On November 6, 2021, thousands of climate activists took to the streets of Glasgow in a stunning display of dissent. Their message was crystal clear: “we, the people” are in the throes of a climate emergency but none of our leaders are considering it to be a priority. The events of COP 26 emphasised the primary responsibility that governments had to respond effectively to the single greatest existential threat faced by humanity. But although governments have to lead the charge against climate change, the vastness of this historic challenge means that everybody has to consider how they can contribute. This applies in particular to policymakers, including Central banks. Central banks all around the world have forever grappled with the formulation of a cohesive strategy to “green” their portfolio without hampering monetary policy and overall price stability. In its paper series, the European Central Bank succinctly phrased this balancing act as “To be or not to be green”. 

‘To be or not to be green’ is the fundamental question that is dissected in length below.

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What is the cost of not “going green”?

A central bank is an institution that “manages the currency and monetary policy of a state or formal monetary union, and oversees their commercial banking system.” Simply put, a central bank’s jurisdiction is primarily over monetary policy. Considering that tenant, why should it even remotely care about climate change? The answer to that question lies in the fact that climate change in its various dimensions could increase the riskiness of the assets held on central banks’ balance sheets, potentially leading to financial losses. Climate risks are those which can impact or disrupt business activities and the institutions financing them. For financial institutions, these mainly relate to credit risk (defaults by businesses or households), market risk (repricing of equity prices following climate-related events), underwriting risk (insurance losses) and liquidity risk. Unabated climate change is likely to render extreme weather events more frequent and disruptive and exacerbate the global warming trend. Extreme weather events can be primarily thought of as supply shocks, which tend to increase prices and lower output. 

 

Central banks thus have to respond to these underlying risks and insure themselves against them. Here is where a “Green” monetary policy comes into play. The ‘greening’ of monetary policy operations is defined as “steering the eligibility criteria towards low-carbon assets.” The intended effect is that the cost of capital that is to be borne by low-carbon companies reduces relative to high-carbon companies.

 

Can monetary policy “go green”?

 

Quantitative easing programmes – those like asset purchases in the open market – are conducted by Central banks normally in proportion to the outstanding market shares (market capitalisation) of a company. It has been argued that this practice gives rise to a “carbon bias” in central banks’ portfolios because carbon-intensive companies are usually also capital-intensive and so have a larger weight in corporate bond markets compared to their less carbon-intensive peers. For example, it is calculated that about 62.1% of the European Central Bank’s corporate bond purchases are in the gas, manufacturing and electricity sectors. These sectors are also responsible for a whopping 58.5 % of euro area greenhouse gas emissions. 

 

Such climate externalities result in market failure and give way to an inefficient allocation of resources that impedes a progressive transition to an ecologically sound economy. Thus, there is a dire need to develop a mechanism that can quantitatively measure climate risks. Central banks should ensure that climate risks are adequately incorporated in their risk management as well as in the financial institutions they supervise. They should ensure the disclosure of climate-related risks by firms and financial institutions. They should also use the instruments at their disposal to incentivise the issuance of green financial products (finance that flows into sustainable development ventures).

 

What strategies are to be followed for policy formulation?

According to Prof. Dirk Schoenmaker, there are two routes for central banks to influence the carbon economy: the best-in-class method, and the portfolio tilting method.

 

The best-in-class method selects a percentage of best performers in a sector for investment, i.e. those companies with the lowest carbon emissions. If the percentage for selection is set relatively high – say 50-60 per cent – then the central bank can maintain a broad, albeit reduced, asset and collateral base for its operations. By contrast, the tilting approach increases the proportion of low-carbon companies at the expense of the proportion of high-carbon companies. A tilting approach is less distorting in the monetary transmission because no assets are excluded, and it’s only the weighting in the portfolio that’s adjusted. These methods can be used to select relatively low-carbon assets, or to tilt the portfolios towards less carbon-intensive assets, thereby reducing the exposure to high-carbon assets, meeting the objective.

In an influential paper, Amel-Zadeh and Serafeim (2018) distinguish several methods for considering ESG (Environmental, Social and Governance) issues:

1. Exclusionary/negative screening: a method of deliberately not investing in companies that do not meet specific ESG criteria.

2. Active ownership: use of shareholder power to engage with companies to improve their ESG performance.

3. Thematic investing: focusing on those parts of the universe that benefit from and provide solutions for certain ESG trends.

4. Impact investing: an approach to investing that deliberately aims for both financial and societal value creation, as well as the measurement of societal value creation.

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Concluding note:

ECB President Christine Lagarde recently spoke passionately at a green capital markets union about the inroads that financial markets can make in ensuring a shift to a low-carbon economy. Carbon taxes and global carbon pricing are not enough to address this issue. The central bank’s key role in the financial system means that it would give an important signal to the financial sector when it acts to reduce carbon emissions, and therefore contribute to combating climate change. Recent evidence points to the crucial role of banks in funding energy-efficient investment projects. Research also indicates that green bond issuance by companies may be associated with an improvement in their environmental performance. 

However, these policy suggestions are not perfect. The transition to a “greener” economy is unlikely to be smooth and without economic costs. Data gaps and the absence of a widely agreed taxonomy for green assets currently prevent researchers from better understanding the impact that greening monetary policy portfolios could have on national and global carbon emissions. Tilting and best-in-class methods could lead to price distortions and have wider problems in the economy. Critics question if propagating a green monetary policy and favouring low-carbon companies goes beyond the realms of the “traditional” role performed by a Central Bank. 

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Is this the time to stay ‘traditional’ and stick to old principles? Or is it the time to effectuate radical change to respond to the underlying challenges?