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Central banks: the tools to fight climate change

Patricia Crifo
Patricia Crifo
Professor of Economics at École Polytechnique (IP Paris), Researcher at CREST (CNRS) and Associate Researcher at CIRANO
Key takeaways
  • At the current rate, the global carbon budget of 580 GtCO2 would be exhausted in less than 15 years.
  • Central banks can play a crucial role in the fight against climate change, especially as it threatens financial stability and economic activity.
  • In finance, climate risk includes physical risk (such as economic costs) and transition risk, which results from changes in government policies.
  • In 2021, the ACPR’s stress test showed that the cost of climate-related claims would increase five or sixfold between 2020 and 2050 in some French departments.
  • To integrate climate risk into financial issues, the central bank has several tools at its disposal, such as investment portfolios or prudential measures.

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.

Infla­tion rates in Europe. Source: Euro­stat1.

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.

Res­i­den­tial elec­tric­i­ty prices. Half-year­ly data 2007–2022, EU27. Source: Euro­stat4.

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.

Mobilisation of central banks

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

Total glob­al CO2 emis­sions. Source: Friedling­stein et al. 2022; Glob­al Car­bon Project 20227.
Illus­tra­tion of the esti­mate of the remain­ing car­bon bud­get. This esti­mate is based on the his­tor­i­cal human-induced glob­al warm­ing lev­el, the net zero com­mit­ment, the con­tri­bu­tion of future warm­ing with­out CO2 (con­sis­tent with glob­al net zero emis­sions or not), the tran­sient cli­mate response to cumu­la­tive car­bon emis­sions (TCRE), and the addi­tion­al cor­rec­tion for unrep­re­sent­ed Earth sys­tem feed­back. The grey area illus­trates how the uncer­tain­ty in the TCRE prop­a­gates from the start­ing point. Source: Rogelj et al. (2019)8.

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.”

What is climate risk in finance?

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

ACPR stress tests

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.

Integrating climate risk into financial issues

  • 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.

2Rogelj, J., Forster, P., Kriegler, E., Smith, C., Séféri­an, R. (2019). Esti­mat­ing and track­ing the remain­ing car­bon bud­get for strin­gent cli­mate tar­gets. Nature 571, 335–342.  
3Schn­abel, I. (2022). Look­ing through high­er ener­gy prices ? Mon­e­tary pol­i­cy and the green tran­si­tion. Speech at the pan­el on “Cli­mate and the Finan­cial Sys­tem” at the Amer­i­can Finance Asso­ci­a­tion 2022 Vir­tu­al Annu­al Meet­ing.
5Fried­man M. (1970). The Social Respon­si­bil­i­ty Of Busi­ness Is to Increase Its Prof­its. The New York Times Mag­a­zine, Sep­tem­ber 13, 1970. Sec­tion SM, Page 17.
6Cri­fo P., For­get V. (2015). The eco­nom­ics of cor­po­rate social respon­si­ib­li­ty : a firm-lev­el per­spec­tive sur­vey. Jour­nal of Eco­nom­ic Sur­veys  Vol. 29, No. 1, pp. 112–130.
7Friedling­stein et al 2022 ; Glob­al Car­bon Bud­get https://​essd​.coper​ni​cus​.org/​a​r​t​i​c​l​e​s​/​1​4​/​4​8​1​1​/​2022/
8Rogelj, J., Forster, P., Kriegler, E., Smith, C., Séféri­an, R. (2019). Esti­mat­ing and track­ing the remain­ing car­bon bud­get for strin­gent cli­mate tar­gets. Nature 571, 335–342.  
9TCFD – Task Force on Cli­mate-Relat­ed Finan­cial Dis­clo­sures.Créée en 2015 dans le con­texte de la COP 21 et sous l’égide du Con­seil de sta­bil­ité finan­cière (FSB), la TCFD vise à aider les entre­pris­es à fournir de meilleures infor­ma­tions extra-finan­cières. Elle pub­lie à l’été 2017 onze recom­man­da­tions, s’articulant autour de qua­tre piliers qui représen­tent des élé­ments fon­da­men­taux du fonc­tion­nement des organ­i­sa­tions : la gou­ver­nance, la stratégie, la ges­tion des risques et les mesures et objec­tifs. La TCFD fait par­tie des lignes direc­tri­ces de 2019 de la Com­mis­sion européenne en matière de report­ing extra-financier
10NGFS ‑Net­work for Green­ing the Finan­cial Sys­tem (NGFS). Le groupe des régu­la­teurs sur la finance verte créé en décem­bre 2017 au One plan­et sum­mit par 8 Ban­ques Cen­trales et régu­la­teurs (dont la Banque de France) réu­nit en octo­bre 2022 121 mem­bres et 19 obser­va­teurs au niveau mon­di­al.
11IPCC (2018). Réchauf­fe­ment plané­taire de 1,5 °C, Résumé à l’intention des décideurs, 2018.
12McGlade, C., Ekins, P. (2015). The geo­graph­i­cal dis­tri­b­u­tion of fos­sil fuels unused when lim­it­ing glob­al warm­ing to 2 °C. Nature 517, 187–190.
13Dées S., Weber PF (2020). Les con­séquences du change­ment cli­ma­tique pour la poli­tique moné­taire », Revue d’é­conomie finan­cière, 2020/2 N° 138, p. 243–257. 
14ACPR (2021) Une pre­mière éval­u­a­tion des risques financiers dus au change­ment cli­ma­tique. Les prin­ci­paux résul­tats de l’exercice pilote cli­ma­tique 2020.
15NGFS (2019). Un appel à l’action Le change­ment cli­ma­tique comme source de risque financier. Réseau pour le verdisse­ment du sys­tème financier. Pre­mier rap­port com­plet
16ACPR (2022) L’action cli­mat de la Banque de France et l’ACPR. Rap­port TCFD. 


Patricia Crifo

Patricia Crifo

Professor of Economics at École Polytechnique (IP Paris), Researcher at CREST (CNRS) and Associate Researcher at CIRANO

At École polytechnique, Patricia Crifo is director of the Masters course “Economics for Smart cities and Climate Policy”, the IdR Sustainable Finance and Responsible Investment (TSE-École polytechnique) and deputy director of the Energy4Climate centre.

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