Greening Monetary Policy: Central Banks in the Fight Against Climate Change

Imagine you’re driving down the road with a car full of passengers. You suddenly begin to feel unwell and start to lose control of the vehicle. Your friend in the front passenger seat senses danger and asks if they can help. It makes sense to accept but stubbornly you refuse their offer because it’s your car, and you like to be in control. Now the passengers in the rear seat are starting to worry but still, against all logic, you do not want anyone else to have power over the vehicle. As your driving becomes increasingly erratic, the inevitable is about to happen... 

Unlikely? Downright ridiculous? Perhaps both, but a simplistic analogy makes understanding complex concepts such as central bank mandates and responsibilities easier. Now imagine you, the driver, are the executive branch of the government, your friend is the central bank, and together you form the consolidated government. The car is the economy and the imminent crash represents a looming future plagued by environmental disasters resulting from global temperatures rising more than two degrees Celsius above pre-industrial levels.

On 17 April, central bank governors in London and Paris warned in a joint open letter that “a massive reallocation of capital” will be necessary to bring global carbon emissions to net zero by 2050, a critical step in slowing the rise in global temperatures. In the powerful statement, the Bank of England and the Banque de France pled for governments and the private sector to allocate capital appropriately to limit the “enormous human and financial costs of climate change.”

Central banks have recently started to look at climate-related risks in the context of their government-mandated responsibilities. Should Central Banks take the carbon intensity of assets into account in the context of monetary policy? This is a contentious consideration because central banks have recently come under fire for succumbing to increasing political influence over their supposedly independent decision-making.

Different central banks pursue policy goals mandated by their respective countries’ legislation. Most receive a single mandate to ensure price stability. Some, like the US Federal Reserve, have a dual mandate with the objectives of stabilising prices and maximising employment. In addition, central banks are often asked to support economic growth, suitably ambiguous legal wording that leaves room for monetary policy to assume secondary objectives such as sustainable development, social progress, and improving the quality of the environment.

While a broad interpretation of the legal mandate is possible, critics question whether central banks should have such a wide remit. The discussion raises the valid question of delegating economic policy from elected policy makers to unelected technocrats and central bankers. Central banks have for a long time managed to maintain a dogmatic air of independence from governments’ economic policies, adhering to the guiding principles of autonomous decision-making and market-neutrality.

However, different central bank policies have different distributional effects, which complicates the claim of neutrality. In theory, monetary policy would only involve open-market operations with assets issued by the government, thus remaining impartial to market dynamics. Nonetheless, post-Great Recession, the EU accelerated large scale asset purchases of corporate bonds and bank bonds under quantitative easing.

Bruegel, the Brussels based think tank, recently found that private assets purchased by the European Central Bank (ECB) were largely carbon-intensive companies, such as fossil fuel corporations or car manufacturers. The paper also found that market indices for corporate bonds are dominated by high-carbon assets. The supposedly market-neutral monetary policy of the EU has therefore, unwittingly or otherwise, favored carbon-intensive industries while neglecting low-carbon sectors.

This needs to change. Central banks need to put their money where their mouths – or joint declarations – are. In lieu of fuelling high-carbon sectors by buying high-carbon sector companies’ bonds, central banks ought to acquire low-carbon assets, such as green bonds, sustainability bonds, or assets that meet minimum environmental, social, and governance (ESG) standards. In so doing, central banks would not only reduce the cost of capital for less carbon-intensive sectors but also increase the cost of capital for players harmful to the environment.

With no end in sight for the Fed or the ECB’s asset purchasing programs, central banks have a real opportunity to steer monetary policy towards contributing to a low-carbon economy. As our dysfunctional relationship with the environment is spiralling out of control, combatting climate change requires bold and concerted policy efforts, even if that means handing more power – with updated mandatory responsibilities – to already powerful institutions.

In exceptional circumstances, relinquishing some control to avoid catastrophe is preferable to crashing with fatal consequences. The cost of inactivity will far outweigh the potential risks of sharing power with your mate in the passenger seat.

Steering monetary policy towards low-carbon industries is only part of a broader policy agenda that will also require fiscal stimuli and structural innovations if central banks are serious about reducing global carbon emissions. There are substantial obstacles to overcome, but immediate action is imperative. Standards for low-carbon industries must be set and “greenwashing” of asset classes avoided. The challenge of sustainably adapting the global economy to the new reality can no longer be kicked into the long grass. Addressing these challenges in addition to fulfilling their legal mandates will undoubtedly be no small feat.  

No one said it was going to be a smooth ride.

Alexander Rustler is a Lemann Foundation Fellow and MPA in Development Practice candidate at Columbia University’s School of International and Public Affairs. He specialises in Advanced Policy and Economic Analysis in Emerging and Developing Economies. He holds a Masters in Political Economy from the London School of Economics.