Central banks waking up to climate change

Leading central bankers have warned that climate change – combined with a poorly managed low carbon transition – has the potential to trigger a sudden collapse in asset prices that could devastate the financial system. After sounding the alarm bells, central banks themselves are calling for action.

Financial institutions need to adjust to the new world of climate change or ​“they will fail to exist” cautioned the heads of the Bank of England, the Banque de France, and the Dutch National Bank.

Their comments accompany the launch of a new report from the Network for Greening the Financial System (NGFS), a growing international group of central banks and financial regulators. The report highlights an urgent ​‘call for action’ to the broader central banking and regulatory community. It has six main recommendations:

• Supervisors should set expectations for financial institutions to begin integrating and monitoring climate risks in day-to-day operations (including at the board level).
• Central banks should incorporate climate-related financial risks into their own portfolios (e.g. their pension funds).
• There should be greater collaboration to enhance the management, collection, and assessment of data related to finance and climate change.
• Central banks and regulators should share lessons and experiences with other stakeholders on how to manage the financial risks posed by climate change.
• The sector should achieve robust and internationally consistent climate and environment-related disclosure.
• The sector should support the development of a taxonomy of economic activities.

Most encouragingly, these recommendations are coming with a big new step being taken by the Bank of England. After a letter drawn up by NEF, signed by over 50 different NGOs, called on the Bank to lead by example in disclosing in climate related financial risks, the Bank yesterday announced its decision ​“to disclose how financial risks from climate change are managed across its entire operation.”

This huge win for us and other campaigners doesn’t just enhance the transparency of our central bank, but it effectively means the Bank will have to think twice before indirectly subsidising environmentally damaging activities.

Another pioneering central bank leading the way on climate change is the People’s Bank of China (PBOC). Not only has it introduced green criteria into its monetary policy operations, but also into its macroprudential assessment system. For example, the PBOC has introduced a macroprudential framework that incentivises banks to finance green activities (and implicitly dis-incentivises carbon intensive activities). It is also the only central bank to accept green loans from banks as collateral for refinancing.

Indeed, at a conference hosted by NEF last month, we were privileged to have a member of the PBOC’s monetary policy committee — Dr. Ma Jun — give a keynote speech (below).

The Bank of England, PBOC, and the NGFS are all taking encouraging steps in the right direction. There has so far been a tension between the words and actions taken by the central banking sector. One study suggests that the amount of central banks participating in green networks vastly outnumbers the number taking actual action on sustainability.

The urgency for action is highlighted by the fact that climate related losses could reach between $1trillion and $4trillion when considering fossil fuels alone, or up to $20trillion when looking at a broader range of sectors (more than 10 times the losses of the global financial crisis). And Canadian, Chinese, European, Japanese, and US banks have financed fossil fuels with $1.9 trillion since the Paris Agreement was adopted.

It is primarily the government’s responsibility to lead on the low carbon transition. But there is also a role for central banks and financial supervisors, and the NGFS is right to issue this call for action to the central banking sector.

In particular, the report alludes to central banks walking the talk and taking into account climate related financial risks into their own monetary policy operations. Central banks have warned that financial markets are failing to price in climate related financial risks, but they too are exposed to those very same financial risks. As we have argued elsewhere, by failing to integrate these risks into their operations, central banks also end up biasing the allocation of capital towards carbon-intensive activities. So it seems sensible that central banks reflect climate risks in their day-to-day monetary policy operations.

Given the severity of both climate change and the potential financial risks in entails – central banks should also consider deploying macroprudential policy in a way that curbs the flow of lending to polluting economic activities. We already have and apply these tools to the property sector (to curb house prices and the property bubble), why not apply them to tackle climate change and the carbon bubble?

Finally, central banks can also help promote green forms of financing. The Bank of England and the European Central Bank could repurpose their current schemes aimed at reducing the cost of borrowing for businesses and households (the £125billion Term Funding Scheme in the UK, and the EZ TLTRO programme). These programmes could be tweaked to reduce the cost of lending for green activities. A more radical alternative would be to transfer the funds of these programmes to a public investment bank that could on-lend for green projects.

Image: Graham Chandler (CC BY-NC-ND 2.0)