Why Monetary Policy Should Go Green

Bookmark and Share

This article was first published by the Financial Times (here).

Monetary policy is rarely a topic in debates on green finance. It should.

The €60bn that the European Central Bank is currently injecting into financial markets on a monthly basis are a case in point. Its intervention amounts to nearly three times as much as the monthly average of €23bn in clean energy investments globally in 2016. A transparent review of how to better align ECB injections with the goal of funding a low-carbon economy and whether some of its purchases in fact undermine that objective, is critical.

Central banks have already started to explore what climate change could mean for them, with a slew of European authorities, including the Bank of England, the European Systemic Risk Board, and the Dutch central bank, looking at the possible effects of climate change on financial stability and how financial regulation can mitigate these effects.

Similar questions need to be explored with regard to the monetary policy remits of central banks. Monetary operations from plain vanilla refinancing to more unconventional quantitative easing have a suite of often unseen impacts and potentials. Central bankers are careful to ensure that their monetary decisions are sector neutral. Nonetheless, explicit and implicit biases abound – from the routine acceptance of high carbon assets, such as car loans, in refinancing and asset purchase programmes, to the deliberate targeting of monetary measures at key parts of the economy, e.g. real estate.

Last September, G20 leaders highlighted the need to scale up green finance and expressed their support for “clear strategic policy signals” to pursue this objective. Monetary policy should not be carved out from this goal. Importantly, the constitutional foundations of key central banks provide a clear mandate to be part of the solution. The ECB mandate offers an illustration as it states that

“without prejudice to the objective of price stability [the Eurosystem] shall also support the general economic policies in the Union with a view to contributing to the achievement of the objectives of the Union”,

including inter alia

“a high level of protection and improvement of the quality of the environment”.

Three steps will be critical to move in this direction.

First, monetary policy measures may unwittingly support high carbon assets or discourage clean alternatives. In particular, the choice of assets that central banks buy and accept as collateral may not be sector neutral. Identifying such sector biases and mitigating them, where they are misaligned with the objective of a low-carbon economy, is one of the most concrete short-term measures to take. A closer look at whether central banks should indeed be buying asset-backed securities based on car loans may be a good starting point in this context. Ditto for a review whether the eligibility criteria and haircuts in their collateral frameworks are indeed based on an accurate risk assessment – including a robust analysis of carbon risks. Accounting for default risks due to stranded carbon assets in the external ratings and in-house credit assessments of central banks that underpin their collateral rules would be a critical pillar for that.

Second, the current environment of ultra-low interest rates, together with significant asset purchases by central banks could offer a remarkable opportunity to channel more capital towards a low-carbon economy, and to pursue what several experts and policymakers have coined as “Green Quantitative Easing”. This proposal may not only be an option for those central banks, like the ECB and the Bank of Japan, that are still expanding their balance sheets, but also for those, like the Bank of England and the Fed, that aim to keep the size of their balance sheets unchanged, and are thus forced to re-invest the proceeds from maturing securities into new ones. Increasing the share of these flows into green investments could become an important driver towards a green economy – both through the direct provision of public money, as well as a catalyst for further private investments in the field.

The design of such a Green QE program will require a thorough assessment of the underlying market structures and bottlenecks in funding low-carbon investments. It will require a detailed analysis to what extent the purchase of green bonds is an option for central banks, how much money could currently be absorbed through low-carbon asset purchases, how such purchases would change the funding situation for green investments, and how to measure success. It will also require a rigorous evaluation what institutional set-up could underpin a Green QE program, how to mitigate the risk of greenwashing, what role external rating agencies, research providers and auditors may play in that context, and whether for example in Europe the European Investment Bank could be a key pillar for such an initiative.

Finally, beyond the scope of targeted asset purchases lies the need to manage central bank assets as a whole using best practice approaches to integrate environmental, social and governance (ESG) factors into investment strategy. Institutional investors with over $60tn in assets have already pledged to doing this. Many of them have built-up in-house capacity to account for ESG criteria in their investment processes. Others use external researchers and a broad offering of specialized indexes to reflect ESG criteria in their decisions. Central banks should explore similar commitments and pathways for the $18tn on their balance sheets.

Leading central bankers are increasingly clear that dealing with the financial risks of climate change is part of their job. Making sure that monetary policy is pointing in the same direction is a logical and necessary next step.