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.