Thematic Tags: Monetary policy

Carbon Taxes and Tariffs, Financial Frictions, and International Spillovers

Ambitious climate policy, coupled with financial frictions, has the potential to create macrofinancial stability risk. Such stability risk may expand beyond the economy implementing climate policy, potentially catching other countries off guard. International spillovers may occur because of trade and financial channels. Hence, we study the design and effects of climate policies in the world economy with international trade and financial flows. We develop a two-sector, two-country, dynamic general equilibrium model with financial frictions, climate policies, including carbon tariffs, and macroprudential policies. Using the calibrated model, we evaluate spillovers from unilateral domestic carbon pricing to foreign economies and back. We also examine more ambitious climate architectures involving carbon tariffs or a global carbon price. We find that accounting for cross-border financial flows and frictions in credit markets is crucial to understand the effects of climate policies and to guide the implementation of macroprudential policies at the global scale aimed at minimizing transition risk and paving the way for ambitious climate policy.

Climate-related systemic risks and macroprudential policy

Climate change has a clear systemic dimension: its consequences are not only widespread across all sectors and regions, but potential concentrations, spillovers and interlinkages within the financial system risk further amplifying its economic and financial impacts. The systemic nature of climate change for financial stability suggests the need for a macroprudential response that goes beyond a (microprudential) focus on individual firms and ensures a consistent approach across the financial system.

While climate change may be predictable, the timing of its financial impacts is uncertain. Therefore, central banks and financial supervisors must rapidly develop sound risk management practices adapted to a context in which policy decisions rely on imperfect data and high uncertainty.

Existing macroprudential policy toolkits can be deployed now to address climate-related systemic risks with some possible adaptations to reflect the unique features of climate-related risks, like the long time horizon over which they may materialise, their strong dependency on the speed and direction of the low-carbon transition, and the specific data and forward-looking measurement methodologies required to manage them.

Two possible instruments that can be tailored to address systemic climate-related financial risks are: (i) ‘systemic risk buffers’, to increase the resilience of the financial system to climate-related shocks and contribute to mitigating the build-up of future risks; and (ii) measures limiting exposure concentrations, which could target and thereby mitigate sources of risk where they are greatest. While there are undeniable challenges in devising these macroprudential responses to climate-related systemic risks (e.g. modelling complexity and uncertainty, partial data coverage), the risks will only increase with inaction. This points to the need for central banks and financial supervisors to adopt a forward-looking approach and progressive deployment of policy in their response to climate risk.

Using green credit policy to bring down inflation: what central bankers can learn from history

Central banks typically associate climate-supporting measures with an expansionary monetary policy stance. Accordingly, such measures are thought to be inappropriate in an inflationary context. Against this view, we highlight a longstanding tradition in central banking which held the contrary: it is desirable to protect some sectors during a tightening cycle because certain types of investment prevent, rather than cause, inflation. This view is informed by examples of policy that was made at the German Bundesbank and other central banks, and made in ways that were entirely compatible with economic liberalism and central bank independence.

There are several reasons for central banks to use green credit policy in an inflationary context. First, a lack of sufficient green investment is undesirable in terms of ensuring long-term price stability. Second, the high upfront costs associated with renewable energy production and infrastructure makes them particularly sensitive to interest rates. Third, monetary policy that seeks to bring down inflation in the short term by restricting investments in climate mitigation would make the global economy more vulnerable to future climate- and biodiversity-related economic shocks, including adverse shocks to price stability. Fourth, a lack of green investment would also expose the domestic economy to stronger price shocks to high-carbon energy or other goods whose production is affected by ecological transformation. Fifth, the failure of central banks to consider the environmental impact of their instruments can undermine the broader role for monetary policy in supporting financial stability, government economic policy, stable employment and other central bank objectives.

Giving priority to certain investments through targeted central bank refinancing is compatible with central bank independence and current mandates. It will, however, require more coordination with regard to other aspects of credit policy (e.g. sustainable finance taxonomy, financial regulation, public development banks), and a change in central bank accountability and communication with the public. There are many institutional arrangements to ensure both the effectiveness of central bank measures and their democratic legitimacy.

