July 4, 2024 Steffen Murau, Andrei Guter-Sandu, and Armin Haas OBFA-TRANSFORM Project Climate change stands as one of the most pressing challenges of our time, exerting profound impacts on ecosystems, communities, and economies worldwide. As its consequences become increasingly apparent, so too does the recognition that more needs to be done in accelerating the transition to a net-zero economy. In this context, central banks emerge as pivotal actors in addressing the complex nexus between climate change and the economy. Traditionally tasked with maintaining price stability and financial stability, central banks have repeatedly transformed their roles and operations. Now they are facing calls to broaden their focus and include policies that not only safeguard financial stability in the face of climate shocks but also promote decarbonising activities. These calls come as other institutions are perceived not to be pulling their weight in the race to decarbonise the economy, and as central banks are increasingly recognised as concentrating large amounts of potentially transformative power. So far, some action in the climate policy field has been undertaken by central banks. For instance, the Network for Greening the Financial System (NGFS) has grown to including 138 central banks. The Bank of Japan (BoJ) offers zero interest funding to projects contributing towards the country’s climate goals. The Bank of England (BoE) and the European Central Bank (ECB)  voiced their commitment to greening their corporate asset purchasing programmes. And the People’s Bank of China (PBoC) has implemented a carbon emission reduction facility. That being said, the direction of travel is often opposite to what is hoped for: The BoE has recently had climate change removed from the list of policy priorities in its remit. The Banque de France (BdF) stated that Green QE would be neither economically nor legally feasible. The Federal Reserve hinted that there are no foreseeable plans to becoming a climate policymaker and did not identify climate change as being among near-term risks to the financial system, despite its NGFS membership. And although the PBoC set up its carbon emission reduction facility, it also established a parallel facility to provide special central bank lending for coal. Even where climate policies were implemented by central banks, these have turned out to be symbolic rather than transformative. For instance, the BoE bought less than £20bn worth of green corporate bonds out of a total of £895bn in its QE operations. Similarly, the ECB brought its green purchasing policy to a virtual standstill when it stopped reinvesting maturing bonds in 2023 as part of its attempt at monetary tightening to fight inflation. As of now, despite a lot of public rhetoric, there is no central bank success story in the field of climate policy that can be replicated or ramped up. From our perspective, looking to penalise carbon-intensive activities one way or another is certainly a commendable practice for central banks. Likewise, targeting carbon reduction instead of maintaining erroneous ideas of market neutrality is worth striving for. However, those activities can only be one piece of the puzzle. Pinning all hopes for a timely Green Transition on an institution that has been called on to maintain systemic financial stability repeatedly in times of economic distress and is mandated to fight inflation in a rapidly changing macro-financial environment riddled with uncertainties may not be the best way to hedge our bets. In fact, there is a danger that placing central banks at the forefront of decarbonisation would put too many tasks onto one single balance sheet. It is true that central banks have shown extraordinary capabilities to defend the financial system over and over again, but their currently expanded balance sheets should be taken as a sign of systemic stress, the usage of a safety mechanism, and not an activity that we should seek to push further and further. It would also not be very reliable because as soon as the next crisis hits, decarbonisation will be among the first objectives to sacrifice. When push comes to shove, central banks have, so far at least, always prioritised their primary mandates. The sheer volumes of investments that are needed to properly decarbonise the economy go beyond what we can reasonably expect to be provided by a single balance sheet. The US Energy Transitions Commission suggested a price tag of 30-60 trillion USD for the US only, at a pre-pandemic price level. From our perspective, financing the Green Transition is an activity that the entire financial system needs to provide, while various public and private balance sheets act in tune. We see the role of the central bank as an important institution that can help steer the system in this process, albeit not as the primary institution to be at the forefront of the financing activities but—more akin to its traditional mandate—as an institution that stabilises the financing process of the Green Transition in the long run, throughout its various stages. Monetary Architecture and the Role of Central Banks How states can finance politically desired large-scale transformations like the Green Transition is the topic of inquiry in the OBFA-TRANSFORM project that we are jointly working on. We approach this question both from a theoretical and an economic history angle. In our article “Monetary Architecture and the Green Transition”, we develop a systemic and procedural understanding of what it means to finance a large-scale transformation such as the Green Transition. In line with the ideas of this online symposium on “Central Banks & the Climate Crisis”, we believe that central banks have a pivotal role to play in the financing process for the decarbonisation. But given the institutional design they have today and their