Central Banks Should Reflect Climate Risks in Monetary Policy Operations

This policy note was published by SUERF, the European money and finance forum, here

The transition to a low-carbon economy requires a shift in capital allocation from incumbent carbon-intensive technologies to new low-carbon technologies. Financial markets play a key role in this process: they influence firms’ investment costs and serve as reference point in investors’ decisions. Currently, there are strong concerns that financial markets underestimate risks related to climate change. This introduces biases in favour of carbon-intensive economic activities. Such biases slow down the transition to a low-carbon economy.

Central banks play a critical role in this context: monetary policy operations affect financial market prices, which in turn influence capital allocation. Currently, both central banks’ asset purchase programs and collateral frameworks extensively rely on financial markets’ risk assessment. By doing so, central banks are likely to also underestimate climate risks. This consolidates the biases in financial markets and cements carbon lock-in.

An accurate assessment of risks is essential for central banks. A sound implementation of monetary policy, both through asset purchases and through credit operations, requires a comprehensive and conservative consideration of all risks, including climate risks. Given the current size and composition of central banks’ balance sheets, the need for adequate risk assessments becomes even more critical for them.

This policy brief argues that central banks should better reflect climate risks in monetary policy operations. A first step in this direction is for central banks to contribute to the development of appropriate environmental risk measures. A second step is for them to integrate such measures in their asset purchase strategies and in their collateral frameworks. Such adjustments would realign central banks’ policies with the strong risk standards needed for sound monetary policy. They would also generate financial incentives aligned with the transition to a low-carbon economy and send a strong signal to market participants to reflect climate risks in their decisions.