Central banks and climate change: Lagarde becomes leader
Long used to scanning the horizon for risks, central banks have belatedly woken up to the biggest one of all — climate change. Monetary policy has so far been ignored — but the European Central Bank, until now on the fringes of this issue, is plunging in
“Whatever it takes.” Those words of Mario Draghi’s in 2012 reverberated with power. Politicians might dither, he implied, but the European Central Bank he led would “within our mandate… preserve the euro”.
The ECB succeeded absolutely. With limitless monetary firepower, it drove back the bears snarling at the eurozone.
When the coronavirus pandemic struck, no one doubted that central banks would respond with an arsenal of policies to prevent a health and economic crisis becoming a financial one.
In late September Christine Lagarde, Draghi’s successor, was able to declare “we have prevented a massive deterioration that would otherwise have been seen”.
But behind Covid-19 lurks a far greater threat: climate change. Policymakers of all kinds have known it was coming since the 1980s, but barely lifted a finger. Now, it is inflicting damage on lives and assets that cannot be ignored. Nearly all governments have promised to take some action, and a few — including the EU, the UK and China — have grasped the nettle and set targets to reach zero net greenhouse gas emissions.
Financial specialists have grown used to central banks being the most potent and — from their point of view — rational actors on the scene. They naturally expect them to wield their magic to defeat this evil. But do they have the necessary might? And do they dare to use it?
So far, central banks are not keen to talk big about what they can achieve in this field. But they are certainly doing a lot of talking.
Although each central bank has its own national mandate and operations (or, for the ECB, multinational), they are a community that likes to interact. Responding to climate change requires fresh thinking and policies not found in their classical toolboxes, and possibly reinterpreting or stretching their mandates. When venturing into the unknown, central banks feel there is safety in numbers.
The Central Banks’ and Supervisors’ Network on Greening the Financial System (NGFS), formed as a quiet club of eight central banks in December 2017, has swiftly become one of the most prominent and influential green finance organisations.
Its 72 members come from nearly all major economies. “It’s clearly creating momentum in a lot of countries,” says Orith Azoulay, global head of green and sustainable finance at Natixis in Paris. “It is one of those initiatives where you start to be remarked when you are not in it, rather than when you are, which is the sign of a successful initiative.”
Among G20 members, only Argentina, India, Saudi Arabia and Turkey are not involved. From the US, the Dept of Financial Services of the State of New York has joined.
“Virtually all central banks and supervisors are starting to do something on the climate front, though the level varies very much,” says Morgan Després, deputy head of financial stability at the Banque de France, who heads the NGFS secretariat.
The early involvement of the People’s Bank of China and Mexican and Brazilian central banks has been crucial, argues Nick Robins, professor in practice in sustainable finance at the Grantham Institute of the London School of Economics. “One of the things that has made the agenda take off is that it’s no longer the preserve of Europeans,” he says. “South Africa and China are more carbon-intensive economies than Europe, and emerging economies are the most exposed to physical risks. So the case for thinking it through very seriously is much greater in emerging economies.”
The NGFS has produced a wealth of studies and documents to share best practices. Its achievements are particularly impressive in two areas. It has succeeded in making the central banking community accept that climate change is part of its remit, because it threatens financial stability.
But that does not mean central banks know how to tackle the problem — or even talk about it. The NGFS has started to provide a language, by showing how to break the issues down into parts and assess where and how they will impact the financial system.
Although each central bank and supervisor acts independently, all significant work in this area is nourished by the work of the NGFS and feeds back into it.
But financial market players hoping that central banks are polishing their bazookas, preparing to train them on the climate crisis, are off the mark.
Monetary policy — the big guns that move market prices — is barely even on the agenda.
Knowledge, risk and investing
In its first major report, A Call to Action, in April 2019, the NGFS recommended members strive to improve data, disclosure and taxonomies on environmental risks and solutions; invest sustainably themselves; and integrate climate risks into their monitoring of financial stability and supervision of individual banks and insurance companies.
Central banks are becoming more adept at responsibly investing their own funds and pension portfolios. When Germany issued its first green Bund for €6.5bn in September, bankers hailed the expected future green Bund curve as a key to open one of the last parts of the bond investor base that had yet to become committed to green investing: treasury portfolios, including at central banks, which hold bonds for liquidity purposes.
But central banks have much more scope to help the world deal with climate change through their ability to influence the financial system as a whole.