structural positioning in the hierarchy of money, we argue that central banks are best used as “firefighters” to stabilise the financing process and use their power of balance sheet expansion ex post, rather than engage them as “workhorses” that need to create the initial balance sheet expansions ex ante. In our research, we approach the financing challenge of the Green Transition through the prism of the ‘Monetary Architecture’ framework. Monetary architecture is a shorthand to describe an institutionalist model of historically specific formations of the monetary and financial system as a web of interlocking balance sheets that is subject to continuous institutional evolution. It consists primarily of four segments: central banks, commercial banks, non-bank financial institutions (NBFIs), and a fiscal ecosystem, which is made up of treasuries and off-balance-sheet fiscal agencies (OBFAs). Moreover, we may add firms, households, and institutional cash pools such as pension funds to the picture. The institutions in these segments are conceptualised as balance sheets. These can be either individual entities as in the case of the Fed or the Treasury, or aggregate balance sheets for households, firms, banks, etc. These institutions are either public (such as the Treasury), private (such as banks and NBFIs), or a hybrid of both (such as the Fed and many OBFAs). All these institutions interlock through the different credit instruments they hold as assets and liabilities. Each asset of an institution must be another institution’s liability. Some of the institutions have a hierarchical relationship with each other. For instance, central banks are hierarchically higher than commercial banks, which in turn are hierarchically higher than NBFIs. The hierarchical structure is due to the nature of payment systems which need central nodes through which payment flows are organised. This is true for banking systems, which typically have a central bank at the apex, and commercial banks and NBFIs that occupy layers below. One implication of the Monetary Architecture framework is that the initial financing of large-scale investment projects is best carried out by hierarchically lower balance sheets who should thus act as “workhorses”. When they expand their balance sheets on both sides to create credit money, for instance in the form of deposits, against longer-term instruments such as loans or bonds, they issue hierarchically lower monetary instruments that are constructed as promises to pay hierarchically higher money, which would be ultimately provided by the central bank. It is the nature of credit money systems that the hierarchically higher money does not have to exist when the financing operation is carried out at a level further down in the hierarchy. But the hierarchically higher monetary instruments can be created out of nothing when stress in the system emerges and a safety valve is required that is capable of acting as “firefighter”. In terms of balance sheet mechanics, there is no technical obstacle to also use the central bank balance sheet to expand and create new money to finance decarbonisation projects. However, if central bank money creation is used for this purpose, there will be no other hierarchically higher balance sheet as a rear-guard that could expand and backstop the system in a moment of stress. In case of a crisis, as these balance sheets are situated at the apex of a hierarchical system, they are the ones that expand to accommodate distressed assets from hierarchically lower balance sheets. Hence, there is an argument to be made for keeping the central bank as hierarchical highest balance sheets lean in “normal” times in order to maintain its capacity to forestall the next crisis. Financing the Green Transition as a Four-Step Macro-Financial Governance Process From the perspective of the Monetary Architecture framework, how would the ideal-typical process of financing the Green Transition look? In our conceptualisation, this process entails four analytically distinct phases of macro-financial governance that comprise a carefully crafted division of labour between various balance sheets in the monetary architecture. This division of labour draws on the idea that hierarchically lower balance sheets are best suited to act as “workhorses” whereas the hierarchically highest balance sheets function as “firefighters”. The first phase of the macro-financial governance process would be to provide financing via an initial expansion of balance sheets. Financing implies the creation of means of payment, typically in the form of deposits, which are defined as promises to pay higher-ranking money—typically central bank notes or reserves. The internal logic of our credit money system is that central bank money forms the rear guard. At the moment of financing, central bank money is not itself necessary. The initial expansion is undertaken by workhorse institutions, which can be public, private, or public-private hybrids. The typical institutions expected to provide financing are banks, which engage in swapping IOUs with firms seeking to invest in decarbonising projects. In some cases, such profit-oriented firms may deem that there is no business case for starting these kinds of projects, and this is where other state sub-balance-sheets like OBFAs can play a crucial role. Think state-sponsored entities like the Connecticut Green Bank in the US, the Clean Energy Finance Corporation in Australia, the Malaysian Green Technology Corporation, or the National Bank for Economic and Social Development in Brazil. These entities can provide grants and discounted finance to businesses, as well as loan guarantees and credit enhancements. The second phase comprises long-term funding. What this means is that the various credit instruments created in the first phase must be allocated within the