Central banks: the tools to fight climate change

The Cov­id pan­dem­ic, the crisis linked to the war in Ukraine and the chal­lenges posed by cli­mate change present cent­ral banks with a com­plex chal­lenge: to steer and con­trol infla­tion that is con­stantly rising. The European Cent­ral Bank’s (ECB) object­ive is to achieve 2% infla­tion in the medi­um term – com­pared with 3% in Europe today – but without curb­ing the invest­ments needed for the energy transition.

On the one hand, the scale of the invest­ments required to meet cli­mate object­ives is colossal.

Our remain­ing glob­al car­bon budget, which rep­res­ents the CO₂ emis­sions com­pat­ible with the Par­is Agree­ment, would be 580 GtCO₂ for a 50% prob­ab­il­ity of keep­ing warm­ing below 1.5°C accord­ing to the estim­ates of the IPCC report². On aver­age, annu­al glob­al anthro­po­gen­ic emis­sions are around 40GtCO₂ (Glob­al Car­bon Pro­ject, 2022). At this rate, this car­bon budget would be exhausted in less than 15 years. On the oth­er hand, the sources of infla­tion today are mul­tiple, from the dis­or­gan­isa­tion of value chains dur­ing the pan­dem­ic to the imbal­ance between sup­ply and demand at the end of the crisis. In addi­tion, the rise in energy prices linked to the war in Ukraine and energy trans­ition policies are fuel­ling “green infla­tion”³.

Is it legit­im­ate for cent­ral banks to take up the issue of com­bat­ing cli­mate change? This ques­tion was already raised by Milton Fried­man in 1970 regard­ing the envir­on­ment­al and social respons­ib­il­ity of com­pan­ies, when he ques­tioned the polit­ic­al legit­im­acy of com­pany dir­ect­ors to provide pub­lic goods⁵. How­ever, in terms of the fight against cli­mate change, we are faced with a double fail­ure to integ­rate cli­mate risk: the fail­ure of mar­kets but also the fail­ure of gov­ern­ments⁶.

The expect­a­tions of eco­nom­ic and fin­an­cial act­ors and reg­u­lat­ors are legit­im­ate. But this does not mean that cent­ral banks should replace governments.

The need for cent­ral banks to mobil­ise in the fight against cli­mate change is two­fold: cli­mate change is a threat both to eco­nom­ic activ­ity and to fin­an­cial sta­bil­ity. It is there­fore an integ­ral part of the cent­ral bank’s man­date. Indeed, the TCFD report⁹ by the Banque de France and the ACPR in 2022 begins:

“Con­trib­ut­ing to assess­ing, redu­cing, and man­aging the impact of cli­mate risks on the real eco­nomy and the fin­an­cial sys­tem is in our view an integ­ral part of the man­date of cent­ral banks and super­visors, both in terms of mon­et­ary strategy and fin­an­cial sta­bil­ity. The Banque de France has there­fore been an early advoc­ate for the com­munity of cent­ral bankers and super­visors to take cli­mate change issues into account. Inter­na­tion­ally, it was one of the found­ing mem­bers of the Net­work of Cent­ral Banks and Super­visors for the Green­ing of the Fin­an­cial Sys­tem (NGFS)¹⁰ in 2017, which now has 121 mem­bers and for which it provides the glob­al secretariat.”

Cli­mate risk in fin­ance is defined in terms of two main com­pon­ents: phys­ic­al risk and trans­ition risk (Car­ney, 2015). Phys­ic­al risk rep­res­ents the eco­nom­ic and fin­an­cial costs incurred because of the increas­ing sever­ity and fre­quency of phys­ic­al cli­mate haz­ards. Trans­ition risk, on the oth­er hand, res­ults from changes in gov­ern­ment policies, tech­no­lo­gic­al changes and changes in investor and con­sumer behaviour.

The trans­ition to a low-GHG eco­nomy requires rap­id and far-reach­ing trans­itions in energy, land use, urb­an plan­ning, infra­struc­ture, and indus­tri­al sys­tems. €830 bil­lion per year would be needed to make this trans­ition¹¹.

€830 bil­lion per year would be needed to ensure the trans­ition to a low-GHG economy.

