Climate Change and Monetary Policy
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Bibliographic details
- Authors: ISABEL SCHNABEL
- Published: September 2, 2021
Overview
- Author: ISABEL SCHNABEL, member of the executive board of the European Central Bank.
- Publication: F&D Magazine, September 2021.
- Core argument: Central banks must "do their part in fighting global warming" because climate change materially affects central banks’ ability to achieve their mandates, including price stability, financial stability, and banking supervision.
Observed climate change benchmarks
- 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).
ECB economy-wide climate stress test (scope and approach)
- The ECB is conducting an economy-wide stress test to quantify consequences of climate change on companies and banks.
- The exercise draws on a range of climate scenarios developed by the Network for Greening the Financial System (NGFS).
- The scenarios are used to assess the potential impact on roughly 4 million companies worldwide and nearly 2,000 banks in the euro area.
- NGFS membership evolution: established with eight members in 2017; now has 95 members and 15 observers. The IMF joined as an observer in 2019.
Preliminary stress-test findings and model results
- Without further mitigation policies, physical risks (heat waves, windstorms, floods, droughts, and the like) will probably increase substantially (Alogoskoufis and others 2021).
- 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 from climate change, although risks are distributed unevenly.
- Compared with physical risks, the costs of transitioning to a carbon-neutral economy appear relatively contained (de Guindos 2021).
- Recent IMF research (IMF 2020) echoes the finding that up-front investment in mitigation will likely be more than offset over the long run as firms avoid aggravated physical risk and reap economic rewards of mitigation.
Channels through which climate change affects central bank mandates
- Transmission channel:
- Losses from materializing physical risks or stranded assets could weigh on financial institutions’ balance sheets.
- Reduced balance-sheet health may reduce the flow of credit to the real economy and weaken transmission of monetary policy to consumption and investment.
- Central banks are exposed to potential losses from securities acquired in asset purchase programs and on collateral provided by counterparties.
- Equilibrium real interest rate channel:
- Climate impacts (e.g., impaired labor productivity, increased morbidity and mortality) and reallocation of productive resources to adaptation could lower the equilibrium real rate of interest.
- Increased precautionary savings and reduced incentives to invest could further lower the equilibrium rate, increasing the likelihood that policy rates will be constrained.
- Countervailing possibility: green innovation and investment might raise equilibrium rates and help exit the low-inflation, low-interest-rate environment.
- Inflation dynamics channel:
- Greater incidence of physical risks can cause short-term fluctuations in output and inflation that amplify longer-term macroeconomic volatility.
- Mitigation policies (for example, carbon pricing programs) can affect price stability by precipitating large and long-lasting trends in relative prices and driving a wedge between headline and core measures of inflation.
Policy implications and central bank responses
- Timing: There are clear benefits to acting early—short-run transition costs can be offset over the long run by avoided physical risk and mitigation benefits.
- Role of central banks:
- Central banks cannot remain on the sidelines; a consensus is building that they should increase attention to climate change given its implications for mandates.
- Central banks are starting to integrate climate-related risks into their monetary policy operations.
- Strategic message: Now is the time to undertake ambitious and broad-based action to ensure an orderly transition and mitigate the effects of climate change.
Key citations and referenced works (as cited in the source)
- Alogoskoufis, S., and others. 2021. “Climate-Related Risks to Financial Stability.” Financial Stability Review, European Central Bank, Frankfurt.
- de Guindos, L. 2021. “Shining a Light on Climate Risks: The ECB’s Economy-wide Climate Stress Test.” ECB Blog, March 18.
- International Monetary Fund (IMF). 2020. “Mitigating Climate Change—Growth- and Distribution-Friendly Strategies.” World Economic Outlook, Chapter 3, Washington, DC, October.
- Papoutsi, M., M. Piazzesi, and M. Schneider. 2021. “How Unconventional Is Green Monetary Policy?” Stanford University working paper, Stanford, CA.
- Schnabel, I. 2021. “From Market Neutrality to Market Efficiency.” Welcome address at the ECB DG-Research Symposium “Climate Change, Financial Markets and Green Growth.” Frankfurt, June 14.
Source: Climate Change and Monetary Policy, ISABEL SCHNABEL, F&D Magazine, September 2021.
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