monetary architecture. When balance sheets swap IOUs as part of the initial expansion, this results in one balance sheet acquiring a short-term IOU that will be spent on the respective green project involved, while the other balance sheet acquires a long-term IOU, say a five-year green bond. This must be funded throughout its lifecycle, either by that same balance sheet, which would hold it itself, or by another balance sheet, which would procure it on secondary markets. This can be left to the decentralised activities of private profit-oriented institutions. However, similar to the previous step, in some cases green asset markets might not be appealing, either due to detrimental risk-return profiles, limited secondary market liquidity, or some other factors. Here is where OBFAs can again step in and provide the right environment for a functioning market in green assets: by becoming themselves investors in green assets or even by creating green securities through pooling together smaller green loans and structuring them according to the risk-return profiles demanded by patient capital institutions like pension funds or insurance companies. The third phase comprises stabilisation. Green assets created in the financing process are not inherently less risky than any other assets. Hence, they are subject to financial instability and endogenous credit implosion. This is where the central bank plays a paramount role. In our conception, the central bank as hierarchically highest balance sheet is designed to provide system stabilisation by expanding its balance sheet ex post. It does so when acting as a lender-of-last-resort that provides liquidity insurance for commercial banks or treasuries. Central banks are complemented by OBFAs that provide solvency and deposit insurance with the goal to avoid self-fulling prophecies that would lead to a bank run. This is organised differently in different states. Treasuries provide, as further building block of financial stability, capital insurance for any other balance sheet in the monetary architecture. The fourth phase concerns orderly contraction. In this respect, green assets are not different than assets in general: In order to sustain system stability, a substantial part of green assets must be paid back and the respective balance sheets contract. Nevertheless, some green assets will fail. Hopefully, the markets will be able to allocate the funding of green assets such that the system can sustain these losses without triggering an avalanche of disorderly contraction. Two strategies have been conceived for containing disorderly contraction. One strategy is to establish mechanisms that allow the shrinking or even defaulting of balance sheets while shielding the rest of the monetary architecture from its implications and finding ways to maintain the critical functions provided by the contracting balance sheets. This strategy is behind the concept of “resolution”, which became popular after the GFC as a silver-bullet to deal with the too-big-to-fail problem. The alternative strategy concerns public firefighting institutions that use their in-principle unlimited elasticity space to pull the instruments of defaulting institutions onto their balance sheets and conduct organised write-offs or redistributions of instruments. As a result, the public firefighters can close down some institutions and recapitalise others before eventually reprivatising them with a lean balance sheet. Central Banks, State Sub-Balance Sheets, and Greener Pastures In sum, our conceptualisation of financing the Green Transition as a long-term process emphasises the crucial role that central banks play in it, although not primarily as investors of first resort, but rather as safeguards of the process. This does not mean that we see no role for the state or public entities in bringing about the Green Transition. Quite the contrary, we believe that the Green Transition will not happen without substantial state involvement. This can be at the level of the green initial expansion, but also concerns long-term funding, stabilisation, and even final contraction. Indeed, according to the Monetary Architecture framework, the state is a highly complex entity that comprises a large number of sub-balance sheets. These are present throughout all the levels of the financing of a large-scale transformation of our economies. Moreover, the ‘state’ is also a dynamic construct: new sub-balance sheets appear, old ones wane away. Central banks are by no means the only public balance sheet in town capable of contributing to the process of financing the Green Transition. It is true that central banks have received a lot of public attention and scrutiny due to their paramount role in backstopping the financial system, notably during the 2007-9 Global Financial Crisis and more recently during the COVID-19 crisis. The notion that central banks should be at the forefront of financing the Green Transition is thus all too understandable given the power they have demonstrated to have when they pulled large volumes of the financial system onto their balance sheet and backstopped various entities both domestically and internationally. However, the role attributed to them by the logic of the real-world credit money system remains that of a lender of last resort, not primarily a lender of first resort. This is where central banks have mostly demonstrated effectiveness and impact. That said, green credit policy is still possible, and indeed needed. The focus just needs to be shifted to the complex web of state sub-balance sheets and to how these already are—but can also be better—mobilised into the first and second phase of the macro-financial governance process, while keeping the hierarchically highest institutions in place to safeguard the system and steer the financing process further down the line.