Some sec­tors may lose much of their value or even dis­ap­pear in the com­ing dec­ades (referred to as stran­ded assets). Stud­ies¹² estim­ate that a policy to lim­it glob­al warm­ing to 2°C would mean that 35% of oil reserves, 52% of gas reserves and 88% of coal reserves would become unus­able. In this con­text, should we then con­tin­ue to invest cap­it­al in the search for and exploit­a­tion of these reserves? These invest­ments risk becom­ing unus­able, very expens­ive, and pos­sibly totally depreciated.

All these changes can gen­er­ate losses iden­ti­fi­able through tra­di­tion­al fin­an­cial risks: cred­it (sub­ject-sens­it­ive bor­row­ers), mar­ket (asset valu­ation), liquid­ity (access to bank fin­ance) or oper­a­tion­al (com­pli­ance and reg­u­lat­ory risk).

In terms of infla­tion – a core man­date of the Cent­ral Bank – the phys­ic­al risks of cli­mate change lead to neg­at­ive sup­ply shocks (cap­it­al destruc­tion, reduced labour sup­ply, pro­ductiv­ity uncer­tain­ties) that reduce poten­tial out­put, increase out­put gaps and infla­tion­ary pres­sures. An increase in the fre­quency and sever­ity of these neg­at­ive sup­ply shocks could lead to increased volat­il­ity in head­line infla­tion and, under cer­tain cir­cum­stances, could affect infla­tion expect­a­tions¹³. 

The ACPR (Autor­ité de con­trôle pruden­tiel et de régu­la­tion), con­duc­ted a pilot cli­mate stress test in 2021 that high­lights the expos­ure to cli­mate risk in France of 9 bank­ing groups and 15 insur­ance groups, which togeth­er account for 85% of the total bal­ance sheet of banks and 75% of the total bal­ance sheet of insurers in France. This exer­cise shows that, for the insur­ance sec­tor, the cost of cli­mate-related claims should be mul­ti­plied by 5 or 6 between 2020 and 2050 in cer­tain depart­ments (par­tic­u­larly in the west of France).

The cost of weath­er-related claims should be mul­ti­plied by 5 or 6 between 2020 and 2050.

The main haz­ards con­trib­ut­ing to this increase in claims are related to the risk of drought and flood­ing, and the increased risk of cyc­lon­ic storms in the over­seas ter­rit­or­ies. If this risk were to be off­set by an increase in premi­ums, insur­ance premi­ums would have to increase by 130 to 200% over 30 years, i.e. 3 to 3.7% per year¹⁴.

• To integ­rate cli­mate risk into fin­an­cial sta­bil­ity mon­it­or­ing, pruden­tial super­vi­sion and port­fo­lio man­age­ment, the cent­ral bank has sev­er­al tools at its dis­pos­al (see for example the recom­mend­a­tions of NGFS, 2019¹⁵):
• Eco­nom­ic and fin­an­cial ana­lys­is (tak­ing cli­mate change into account in its mod­els, mac­roe­co­nom­ic pro­jec­tions, and risk assessment).
• Bank­ing and insur­ance super­vi­sion (rais­ing aware­ness and ensur­ing that banks and insurers man­age cli­mate risk adequately).
• Mon­et­ary policy and invest­ment port­fo­li­os (cent­ral banks can invest in green bonds, for example).
• Pruden­tial and fin­an­cial sta­bil­ity meas­ures (e.g. on cap­it­al require­ments and sec­tor­al lever­age ratios).

The cli­mate strategy of the Banque de France and the ACPR is thus embod­ied in all of the institution’s mis­sions (mon­et­ary strategy, fin­an­cial sta­bil­ity, ser­vices to the eco­nomy and soci­ety and sus­tain­able per­form­ance). Five stra­tegic cli­mate actions are ded­ic­ated to pri­or­ity areas: adapt­ing mon­et­ary policy oper­a­tions to cli­mate risks, increas­ing the fin­an­cial sec­tor’s con­sid­er­a­tion of cli­mate risk, assess­ing the integ­ra­tion of cli­mate risks into com­pany rat­ings, act­ively com­mit­ting to car­bon neut­ral­ity, and aim­ing for digit­al sobri­ety in all uses¹⁶.