June 5, 2024 Ulrich Volz – SOAS University of London The climate crisis is worsening dramatically. A recent report from the World Meteorological Organization shows that climate change indicators including greenhouse gas levels, surface temperatures, ocean heat and acidification, sea level rise, Antarctic sea ice cover and glacier retreat reached record levels in 2023. Not only was 2023 the warmest year on record with the global average near-surface temperature at 1.45°Celsius above pre-industrial levels – we just lived through the warmest ten-year period on record. The goal of limiting global warming to 1.5°Celsius is hardly achievable anymore. According to the latest UN Emissions Gap Report, temperature will rise to 2.9°C above pre-industrial levels this century, provided governments fully implement the commitments they have made in their Nationally Determined Contributions. Meanwhile, nature loss is progressing at an unprecedented rate, accelerated by and accelerating the climate crisis. The impacts of the global ecological crisis on our economies are becoming ever more evident, and risks for macroeconomic stability – that is, stable growth and prices – and financial stability are rising. Those criticising central banks for addressing climate challenges and warning of mission creep are failing to understand how profoundly climate-related risks are threatening macroeconomic and financial stability. At this point, it should be blindingly obvious that the consequences of the climate and environmental crises directly affect central banks’ core mandate of maintaining macroeconomic and financial stability. It is increasingly well documented that climate impacts are already threatening macroeconomic and price stability – and not only in developing countries but also in advanced economies. The Network of Central Banks and Financial Supervisors for Greening the Financial System (NGFS) – a group that now comprises 138 members and 21 observers – has recognised that climate change and its mitigation will increasingly affect key macroeconomic variables across different time horizons as well as the transmission channels of monetary policy and hence the conduct of monetary policy. Clearly, central banks need to revamp their analytical toolkit to understand macroeconomic risks and impacts related to climate change to respond appropriately. Macroeconomic models, forecasting tools or monetary policy framework that do not consider climate impacts are futile. The risks for financial stability arising from the physical risks of climate change and nature loss as well as transitional risks associated with the shift to a low-emission, more sustainable economy have been analysed widely, and central banks and supervisors are rightly starting to integrate environmental risks in prudential frameworks. Central banks and supervisors should ensure that climate-related and nature-related risks are adequately disclosed and incorporated in the risk management of the financial institutions they supervise. A rapidly growing number of central banks are rolling out climate stress tests (and increasingly also nature stress tests) to assess these risks. In April 2024, the Basel Committee on Banking Supervision published an updated version of its Core Principles for Effective Banking Supervision, one of the most important sets of global supervisory standards. The revisions to the Core Principles explicitly include climate-related financial risks and recognise them as drivers of traditional risk categories such as credit, market, operational, liquidity, strategic and reputational risks. The Core Principles also highlight the relevance of climate-related financial risks for banks’ solvency and the stability of the financial system, echoing the findings of a large body of academic and policy studies. They put stronger emphasis on the forward-looking perspective in supervision and risk management and recommend that “the time horizon for establishing a forward-looking view should appropriately reflect climate-related financial risks and emerging risks as needed”. As Frank Elderson, Member of the Executive Board of the ECB and Vice-Chair of the Supervisory Board of the ECB, writes, the inclusion of climate-related financial risks in the Core Principles “is proof that there is a global consensus on the relevance of these risks, and broad agreement on the need for action.” If central banks and supervisors identify large risks either at the level of individual financial institutions or at the systemic level, they will have to take corrective measures. This is not woke or mission creep – it’s prudent supervision. Furthermore, central banks must also consider the impact of climate- and environment-related risks on their own balance sheets. Central banks’ investment strategies and collateral rules should minimise the environmental risks associated with such activities. This will serve to protect their own balance sheets, while sending important signals to the financial markets and the real economy. Critics have argued that central banks should adhere to the principle of market neutrality. But the supposed market neutrality of central banks is a fallacy – whatever actions central banks take (or not) will have distributional impacts. The Stern Review famously described climate change as “the greatest and widest-ranging market failure ever seen.” As recognised by ECB Board Member Isabel Schnabel, “[i]n the presence of market failures, adhering to the market neutrality principle may reinforce pre-existing inefficiencies that give rise to a suboptimal allocation of resources.” Against this backdrop, it is important that central banks adopt a double materiality perspective and consider how their actions affect environmental outcomes. For instance, if a central bank conducts a corporate bond purchase programme, it needs to consider its environmental impact. It has been shown that the corporate bond purchase programmes of the ECB and the Bank of England were highly skewed towards high-carbon sectors, effectively easing the financing cost of carbon-intensive corporations. The buying of carbon-intensive assets by central banks directly contradicts the signals they are sending to markets about the transition risks associated with such investments. It is hence reasonable that both the ECB and the Bank of England have decided to decarbonise their corporate bond holdings to reduce transition risk in their balance sheet and to support an orderly economy-wide transition to net zero. How proactively should central banks try to support the government’s response to climate change and nature loss? Central banks have a large toolbox of potential instruments at their disposal to mitigate environment-related risks and incentivise the issuance of green financial products. This doesn’t mean that they should necessarily use all instruments, but as guardians of macroeconomic and financial stability, central banks (and supervisors) need to introduce explicit strategies to mitigate risks and support the transition to net-zero and the scaling up of adaptation finance. They will need to take a systemic perspective, addressing both micro- and macroprudential risks over a much longer time horizon than they do now, and work to ensure that financial flows become aligned with climate and nature goals. Markets respond to signals from central banks. The seriousness of intent with which central banks consider environmental goals will have a profound bearing on financial market decisions that will ultimately determine capital formation and, thus, the trajectory of the economy. As part of this, monetary and financial authorities will need to play a pivotal role in shaping the tools, methodologies, data systems and taxonomies required for achieving environmental goals. Crucially, they also need to align their own policies and operations with environmental goals. In the current context of high interest rates, for instance, they should consider how they can support investments in the much-needed low carbon transition while achieving their price stability goals. As it stands, high interest rates impede investment in low carbon infrastructure. Recognising that recent high inflation rates were largely driven by sky-high fossil fuel prices linked to Russia’s invasion of Ukraine and that, likewise, historically, all high-inflation episodes in advanced economies were linked to fossil fuel price shocks, it would be sensible and in line with their price stability mandate for central banks to offer targeted refinancing operations to banks that finance renewable energy and energy efficiency investment. As an outcome, central banks can support the low-carbon transition while reducing dependency of the economy on fossil fuels and thus the risk of further inflation volatility induced by fossil fuel price shocks. A divine coincidence indeed! How exactly central banks ought to respond to the ecological crisis will differ from country to country, depending on the specific context, including their specific mandate and the political and institutional settings they are operating in. There is no question that it is the task of governments to pursue climate and other environmental policies. But it should be also clear that the central bank cannot be passive in the face of an ecological crisis that is threatening not only economic progress and financial stability but the very existence of human society as we know it. To achieve climate and other sustainability goals, the financial sector needs to be aligned with these goals. Finance sits at the heart of the economy, and central banks sit at the heart of the financial system. If we want our financial systems to be part of the solution, we need central banks to make sure that the rules that govern the financial system are aligned with climate and sustainability goals. A central bank that does not address environment-related risks and support the scaling up of sustainable investment is failing on its mandate to safeguard price stability and financial stability.