So far, they are feeling their way towards exercising that influence in three main ways: through macroprudential analysis, supervision and providing intellectual public goods.
Much of the early work of the NGFS has been about getting climate change into the mindsets of central banks — giving them the arguments for considering it, after they had ignored it so long.
For most central banks, preserving financial stability is an essential mission, and it is easy to see that climate change threatens that. But how do they tackle or even talk about the problem?
Central banks are used to using models of GDP, credit pricing and so on, based on historical patterns. Leaders in the community such as Luiz Awazu Pereira da Silva, deputy general manager of the Bank for International Settlements, have been spreading the message that they need to learn new thinking. Climate change is certain, but its effects will be sudden and unpredictable. Central banks need to make conclusions without empirical evidence, based on scenarios of the future that will necessarily turn out to be wrong, but are better than no planning at all.
With their macroprudential spectacles on, central banks must try to understand how climate change could damage and change the economy. Just as urgent is the microprudential or supervisory side — how to ensure that individual banks and insurance companies are alert to climate risks and trying to reduce them.
Fifteen NGFS members have said they are thinking of putting the firms they regulate through climate stress tests.
Furthest ahead is De Nederlandsche Bank, which stress tested Dutch banks, insurers and pension funds in 2018, modelling four scenarios for the energy transition, meaning how the economy will shift to low carbon technologies, which could involve losses for some industries. DNB found banks’ common equity tier one ratios would decline by between 1.8 and 4.3 percentage points, depending on the scenario.
The Bank of England had planned a climate stress test of UK banks and insurers this year, but put it off until “at least mid-2021” because firms were dealing with Covid-19.
The Banque de France is going ahead. Its supervisory arm the ACPR began a stress test in June. It is voluntary but firms are “highly recommended” to take part, submitting answers by October. Like DNB, the ACPR will publish the results in the spring on an aggregated basis, not revealing individual firms’ exposures.
Other supervisors such as Germany’s Bafin have not got as far as stress testing, but have set out supervisory expectations, such as following the recommendations of the Task Force on Climate-Related Financial Disclosures (TCFD).
Robins expects to see “a classic J curve” in central banks’ activity. “Disclosure frameworks like the TCFD have enabled prudential regulators to start making clear their regulatory expectations: ‘we expect your board to be equipped with expertise and knowledge, and this should be part of your risk models’,” he says. “I’ve seen a number of examples of financial institutions which had thought of this as a distant issue start getting signals from central banks which have changed the game.”
Central to both stress tests and banks’ own risk management is the problem of how to imagine the future. Devising scenarios for how climate change could affect the economy five or 20 years from now is difficult. Moreover, if supervisors are to play a role, they need firms to use the same scenarios.
The NGFS has made a valuable contribution here, by producing in June a detailed guide to climate scenario analysis that lays out three kinds of scenario: orderly transition, disorderly transition and hothouse world, in a total of eight versions.
The ACPR is using one of these. The NGFS's work enables the daunting problem of scenario analysis to be broken into three stages. The NGFS produces standard scenarios. Each central bank then has to model how the chosen scenario would affect the economy in its country. It can then hand the resulting model to regulated firms so each can evaluate how its portfolio would stand up to it.
Turning the dials
Stress tests and data requests will generate information — but what will central banks do with what they learn?
“It probably will take some years before we have the right methodologies [for stress tests] and interpretation of results,” says Azoulay, “but it’s still a very clear sign that [central banks] intend to better understand the sensitivity of the financial system to certain risks, including stranded assets. I cannot help interpreting this as the antechamber to some prudential decision-making.”
By this she means altering risk capital weightings to favour environmentally progressive assets and disadvantage polluting ones.
“The NGFS position is risk weightings should reflect risk profiles, and there is currently no evidence that justifies a ‘green supporting factor’,” says Després. “If something were to be done, a ‘brown penalising factor’ is more likely.”
Central banks would not want to risk blowing a bubble in green assets and exposing banks to risk by giving them a capital break — it would be easier for them to justify penal risk weights for old economy assets that could become obsolete.
“That’s what most central banks would like to see,” says Robins. “Having a high carbon adjustment factor would work very much more with the grain of what regulators do.”
Azoulay sees risk weightings as a strong instrument: “If you have a simple method, that it will cost you more capital, it’s a very clear message that financial institutions understand.”
However, if central banks are going to insist that risk weight changes be based on evidence that climate-harming assets are riskier than climate-friendly ones, it could take years to amass the evidence and negotiate the changes to capital rules.
