-related lending; (ii) adjusting pricing to reflect the composition of pledged collateral; and (iii) adjusting counterparties’ eligibility. The case studies suggest that the focus has been on the first of these options. This could be because pricing adjustments are less likely to interfere with central banks’ core monetary policy objectives than adjustments to counterparty eligibility (NGFS 2021).
Second, central banks can adjust what collateral they accept as part of their lending operations. Options include (i) changing the ‘haircuts’ that are applied to specific types of collateral (e.g. only lending $0.90 against each $1 of carbon-intensive collateral); (ii) making some types of collateral entirely ineligible (‘negative screening’); (iii) requiring all collateral to have certain characteristics (‘positive screening’); or (iv) imposing aggregate ‘pool level’ requirements (e.g. only up to 10% of assets in the collateral pool that a financial institution provides can be linked to fossil fuels). Measures implemented so far have focused on the first two approaches.
Third, central banks can adjust their asset purchase programmes – by increasing their allocation to climate-friendly assets and reducing their allocations to carbon-intensive assets (‘tilting’), or by including or excluding assets from asset purchases based on their climate characteristics (positive or negative screening). Most central banks, including the Bank of England, have focused on the less radical option of tilting their asset purchases.
How have central banks overcome practical challenges?
Central banks’ practical experiences have highlighted several implementation challenges, as well as ways of overcoming them.
Determining what operations to focus on
Many central banks are still building up in-house climate expertise and are yet to identify areas of strategic focus that reflect their local circumstances. For example, in countries with more bank-based financial systems and small capital markets, focusing on the treatment of publicly traded securities may have a smaller impact than in countries with deep and liquid capital markets.
Central banks have typically addressed this by initially focusing on the asset classes that are most material (either from the perspective of the wider economy and/or their balance sheet) and, within that, on those asset classes where climate-related metrics are more readily available.
Deciding on the appropriate calibration of any climate measures
Even where supporting the transition to a low-carbon economy is within a central bank’s legal mandate, the mandate would not typically specify how much weight central banks should put on climate-related factors relative to other considerations. For instance, their mandates would not tell central banks how aggressively to tilt asset purchases towards low-carbon issuers, or the preferential lending rate that they should offer as part of any green lending operations. The answer to this may depend on the specific trade-offs that a given measure would generate. But accurately quantifying these trade-offs can be challenging, if not outright impossible.
Central banks have addressed this challenge by initially taking a cautious approach, while signalling that they may ‘escalate’ actions over time. This allows them to learn about any trade-offs and potential unintended consequences over time, before considering ratcheting up any adjustments at a later stage.
Overcoming challenges around data availability
Central banks need granular data to assess whether an asset they are exposed to via their monetary policy operations is supporting the transition to a low-carbon economy and/or is exposed to material climate-related financial risks. This includes, for example, data on an issuer’s greenhouse gas emissions, green bond labels, or energy efficiency ratings for residential properties. While emissions are now widely disclosed, there are still notable gaps and data will not be available for every single issuer or asset.
Central banks have deployed pragmatic solutions for dealing with missing data, such as filling in gaps in the emissions of corporate issuers through using estimates or data from previous years. Where central banks were unable to obtain emissions data for an entire asset class, they have used third-party assessments (such as green bond labels) or self-assessments by their counterparty instead.
Central banks are also using their monetary policy operations to actively help build better data. For example, the publication of climate disclosures is a common requirement for entities to be eligible as part of green lending operations, asset purchase programmes, or collateral frameworks.
Conclusion
Central banks have already made significant progress in incorporating climate-related factors into their monetary policy operations. And while there are a range of practical challenges, the experience to date suggests that none of these are insurmountable.
That said, there is clearly more work to do here. Much of this entails central banks learning from each other and understanding best practices. But some practices will also need to evolve in light of the current monetary policy environment and the wind-down of asset purchase schemes. This is why the NGFS will continue its work in this area.
source: cepr.org
