ESGnomics n°9 - Central banks and climate: challenges and levers for action

As we discussed in a previous edition, the need for central banks to mobilise in the fight against climate change is legitimate. However, they do face some constraints in using the tools at their disposal.

A legitimate interest for central banks

Climate disruptions and transition policies will have a significant impact on economic activity, present and future. Accordingly, contributing to assessing, reducing, and managing the impact of climate risks on the real economy and the financial system is an integral part of the mandate of central banks and supervisors.

Fed and ECB: two visions 

Several factors are shaping central banks’ attitudes on both sides of the Atlantic.

First, the mandates of the Fed and ECB have specific legal features that will influence their actions. While the ECB’s main goal is price stability, a broad reading of European treaties shows that its must also support the general orientation of the European Union’s economic policies, which encompass environmental goals⁽¹⁾. This allows the ECB to take environmental criteria into account in the conduct of its monetary policy.

However, the Fed’s dual mandate is clear and precise: price stability and full employment, which excludes combatting climate change as an explicit goal⁽²⁾. Until now, these legal differences have resulted in a more proactive attitude by the ECB in addressing climate risks(3).

Furthermore, despite independence acquired in recent decades, central banks’ attitude has been influenced by the political context in which each of them operates.

Varying views of climate issues, for example, are an implicit constraint. In the US, climate change remains an extremely polarising issues between Democrats and Republicans, and, more generally, the US is one of the countries that pays the least attention to environmental risks. No wonder that the Fed ignores this issue as much as possible in the conduct of its monetary policy in order to avoid criticism. In contrast, climate change is a far less divisive issue in European public opinion⁽⁴⁾.

In short, despite clear risks, the Fed is more reluctant than the ECB to take measures that are openly geared to combating climate change, in order to preserve its credibility and independence while shielding itself from political controversies.

What are the levers for action?  

Central banks may use three types of action levers.

First, climate risk supervision focuses on understanding and managing risk. The main example of this is the climate stress test. In overseeing the robustness of the financial system, central banks attempt to measure banks’ capacity for resilience to transition scenarios and climate risks. The goal is to strengthen their capacities to collect data and analyse these risks, and to incentivise them to take remedial measures⁽⁵⁾.

Second, central banks may take measures regarded as more proactive, steering existing monetary policy tools towards a goal of combatting climate change. The ECB’s decision to gradually “green” its corporate bond portfolio is one such example⁽⁶⁾. However, the monetary tightening that it began in 2022 came with an end to its asset-buying programme. As a result, the ECB nolonger has any tangible way to green its portfolio. The greening decision was therefore symbolic and cannot be regarded as a permanent lever of action in combatting climate change.

And, lastly, one alternative path would be to focus on central bank reforms involving a shift in the current manner of conducting monetary policy. This could be in the form of a targeted credit allocation policy with the goal of greening the economy. For the moment, no central bank has gone down this path. We will discuss this further in a coming edition.

Goals that sometimes run at cross-purposes

While central banks possess action levers to combat climate change, the actual impact of such measures should be kept in perspective. Indeed, the monetary tightening policies set up since 2022 have shed light on a sizeable issue – the paradox between short-term vs. the long term price stability.

Amidst a broad increase in prices, central banks are guided by the absolute need to tame inflation. To do so, they raise their key rates.

However, given the huge long-term investment needs⁽⁷⁾, higher interest rates are keeping some projects from being launched and are thus delaying the environmental transition. Paradoxically, in fighting short-term inflation, central banks are promoting greater volatility in long-term inflation, due mainly to “climateflation”, “fossilflation” and “greenflation”⁽⁸⁾. This is causing them a true problem of timing in the conduct of their monetary policy.