## isabel-schnabel-ecb-climate-change

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### Climatic context and macroeconomic risks
- The past six years have been the hottest six on record.
- Temperatures in 2020 exceeded the 1850–1900 average by 1.25°C (2.25°F).
- Exact economic and financial effects of climate change remain uncertain, but risks are increasing materially.

### ECB economy-wide climate stress test and exposure
- The ECB’s economy-wide stress test draws on NGFS climate scenarios.
- Scope of assessment:
  - roughly 4 million companies worldwide
  - nearly 2,000 banks in the euro area
- Preliminary results indicate:
  - Without further mitigation policies, physical risks (heat waves, windstorms, floods, droughts, etc.) will probably increase substantially.
  - The average default probability of the credit portfolios of the 10 percent of euro area banks most vulnerable to climate risks could rise substantially—up 30 percent by 2050.
- Firms across Europe are exposed to physical risks unevenly across hazard types (hurricanes, sea level rise, floods, water stress, heat stress, wildfire, any hazard).

### Channels through which climate change affects central bank mandates
- Three key channels affecting price stability and central bank effectiveness:
  1. Impaired monetary policy transmission:
     - Losses from physical risks or stranded assets could weigh on financial institutions’ balance sheets and reduce credit provision to households and firms.
     - Central banks are exposed to potential losses on securities acquired in asset purchase programs and on collateral provided by counterparties.
  2. Effects on the equilibrium real rate of interest:
     - Higher temperatures may reduce labor productivity and increase morbidity and mortality.
     - Resources may be reallocated to adaptation; climate-related uncertainty may increase precautionary savings and reduce investment.
     - These factors can reduce the real equilibrium interest rate, increasing the likelihood of policy-rate constraints.
     - Countervailing possibility: green innovation and investment could raise equilibrium rates.
  3. Direct impact on inflation dynamics:
     - Physical risks can cause short-term output and inflation fluctuations and amplify longer-term macroeconomic volatility.
     - Mitigation policies (for example, carbon pricing) can change relative prices and drive divergence between headline and core inflation.

### Rationale for central bank engagement
- Climate change affects central banks’ ability to achieve mandates (price stability, financial stability, supervision).
- Consensus is building that central banks cannot remain on the sidelines; NGFS membership expanded from 8 founding members in 2017 to 95 members and 15 observers, with the IMF joining as an observer in 2019.

### ECB strategy, action plan, and operational adjustments
- The ECB concluded a monetary policy strategy review in July 2021 and published an action plan and road map to incorporate climate considerations into its framework.
- Key ECB commitments and operational changes:
  - Embed climate change considerations into monitoring of the economy by bolstering analytical capacity in climate-related macroeconomic modeling and forecasting.
  - Develop new climate-related statistical indicators, such as classifications of green instruments, carbon footprints of financial institutions’ portfolios, and exposures to climate-related physical risks.
  - Advocate internationally consistent and auditable climate disclosures.
  - Introduce disclosure requirements for private-sector assets, either as a new eligibility criterion or as the basis for differentiated collateral treatment and asset purchases.
  - Start disclosing climate-related information on non–monetary policy portfolios and the corporate sector purchase program (CSPP) by the first quarter of 2023.
  - Starting in 2022, conduct climate stress tests of the Eurosystem balance sheet using the economy-wide stress test methodology.
  - Perform a review to assess whether credit ratings and asset valuations under the collateral framework reflect climate-related risk exposures.
  - Incorporate climate-related criteria into corporate bond purchases, moving from a strict market neutrality principle toward a market efficiency principle that accounts for climate-related risks and societal costs and considers alignment with EU legislation implementing the Paris Agreement.

### Policy reasoning and trade-offs
- Market neutrality in asset purchases may perpetuate or exacerbate market failures because emission-intensive sectors often have large fixed long-term capital needs and issue bonds more frequently, leading to high emission intensity in eligible debt and ECB portfolios.
- Replacing market neutrality with market efficiency aims to incorporate risks and societal costs associated with climate change and to accelerate the transition to carbon neutrality.
- Early and broad-based mitigation and up-front investment are favored: transition costs may be contained in the short run and likely more than offset over the long run by avoided physical risks and mitigation benefits.

*Source: Isabel Schnabel, “Climate Change and Monetary Policy,” Finance & Development, September 2021.*

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_Source: https://www.imf.org/-/media/files/publications/fandd/article/2021/september/isabel-schnabel-ecb-climate-change.pdf_