We need Central Banks to Join the Fight against Climate Change

Introduction.

Climate change is the biggest threat to humanity, from the loss of human life, degradation, and extinction of biodiversity, the ecological and financial implications are well documented. Extreme weather events are on the rise, which imperils asset classes ranging from infrastructure to tourism that has come to form a bulwark for economic development and prosperity in several countries across the world. In other to guard against financial stability risks that are latent in extreme climate events, central banks must begin rethinking stress tests and take credible steps to lessen the exposure of economies to climate-induced shocks.

Photo by Kai Brune on Unsplash

However, the COVID-19 has caused the issue of central banks to resurface due to large-scale asset purchases, which were undertaken by central banks to reduce the negative effects of COVID-19 on their economies. A majority of central banks engaged in some form of asset purchases, while central banks across developing market economies were limited to interest rate cuts and liquidity infusions. The issue of deficit-driven spending and the role of central banks in the financialization of the economy has re-emerged ever more strongly.

While COVID-19 was an inflection point in central banks’ asset purchase history, it nevertheless required a swift, comprehensive, and somewhat unprecedented response. In size and scale, it culminates over $17 trillion worth of corporate and public sector purchases, designed to provide buffers for the private sector and support private-sector wages and boost domestic demand and ensure inflation converges back towards its 2% target. While much of the fiscal- monetary debate has revolved around the role of central banks, it fails to outline the important role played by this nexus in economic growth, structural adjustments, and the attainment of the inflation target.

One can admit that central banks’ mandate explicitly excludes the pursuit of other goals other than price and monetary stability. However, central banks' mandate are wide-ranging, and the need to ensure financial stability is closely linked to their ability to redress the incipient climate shocks that are endemic of their economies. Extreme climate events hold grave implications for the agricultural, property, insurance, and household sector. The loss of biodiversity will cause agricultural prices to fall, food prices to rise and the unsustainable balance of cost-push inflation and low productivity will hamper transmission mechanisms from monetary policy. According to Frank Elderson, Member of the Executive Board of the ECB, climate change can directly impact inflation. This may occur when more frequent floods and droughts destroy crops and hamper agricultural output, thereby raising food prices. Mitigation policies can also affect consumer prices such as electricity and petrol directly or indirectly, for instance through higher production costs. These issues clearly lie at the heart of our mandate. Moreover, the effectiveness of monetary policy could be hampered by the impact of climate-related structural change, or by disruption to the financial system. For example, losses from disasters and stranded assets could impair credit creation.

If the real economy is prone to shocks, central banks must pre-empt rather than react to shocks across their economies. For advanced economies, their financial systems are, only somewhat, prepared to redress the risks posed by extreme climate events when they occur. The ability to Marshal capital into higher productivity sectors will reduce the long-term labor market and financial scarring from extreme climate events. There is a direct link between employment and wage growth as these variables have significant effects on the real economy and consumer purchasing decisions.

Given the risks posed by climate change to financial systems, central banks must design monetary policy in a manner that prioritizes the transition to renewable energy. If one looks at central bank mandates closely, it is evident that they are not constrained by their mandate. Rather than exclude the implications of extreme climate events from financial stability, it is imperative that central banks’ embrace their new role as bulwarks for both prices, financial and economic stability.

In the last decade, inflation across advanced economies have slowed and the periodic crisis has been amplified by risks from zoonotic diseases and climate shocks that have loomed large across North America and Europe. It is, therefore, necessary and salient for central banks to utilize their primary tools of interest rates and liquidity infusion and/or repo market operations to support the energy transition.

The ECB and the issue of proportionality

While the ECB has reiterated its commitment to price and financial stability, its most recent asset purchases have been broad-based and comprehensive. What is more, the principle of proportionality requires that the content and form of the ECB actions not exceed what is necessary to achieve the objectives of the Treaties. Finally, the ECB must act “in accordance with the principle of an open market economy with free competition, favoring an efficient allocation of resources”. As such, while the allocation of asset purchases is contingent on a set of pre-defined criteria, which can enable a more climate-centric allocation of asset purchases across the public sector.

One could argue that this will cause central banks to pick winners and losers, but the exclusion or inclusion of companies should be based on the activities of companies rather than the sector of operation. If one takes the example of BP that is forecast to reduce emissions by 40 in the next decade, central banks can use asset purchases to support key and quantifiable targets that will enable central banks to transition to the renewable energy sector. Central Banks can use a target-driven asset purchase model that enables them to first identify companies that are operating in the renewable sector and provide sufficient capital of financial support by way of the targeted longer-term refinancing operations in other to enable them to transition o renewable energy.

It is incomprehensible to preclude central banks to intervene in financial markets or purchase government debt in other to address climate risks. On the one hand, the issue of deficit-financed spending has been present well before the 2008 financial crisis and COVID-19. In the 1960s the Federal Reserve bought government debt, while the Bank of England equally purchases government paper during World War II.

During these periods, the issue of deficit-financed spending was not bought to the fore as it enabled these economies to achieve their objectives even as the central bank-maintained price stability. As such, even as central bank balance sheets have grown in the last decade, it is imperative to note that the rationale for their actions is consistent with their mandates. In the case of climate change, some might argue that stress tests should ensure that the financial sector is not exposed to climate risks and ensuring that prudential frameworks determine the climate transition that will be supported by capital and additional financing for capital banks.

Climate change has already illustrated the nature of shocks that emanate from extreme climate events. Central banks’ mandates do not explicitly ask for their intervention to quell climate risks. However, where such risks are related to financial stability, it is imperative that central banks intervene in financial markets in other to support the energy transition. There are other opportunities that will emerge from such an approach as this will create high-quality jobs, cause wages to rise and inflation will swiftly return to target. Meanwhile, the risk of cost-push inflation and a surge in food prices will equally be averted, thereby staving off a depletion in consumption. In the last decade, the productivity puzzle has exacerbated concerns of the Philips curve as the contribution from oil prices has waned and currencies in developing market economies have become stable. In other to redress the deflation risks that are endemic in a globalized and increasingly competitive marketplace, central banks must play a role in redressing the structural impediments that have restrained consumption and underlying inflation.

Conclusion.

Climate change constitutes a financial stability risk and central banks must take credible steps to mitigate the impact of extreme climate events on food prices, asset classes in the financial sector. The impact of higher public spending after extreme climate shocks such as landslides, floods requires deficit-financed spending and asset purchases to support the financial sector and the real economy. Rather than risk climate catastrophe, higher levels of public debt, and bloated balance sheets, central banks should design asset purchases and monetary policy in a manner that prioritizes the energy transition bolsters the resilience of the financial system, and ensures inflation gradually converges towards the central banks’ 2% target.

I am an economist and contributor to Nkafu policy, a think tank. I cover global economic, fiscal and monetary policy with policy and asset price implications.

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