In the meantime, there is another way central banks can steer firms to change their risk profiles: soft power. They can just call CEOs in for a chat about the risks they face and suggest they do something about them. This is arguably the most effective and quickest way to act.
Show me the money
Central banks’ supervisory sway over the whole financial system is probably the most potent way they can help society fight climate change.
But financial market specialists cannot stop eyeing the trillions of dollars central banks have printed in the past decade.
“Monetary policy and climate change is probably the last frontier,” says Després. “When we started considering it two to three years ago, it was almost unthinkable to address the topic.”
NGFS members at first saw no connection between climate change and monetary policy, and did not want to explore the issue.
Why central banks are so cautious in this area is difficult to explain, Després says: “Certainly it’s to do with the fact that central banks are very keen to respect their mandates. They have a mandate on price stability and until recently the link between climate change and price stability did not seem that obvious.”
Central banks have accepted that climate change is a risk to financial stability, but not price stability. Yet the idea that a climate-induced shock of financial instability could occur without price instability is almost absurd.
Very gradually, the conversation is moving. In June, after a lot of pushing internally, the NGFS published its first brief report on monetary policy. It covers how climate risks can affect price stability and influence how central banks set monetary policy, but does not explore how they could use monetary policy to drive the economy in a greener direction. Buried on the last page is a single sentence about this.
So far, the ECB has kept a low profile on the climate. Oddly, considering that it directly supervises 114 large banks holding 82% of eurozone banking assets, it has left climate risk supervision to national central banks. It is now developing its own stress test.
Observers of the ECB say Draghi was not very supportive of the climate risk agenda — he paid lip service to it, but it was not a core part of his strategy.
However, Després says: “President Lagarde is really keen on doing something — it’s now part of the ECB strategy review.”
The ECB’s first strategy review since 2003 is due to finish in mid-2021. The discussions are confidential, but one very significant fact is clear: the review itself is about monetary policy. This means the ECB is explicitly saying climate change has a bearing on monetary policy — not just prudential policy. The dark horse of the central banking climate race is making a late surge that could put it in the lead.
What form that could take is keenly debated. The best clue comes from Isabel Schnabel, an ECB executive board member, who in September gave possibly the most forthright and determined speech by any central banker about climate change so far.
Addressing monetary policy, she went far beyond the NGFS, arguing that “collective action, by governments, firms, investors, households and central banks, including the European Central Bank, is required to accelerate the transition towards a carbon-neutral economy and correct prevailing market failures”.
Securities could be excluded from acceptable repo collateral if the issuer did not properly disclose its climate risks; the ECB could haircut more deeply securities with higher climate risks. The ECB could also reassess how it deploys its bond purchase programmes to better match a sustainable, rather than the present unsustainable, economy.
A proposal for greening the Targeted Longer-Term Refinancing Operation programme, put forward by Positive Money Europe and the Sustainable Finance Lab, will also be considered in the ECB’s strategy review. TLTROs are the ECB’s handouts of cheap loans to banks, to encourage them to lend.
The plan’s authors argue a green TLTRO would encourage lending to sustainable activities, instead of stimulating unsustainable ones, as ECB monetary policy does now — and that this choice is permitted under the ECB’s mandate.
Jens van ’t Klooster, one of the writers, says a green TLTRO would be “more useful than a green Asset Purchase Programme”. Whereas bonds are issued by big companies, “what is so great about a bank-based system is that it’s all small things like house refurbishments — activities that wouldn’t happen without funding.”
However, van ’t Klooster admits that although a green TLTRO would give banks an incentive to make green loans, they would not have to pass on the cost benefit to the underlying borrowers.
At the moment, such ideas still seem too politically controversial for central banks to dare. But considering how far they have already moved — and how uninhibited a few leaders such as Schnabel have become — it is more than likely green monetary policy is on its way.
Robins points out some central banks and regulators, such as the Central Bank of Brazil, Reserve Bank of Australia and US Commodity Futures Trading Commission, are “taking their independence very seriously as they address climate and environmental issues and coming forward with policies that are very robust”.
Schnabel sounds eager to get into the fray and “react pre-emptively”. But even she argues climate change “requires collective and concerted action by all stakeholders, first and foremost by legislators and national governments”.
When it comes to climate change, no central banker is going to be able to declare, as Draghi did of his eurozone measures: “Believe me, it will be enough”. Government, civil society and the private sector will have to do without a magic wand on this one.