Climate change is a major finacial risk. Central banks acknowledge that. Why are they not doing anything about it?

 By , who leads Positive Money’s research on climate policy and the monetary system.

Cross-posted from Positive Money

Policymakers increasingly recognise that building a low-carbon economy means reforming the financial system. In September the government set up a taskforce to advise policy development on green finance, and now the the Environmental Audit Committee is carrying out its own a Green Finance inquiry. But, as Positive Money wrote in our response to the committee’s call for evidence, there’s a striking gap in the government’s green strategy: the role of the central bank.

Despite paying attention to the growth of green bonds and launching funds to channel finance towards green innovation, the government seems unwilling to consider the broader question of its framework for monetary and financial policy. This matters because the Bank of England, despite its many powers, currently does little to assist the low-carbon transition and has actually promoted high-carbon sectors.

It’s not that the Bank of England doesn’t recognise that climate change has huge implications for the future of finance. It is among several central banks leading the pack in identifying climate change as a major financial risk. It is a founding member of the Central Banks and Supervisors Network for Greening the Financial System, along with the central banks of China and France, among others. Its Governor, Mark Carney, is often credited with first raising the profile of climate risk to the attention of the central banking community with his speech in September 2015. And the institution published its official response to the challenge in its Quarterly Bulletin of Q2 2017.

In that article, a team of staff at the institution explained how various facets of climate change contribute to financial risk and threaten financial instability. They built on the influential dichotomy between ‘physical’ and ‘transition’ risk – the former relating to damages from weather, the latter to economic changes taking place due to policies and market shifts as part of the low-carbon transition. Having already conducted a review of likely effects on the insurance sector, the Prudential Regulation Authority is currently working on a similar review of UK banks.

For all the Bank’s warnings of the need to mitigate climate risk, the way it delivers its most important function – the direction of monetary policy – has the opposite effect. To date, its purchases of corporate bonds via quantitative easing have disproportionately benefited carbon-intensive sectors, including manufacturing and power generation from fossil fuels. The most straightforward implication of the transition risk concept is that funding fossil fuels promotes a dirty climate and an unstable future financial system. So why does the Bank itself do exactly that?

The answer has a lot to do with the way its committees make decisions. A letter from the Chancellor of the Exchequer outlines the monetary policy remit. The Monetary Policy Committee is tasked with achieving price stability – currently defined, by the government, as an inflation level of 2 per cent. But it is also required to ‘promote an understanding of the trade-offs inherent in setting monetary policy.’ It must communicate how it reached its decisions and ‘the trade-off that has been made with regard to inflation and output volatility,’ as well as ‘how this approach meets the government’s monetary policy objectives.’ This is standard operating procedure for making monetary policy at the Bank of England.

There is no reason why climate variables – such as emissions of CO2e – couldn’t receive the same treatment as economic output under the current framework. There are two potential ways forward. One option is for the government to include ‘a smooth but rapid transition to a low-carbon economy’, or similar, in its monetary policy objectives. This would mandate the Bank to give the issue due consideration, while retaining price stability as the primary objective. Another option, less dramatic but certainly of substance, would see the letter ask that the Bank report on the climate or environment in its discussion of trade-offs.

These changes are well within the legal power of the Chancellor to make. It is crucial for the UK’s public institutions to coordinate for a credible and stable low-carbon transition, and monetary policy must be reconciled with the Bank’s concern that climate change represents a severe financial stability risk. Our central bank has an important role to play in the future of green finance, and it’s up to government to build an institutional framework that allows that to happen.

Be the first to comment

Leave a Reply

Your email address will not be published.