April 11, 2024 David Barmes & Simon Dikau, London School of Economics and Political Science (LSE) Over the past decade, a climate-related financial risk (CRFR) discourse has been the primary approach in shaping central banks’ engagement with climate change and a green transition. Legitimized with reference to financial stability mandates and safeguarding central bank balance sheets, this ‘protective’ approach entails a strong focus on the assessment of these risks as well as a recalibration of prudential policies and monetary operations to account for CRFRs. Mark Carney’s 2015 speech ‘Breaking the Tragedy of the Horizon’ and the subsequent launch of the Taskforce on Climate-Related Financial Disclosures (TCFD) popularized this narrative, triggering a rapid increase in financial policymakers’ speeches mentioning and centering climate change. Reflecting on the limitations of the exclusive focus on the CRFR approach and the green legitimizing power of financial stability mandates, this essay makes the case for a shift toward price stability mandates as the primary justification for central banks to engage with climate change, environmental degradation, and a green transition. We then conclude with reflections on implications for monetary policy.

1. The green limitations of financial stability mandates and secondary objectives

Early critiques of the CRFR discourse from Aglietta and Espagne, Christophers, and Chenet and colleagues among others argued that it rests on flawed assumptions relating to the efficient markets hypothesis (EMH) and a misguided conceptualization of CRFRs as being knowable and calculable ‘risks’ rather than fundamentally unknowable ‘uncertainties’. In 2020, the incalculability of CRFRs characterized by radical uncertainty was discussed at length in “The green swan”, a major publication by the Bank for International Settlements (BIS) and the French Central Bank, which argues that scenario analyses and forward-looking methodologies – despite being useful tools for exploring potential economic and financial consequences of different transition pathways – do not resolve the radical uncertainty associated with climate change and the transition to a sustainable economy. The authors conclude in favor of “a move from an epistemological position of risk management to one that seeks to build the resilience of complex adaptive systems that will be impacted in one way or another by climate change”. While this is a frequently referenced publication, which resulted in the establishment of an annual Green Swan conference hosted by the BIS, the view that climate change presents calculable risks that can be hedged remains widespread across the sustainable finance and central banking community. Elliott argues that the ongoing dominance of a “risk-based policy paradigm” over a “radical-uncertainty-based policy paradigm” results from vested interests’ opposition to the prohibitive, restrictive, and precautionary policy implications of the latter approach. That said, even if monetary and prudential authorities adopt a radical uncertainty position, there are several reasons for which they may refrain from taking proactive financial policy action to support a green transition. For example, they may believe that financial stability can be maintained under highly unstable climatic conditions, that their financial policy tools are unsuited to addressing the causes of climate change, or that proactive measures taken under financial stability mandates would be misaligned with their monetary policy stance and therefore their price stability objectives. Though dominant in sustainable central banking discourse, the financial stability justification for climate-related monetary and prudential policy hasn’t been the only game in town. A promotional approach adopted under secondary mandates to support government’s economic policy priorities pre-dated Carney’s intervention and the rise of the prudential approach. A small number of central banks and financial supervisors in emerging market and developing economies, particularly in Southeast Asia and South America, implemented green policies in support of the sustainable development agendas of their respective governments as far back as the 1990s and 2000s. More recently, in its latest announcement on its operational framework, the ECB referred to its secondary objective (to “support the general economic policies in the Union with a view to contributing to the achievement of the objectives of the Union”) when stating that “the design of the operational framework will aim to incorporate climate change-related considerations into the structural monetary policy operations.” However, the details, interpretations, and operationalization of secondary mandates are often unstable as they are highly dependent on political developments. In the UK, for instance, the Treasury recently (partially) reversed its previous decision to include net-zero and environmental sustainability to the Bank of England’s remits in 2021.

2. Typologising the environmental dimensions of price (in)stability

This leaves the price stability mandate – the primary objective common to all central banks – which has received comparatively little attention from advocates of sustainable central banking. Price stability was even frequently invoked by opponents of central banks engaging with climate issues, suggesting that central banks should not be distracted from their inflation-targeting purpose by social and environmental concerns. But times are changing. Massoc traces the rise of a climate-related price stability narrative adopted by a coalition of pro-climate Members of the European Parliament and central bankers, and Aguila and Wullweber argue that the price stability objective is already displacing financial stability as the primary justification for the ECB’s climate and nature agenda. Schnabel popularised this issue in her 2022 speech “A new age of energy inflation”, where she coins the terms ‘climateflation’, ‘fossilflation’ and ‘greenflation’ to describe the ways in which climate change, fossil fuels and a transition to renewable energy can generate inflationary pressures. Building on this typology, we propose thinking about environment-related price pressures along two dimensions: i) the extent to which they are generated by physical or transition impacts; and ii) the extent to which they are inflationary or disinflationary. This yields four categories, as displayed in Figure 1 below: Figure 1: (Dis)inflationary pressures in the context of physical and transition impacts These four types of effects can be generated to varying degrees by supply and demand shocks (both positive and negative) and the extent to which they materialize would depend on different transition pathways. For example, delayed transition scenarios would entail elevated levels of environment-related inflationary and disinflationary pressures, alongside transition-related inflationary pressures. On the contrary, in a smooth transition scenario, transition-related disinflationary pressures would feature more prominently. If multiple distinct types of (dis)inflationary pressures are present simultaneously (which is likely), an increase in the variability of prices may result, potentially leading to a situation in which significant price volatilities and divergences across different sectors, and even across goods and services within sectors, lie beneath apparent price stability at the aggregate level.

