COP26: Six climate change policies for central banks

08 November 2021

Core Insights: Finance

By Paul Fisher

The image of an upside-down car hurtling along a river that only minutes before was a road punctuated our screens with alarming regularity in the summer of 2021.

As if the threat of climate change was not apparent enough the number of extreme weather events from wild fires to flash floods hitting the news has brought it front of mind for many as the United Nations Climate Change Conference, or COP26, in Glasgow takes centre stage this month.

These pictures may seem far removed from the dusty corridors of finance, interest rates and inflation targets, but central banks do in fact have a crucial role to play in the battle to limit global warming to well below 2C above pre-industrial levels, as agreed by world governments in the historic 2015 Paris Agreement, with ambitions of keeping temperatures rising to under 1.5C.

Some may ask is this really the responsibility of central banks? Many believe that effective monetary policy requires complete independence from Government and that central banks have no democratic legitimacy to consider climate change.

But more than half of the world’s central banks have ‘secondary objectives’, which means they need to support their Government’s wider economic policies, as long as that doesn’t prevent them achieving their primary objectives, such as controlling inflation.

In the UK, in 2021, the Government specifically amended its remit for the Bank of England’s Monetary Policy Committee to make it clear that the Government’s wider policy objectives included climate change.

Also, climate change potentially affects the primary objectives of central banks to a material degree. Central banks are therefore required – under existing mandates – to take action where they can, in order to meet their primary objectives.

Then there is the moral issue. Climate change presents an existential threat to the human race. It is the duty of everybody and every entity to do what they can to leave a liveable planet to future generations.

Mandates and objectives for central banks differ across countries so let’s take the broadest possible set of objectives and consider what, practically, central banks should be doing.

1 Monetary policy

Climate change will likely cause volatility in output and inflation – and put pressure on exchange rates for those with fixed rate regimes. 

Central banks must be aware of this threat and reflect such pressures in order to maintain price stability – and if they can do something to reduce the shocks, then that may well be justified by their monetary policy mandate. 

Changing interest rates or the money supply does not do that, but central banks have other potential levers, such as the composition of their balance sheets.

 

2 Financial stability

Claims on fossil fuel companies and other polluting enterprises form a very large part of the economy's financial assets – both on stock markets and in debt markets. 

These companies could lose significant value as demand moves towards cleaner alternatives and governments clamp down on emissions. A sudden sell-off of asset prices could threaten financial stability. 

The main policy to mitigate this and similar threats is to insist that firms disclose their exposure to climate-related risks. Such disclosures are on their way to becoming mandatory in the UK and the EU starting  in 2021 and many other countries are set to follow their lead.

 

3 Regulation and Supervision

Financial firms are significantly exposed to sudden drops in the asset prices of fossil fuel firms both collectively and individually.

Supervisors – whether located in the central bank or in an independent authority – will need to make sure that they are aware of and managing those risks safely.

This can be done under existing supervisory rules which require banks and others to manage their risks prudently. Climate stress tests are another policy being introduced, with the UK currently undertaking an exploratory exercise, and the EU set to follow suit. Firms not taking the issue seriously could eventually find themselves with higher capital requirements.

 

4 Bank notes

Most of the world’s bank notes are produced using plant-based materials – but those do not last long and are surprisingly difficult to recycle – when they are finished most are burnt.

Independent research undertaken for the Bank of England shows that polymer notes – as used in more than 20 countries world-wide – are more environmentally friendly as they last longer and can be recycled.

5 Balance sheet management

This is the most controversial topic of all. Many central bank balance sheets have expanded massively for monetary policy purposes since the great financial crisis of 2007-09.

They also conduct a wide variety of other financial operations, for example, taking temporary control over assets as collateral. The financial assets they have purchased were chosen to suit particular policy objectives. 

Pressure is now on for these portfolios to move away from ‘brown’ assets, such as those that are fossil fuel-related, towards ‘green’ assets, which are more sustainable, not just for risk management purposes, but because – it is argued –it can help channel financial flows.

This is controversial because some people see it as an undemocratic extension of the central bank’s policy objectives.  It is also unclear whether central bank purchases of green assets would help those markets grow – or hinder their nascent development. This is a debate in its infancy that has much further to run.

 

6 Financial conduct

Some central banks, such as Ireland and Singapore, are also the conduct regulator, seeking out bad behaviour and punishing those who are found to have broken the rules.

This can also involve promoting effective competition and ensuring that suitable products are offered to retail customers. As firms try to present themselves or their products as ‘green’ or ‘eco-friendly’ the conduct regulator has the job of ensuring that such claims are valid and fining or closing down operations if not (this is often referred to as ‘greenwashing’).

 

The effects of climate change can already be seen, and it is changing the insurance industry already due to the number of extreme weather events rising every year.

It’s time for central banks to step up and meet the challenge head on. Collectively these six interventions will not stop climate change, but they are powerful and will help the world move in the right direction.

 

Paul Fisher is Chair of the London Bullion Market Association. He is also ex-Deputy Head of the Bank of England's Prudential Regulation Authority and a former member of the Bank's Monetary Policy Committee. He lectures on Comparative Central Banking on the MSc Global Central Banking and Financial Regulation.

Find out more about the role of central banks on the MSc Global Central Banking and Financial Regulation or download a brochure.

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