Environment-related financial risks and regulatory capital requirements

The project focuses on green central bank policies, with a focus on green credit policy and regulatory capital frameworks. We shed light on the adoption of green policies by central banks as a means to mitigate the adverse effects of climate change. Our project develops general equilibrium models with incomplete markets, liquidity, collateral constraints and default that can be used for ex-ante evaluation of green climate policy and capture multiple channels of interaction. Our emphasis is on income and wealth inequality consequences of central bank green regulatory and monetary policy, and the importance of the rate of taxation to supplement the role of central banks.

Supporting the just transition: a roadmap for central banks and financial supervisors

Shifting to a sustainable economy will reshape the outlook for countries and sectors across the world. Managed well, the net zero transition could lead to more and better jobs as well as reduced risks from climate shocks. Managed poorly, however, it could result not only in stranded assets but also stranded workers and communities – and even stranded countries. In response, government policymakers have stressed the necessity for a ‘just transition’ that leaves no one behind in this process of change.

This objective requires action across all policy fields, including financial and monetary policies. A growing number of commercial banks and institutional investors are starting to incorporate just transition considerations into their climate strategies. Until recently, central banks and financial supervisors have focused their attention on the first order climate risks that confront financial systems and institutions. They have tended not to set out how they can respond to the social risks of decarbonisation and what they could do to support a just transition. However, there are emerging signs that central banks are starting to recognise the just transition agenda.

This paper sets out why it is important for central banks and supervisors to take an active role in supporting the just transition. It suggests a roadmap containing three steps – assessing, advising, and acting – for them to achieve this goal and explores some concrete policy options for aligning monetary policy operations and financial regulation with the imperative of a just transition.

Aligning financial and monetary policies with the concept of double materiality: rationales, proposals and challenges

The concept of double materiality is developing rapidly, with potential implications for monetary and financial policies. Double materiality builds on the historical accounting and auditing convention of materiality and expands it by considering that non-financial and financial corporations are not only materially vulnerable to environment-related events and risks, but also materially contribute to enabling dirty activities and environmental degradation.

Three rationales that support the use of double materiality are distinguished in this paper, each with different policy implications: i) an idiosyncratic perspective – closely connected to the concept of dynamic materiality – which considers that an entity’s environmental impacts are relevant as they provide information on the institution’s own risks; ii) a systemic risk perspective – closely connected to the concept of endogeneity of financial risks – which seeks to reduce financial institutions’ contribution to negative environmental externalities because of the systemic financial risks that could result from them; and iii) a transformative perspective seeking to reshape financial and corporate practices and values in order to make them more inclusive of different stakeholders’ interests and compatible with the actions needed for an ecological transition. Each of these rationales has potential implications for monetary and financial policies, as well as possible theoretical and practical challenges.

While the adoption of a double materiality perspective remains an open question, the concept proposes the opportunity to think more comprehensively about the role of the financial system in urgently addressing the ecological challenges of our times.

This paper is part of a toolbox designed to support central bankers and financial supervisors in calibrating monetary, prudential and other instruments in accordance with sustainability goals, as they address the ramifications of climate change and other environmental challenges. The papers have been written and peer-reviewed by leading experts from academia, think tanks and central banks and are based on cutting-edge research, drawing from best practice in central banking and supervision.

Quantifying the impact of green monetary and supervisory policies on the energy transition

15 February: To quantify the impact of “green” monetary and supervisory policies of central banks we develop a dynamic General Equilibrium Model for Sustainable Transitions (GEMST-1). This enables us to make a distinction between green and dirty final subsectors and fossil and renewable power sectors and take into account the feedback loops across sectors through energy prices until 2050. We identify four instruments (capital requirements, collateral frameworks, Asset Purchase Programmes, and Refinancing Operations) of central banks that can lower the cost of capital for climate-friendly investments and thus accelerate the energy transition and lower climate risks. We run three scenarios of different green central bank policies where the cost of capital of green final sub-sectors and/or renewable power sectors is lowered by an ambitious 100 basis points. Our analyses show that the maximum impact of such policies is achieved when it is implemented on both green final sub-sectors and renewable sub-sectors at the same time. Moreover, our study finds that green central bank policies can substantially accelerate the transition with a climate contribution that amounts to 5% -12% of the needed emission reductions under an ambitious climate action scenario. Whereas this is a substantial figure, it also indicates that green central bank policy should be seen as a compliment, not a substitute for fiscal and regulatory reports.