3. Evidence of environment and transition-related (dis)inflationary pressures

The evidence of a link between the physical impacts of climate change and price instability is growing, with environment-related inflationary pressures – particularly via negative supply shocks in the agricultural sector – tending to outweigh environment-related disinflationary pressures. Single-country studies on China, Thailand and Peru among others also that extreme weather events and shocks drive food price inflation. A recent cross-country study covering 121 countries by Kotz and colleagues found that temperature and precipitation shocks could contribute 3.2 percentage points per year to food inflation and 1.18 percentage points per year to headline inflation by 2035. These effects occur globally but are most pronounced across Africa and South America and during hot seasons. They also find that the 2022 extreme summer heat in Europe contributed 0.43 – 0.93 percentage points to food inflation. Faccia and colleagues similarly find that severely hot summers cause food price inflation in the short term, and Mukherjee and Ouattara establish that temperature shocks cause inflationary effects that are most persistent (lasting up to 6 years) in low-income countries. However, studies by Bremus and colleagues, Ciccarelli and colleagues, Natoli, Parker, and Kabundi and colleagues show that ultimate effects on headline inflation can be varied, as environment-related disinflationary pressures can outweigh inflationary pressures depending on the type and severity of shocks as well as the economic and climatic conditions in which they occur. As noted by Barmes and Schrӧder Bosch, the ways in which environment-induced inflationary pressures transmit internationally via trade generally fall outside of the scope of these studies, which capture the effects of domestic physical shocks on domestic inflation. This is a considerable omission, as the internationalization of production has resulted in global factors playing an increasingly substantial role in inflation dynamics, and it may be particularly relevant for the food price inflation discussed above. Furceri and colleagues find that a 10% increase in global food prices increases inflation in high-income economies by approximately 0.5 percentage points a year later, and Peersman finds that fluctuations in international food prices account for 25%-30% (on average) of consumer price volatility in the euro area. To the extent that empirical studies on environment-induced (dis)inflationary pressures stop short of considering such international dynamics, estimates of price instabilities related to the physical impacts of climate change are likely to be considerable underestimates. The (dis)inflationary effects of transition policies are equally, if not more, complex and under-studied. On the one hand, high fossil fuel prices drove the majority of inflation over the past couple years, implying that scaling up renewable energy infrastructure and reducing fossil fuel dependence would have disinflationary effects. On the other hand, a green transition could entail its own inflationary effects due to carbon taxation, environmental regulations, booms in green investment and expenditure, and shortages in transition-critical materials necessary for the scaling up of renewable energy infrastructure. Furthermore, Jackson and Jackson find that the lower energy return on energy invested (EROI) of renewable energy compared to conventional fossil fuel sources could also generate higher energy prices and general inflation.

4. Implications for monetary policy and sustainable central banking

The legitimization of green central banking via financial stability mandates and central banks’ own balance sheet risk management has typically resulted in policy recommendations focused on managing CRFRs on central banks’ own balance sheets and across the financial system. The growing evidence of environment and transition-related sources of price instability can strengthen the justification for such policies, yet also raises its own set of policy implications at the core of monetary policy and modern central banking. While a comprehensive treatment of these implications lies beyond the scope of this essay, we highlight three factors: First, the inflation forecasting process will need to account for growing sources of environment and transition-related (dis)inflation, which add an additional layer of complexity and uncertainty to macroeconomic forecasting. Boneva and Ferruci, who highlight the absence of climate-related shocks and trends from central banks’ canonical models, propose a “suite of models” approach intended to bridge climate-specific and macroeconomic models. Furthermore, following the failure to anticipate the recent bout of inflation, central banks are considering a greater focus on alternative scenarios in their forecasting and communications, a likely outcome of Ben Bernanke’s ongoing forecasting review at the Bank of England. Such an approach could include scenarios involving high price volatility linked to climate change, environmental degradation and/or a green transition. Second, central banks could consider green targeted lending schemes, particularly when they engage in cycles of monetary tightening, as green infrastructure projects are disproportionately impacted by interest rate hikes due to their high capital-intensity. Such schemes could allow central banks to pursue a tight monetary policy stance while protecting green sectors from this decision. Versions of this policy have already been implemented in Bangladesh, China, Japan, and South Korea, and green ‘TLTROs’ are currently being considered at the highest levels of the European Central Bank. A proactive green collateral policy, adjusting collateral eligibility and haircuts in favor of green assets, would also be consistent with this attempt to develop a green monetary policy stance. Third, where environment and transition-related inflationary pressures arise due to negative supply shocks, there is a strong case for central banks to “look through” such inflation and refrain from increasing interest rates altogether. As a demand-side tool, there is little that interest rates can do to address supply-side inflationary pressures, and while green targeted lending schemes could shield private green investment from rate hikes, public investment – particularly across the Global South – remains affected as borrowing costs rise, exacerbating debt distress. In a dollar-dominated international system, if the Fed hikes rates, central banks across the world are pressured to follow suit to avoid capital flight and currency depreciation, meaning that looking through inflation is only feasible for central banks globally if the Fed adopts this policy. Therefore, truly sustainable central banking may entail major reforms to the international monetary and financial system and/or a Fed willing to frequently look through inflationary pressures in a new era of supply side disruptions. At the London School of Economics, we recently launched a new Centre for Economic Transition Expertise, devoted to supporting central banks and finance ministries in exploring these issues and responding in ways that best support a green transition and fulfil their mandates. We welcome collaborators and look forward to further work and discussion on the appropriate role for central banking in a green transition.