Climate Change: Should Central Banks Join The Battle?

Central banks (national banks that provide financial services for their countries’ governments and commercial banking systems, implement monetary policies, and issue currency) now find themselves debating the ramifications of taking on bold climate action policies. And perhaps not before time given their pivotal role in managing money supply and interest rates of countries. But can they help the world prevent climate change?

A new report published by the Basel-based Bank for International Settlement (BIS) last week concluded that central banks cannot and instead urged “global coordination” initiatives spanning government policy to financial regulation to address matters. One of the key authors to the report, Luiz Awazu Pereira Da Silva, said: “There is no silver bullet.”

In Europe, central banks edge toward taking action on climate change

The European Central Bank (ECB) last November announced its goal of working towards an enhanced stress test, one which incorporates climate-related risks. Since then there have been increasingly frequent headlines linking climate change to central banks.

Against that backdrop and with the Bank of England’s (BoE) governor Mark Carney preparing for his new role as U.N. Special Envoy for Climate Action and Finance at the end of this month, the announcement late last year from the ECB highlights a ground-breaking new stress testing regime - one that tests the abilities of banks and insurers abilities to cope with three scenarios.

These options include:

• An easy and swift transition to a carbon-neutral economy.
• Late climate policy action, i.e., a delayed transition to meeting global climate targets.
• No new policies are implemented at all, and global temperatures increase above the cap set by global climate change targets.

“While this is merely a stress test that forces banks to consider climate change in their risk management strategies, it could however, push them away from polluting investments,” said Ahmed Babikir, an associate with JCRA, an independent financial risk advisory specializing in hedging and debt advice and part of Chatham Financial.

He added: “The BoE is currently consulting on the design of the stress tests and the first results will be published in the first half of 2021. In the U.S. the Federal Reserve has been reluctant to comment on climate change, being regularly lambasted by Trump for its monetary policies, commenting on climate change could add fuel to the fire.”

It might be hard to see at first glance, why central banks are concerned about the global temperature rise. But soundings are being made.

The canary in the central bank coal mine

Last week’s 115-page ‘Green Swan’ report from BIS, which is often described as a central bank for central banks, explained why, according to JCRA’s Babikir.

The lengthy report argues that climate change could trigger the world’s next global financial crisis through a fire-sale that may occur if fossil fuel reserves cannot be monetized, turning many assets into “stranded assets.” This then could trigger a global financial crisis.

The BIS report stated: “Climate change poses new challenges to central banks, regulators and supervisors. Integrating climate-related risk analysis into financial stability monitoring is particularly challenging because of the radical uncertainty associated with a physical, social and economic phenomenon that is constantly changing and involves complex dynamics and chain reactions.”

It added: “Traditional backward-looking risk assessments and existing climate-economic models cannot anticipate accurately enough the form that climate-related risks will take.”

And, when comparing sub-prime mortgages with highly polluting “stranded assets” there are similarities with the 2008 crisis, pointed out

Babikir, a pricing and structuring specialist within JRCA’s project finance and infrastructure team.

Green quantitative easing

As well as prudential supervision of authorized deposit-taking institutions (ADIs) that aims to protect depositors by ensuring that financial institutions adopt prudent risk management, central banks have powerful tools at their disposal to help fight climate change.

“Green quantitative easing” is a term that has been used by many to describe central banks’ increase of green bond purchases. However, this is easier said than done. At the end of 2018, the ECB held around 24 percent of eligible green public sector bonds and 20 percent of eligible green corporate bonds.

“Skewing any asset purchase program towards green assets risks central banks swallowing the market for green bonds and causing a ‘green bubble’. Selling carbon-intensive assets is also an option,” ventured Babikir.

Sweden’s central bank, the Riksbank, recently announced that it was selling bonds for climate reasons and had dumped debt issued by Alberta, Canada and Queensland, Australia due to their “large carbon footprint.”

For central banks, there’s the horse-before-the-cart conundrum

Yet only a few days before the BoE announced what has been described as its revolutionary climate change-based stress test, there was a breakdown in talks between governments at the U.N. Climate Talks (COP25).

These discussions were meant to define the rules for a new global carbon trading market, which are critical to achieve the Paris Agreement goals.

“Without governments and politicians playing a leading role in tackling climate change, any input from central banks will be of little or no value,” Babikir contended.

Many central bankers such as Bundesbank President Jens Weidmann and chairman of the BIS’ board have criticized the demands for central banks to fight climate change, having stated that: “Politicians with democratic legitimacy must decide how society should combat climate change and they must also bear the responsibility.” 

Whether tackling climate change is “within the remit” of central banks or not and particularly as in most developed nations they are institutionally independent from political interference, climate change clearly presents a challenge for the financial sector.

Whatever else and as Babikir pointed out: “Central banks need to ensure readiness for a time when extreme weather and radical climate change policies could severely impact the global economy.”

Pereira Da Silva, speaking to journalists recently as the Green Swan report was published, said that we “might be on the brink of observing something that might be behind the next systemic financial crisis.” And, were more extreme climate scenarios to come to the fore, central banks might be asked to step into the breach as “climate rescuer of last resort.”

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