Green Banking and Green Central Banking

Andreas Dombret, Patrick S. Kenadjian, Andreas Dombret, Patrick S. Kenadjian

• Publisher: De Gruyter
• Year: 2021
• ISBN:
  9783110752922
• Edition: 1
• Topic: Law
• Subtopic: International Law
• Index: Law

The books deals with the questions that really matter for green finance: Where will the money to finance the transition to a low carbon environment come from, how far do the banks' balance sheets stretch and where will the rest of the money come from? How much can we rely on the capital markets, especially in the EU, to get money to the parts of the economy which really need it, without greenwashing? How do governments organize not just a transition, but a just transition to a low carbon environment? Is it time to revisit received ideas about the proper role for central
banks?

IV. The Role of Central Banks, Regulators and Supervisors

Climate Change and Central Banking

Keynote speech by Christine Lagarde, President of the ECB, at the ILF Conference on Green Banking and Green Central Banking, Frankfurt am Main, 25 January 2021

Christine Lagarde

In the famous fable “Belling the Cat”,¹ a group of mice gather to discuss how to deal with a cat that is eating them one by one. They hatch a plan to put a bell on the cat so they can hear it coming and escape before being caught. When it comes to who will actually do it, however, each mouse finds a reason why they are not the right mouse for the job, and why another mouse should do it instead. The cat never does receive a bell – and the story ends poorly for the mice.

In many ways, that fable describes mankind’s reaction to the threats posed by climate change. Already in 1986, the front cover of Der Spiegel showed Cologne cathedral half-submerged by water and the headline declared a “Climate Catastrophe”.² This is just one example, among many, that demonstrates that people were aware of the risks posed by climate change a generation ago. Yet, while many people agreed on the seriousness of the issue, and that something had to be done, concrete action has been much less prevalent.

It is with this history in mind that I want to talk about the role of central banks in addressing climate change. Clearly, central banks are not the main actors when it comes to preventing global heating. Central banks are not responsible for climate policy and the most important tools that are needed lie outside of our mandate. But the fact that we are not in the driving seat does not mean that we can simply ignore climate change, or that we do not play a role in combating it.

Just as with the mice in the fable, inaction has negative consequences, and the implications of not tackling climate change are already visible. Globally, the past six years are the warmest six on record, and 2020 was the warmest in Europe.³ The number of disasters caused by natural hazards is also rising, resulting in $210 billion of damages in 2020.⁴ An analysis of over 300 peer-reviewed studies of disasters found that almost 70 % of the events analysed were made more likely, or more severe, by human-caused climate change.⁵

That said, there are now signs that policy action to fight climate change is accelerating, especially in Europe. We are seeing a new political willingness among regulators and fiscal authorities to speed up the transition to a carbon neutral economy, on the back of substantial technological advances in the private sector.

This increased action is often considered as a source of transition risk, which we need to take into account and reflect in our policy framework. This is not “mission creep”, it is simply acknowledging reality. Yet the transition to carbon neutral is not so much a risk as an opportunity for the world to avoid the far more disruptive outcome that would eventually result from governmental and societal inaction. Scenarios show that the economic and financial risks of an orderly transition can be contained. Even a disorderly scenario, where the economic and financial impacts are potentially substantial, represents a much better overall outcome in the long run than the disastrous impact of the transition not occurring at all.⁶

It now seems likely that faster progress will be made along three interlocking dimensions. Each of them lies outside the remit of central banks, but will have important implications for central bank balance sheets and policy objectives.

Including, informing and innovating

The first dimension along which we expect rapid progress is including the true social and environmental cost of carbon into the prices paid by all sectors of the economy.

Appropriate pricing can come via direct carbon taxes or through comprehensive cap and trade schemes. Both are used to some extent in the EU. It is likely, though, that the next steps in Europe will come mainly via the EU’s Emissions Trading System (ETS), a cap and trade scheme. The ETS is an essential infrastructure, although it has not always been successful in the past at delivering a predictable price of carbon. Moreover, it currently covers only around half of EU greenhouse gas emissions and a significant amount of allowances continue to be given for free.

The effective price of carbon is expected to rise if the EU’s targets for reducing emissions are to be reached. Modelling by the OECD and the European Commission⁷ suggests that an effective carbon price between €40–60⁸ is currently needed, depending on how stringent other regulations are. The introduction of the ETS Market Stability Reserve and the review of the ETS scheduled for this year should provide the opportunity to deliver a clear path towards adequate carbon pricing.

The second dimension where we expect to see progress is greater information on the exposure of individual companies. At present, information on the sustainability of financial products – when available – is inconsistent, largely incomparable and at times unreliable. That means that climate risks are not adequately priced,⁹ and there is a substantial risk of sharp future corrections. Yet for an open market economy to allocate resources efficiently, the pricing mechanism needs to work correctly.

This requires a step change in the disclosure of climate-related data using standardised and commonly agreed definitions. While TCFD-based¹⁰ disclosures have underpinned public/private efforts to better inform, disclosure needs to be at a far more granular level of detail than is currently available. In Europe. climate disclosures are governed by the Non-Financial Reporting Directive (NFRD), which is currently under review.¹¹ The Eurosystem has advocated for mandatory disclosures of climate-related risks from a far greater number of companies, including non-listed entities. Moreover, disclosures should be complemented by forward-looking measures that assess the extent to which both financial and non-financial firms are aligned with climate goals and net zero commitments.

The European Taxonomy Regulation¹² that entered into force last year is also an important milestone along this path. But it still needs to be fleshed out with concrete technical criteria and complemented by an equivalent taxonomy for carbon-intensive activities. A further essential step is the consistent and transparent inclusion of climate risks in credit ratings. Here, again, we have high hopes that progress will now speed up.

While adequate carbon prices and greater information on exposures will help provide incentives to decarbonise, that economic transformation cannot take place without the third dimension: substantial green innovation and investment. Both, however, require a complex ecosystem of which finance is a key element,¹³ so we expect to see increasing availability of green finance. Green bond issuance by euro area residents has grown sevenfold since 2015, reaching €75 billion in 2020 – this represents roughly 4 % of the total corporate bond issuance.¹⁴

We need to see funding for green innovation increasing from other market segments as well, especially as recent analyses point to the beneficial role of equity investors in supporting the green transition.¹⁵ Assets under management by investment funds with environmental, social and governance mandates have roughly tripled since 2015, and a little more than half of these funds are domiciled in the euro area. Completing the capital markets union should provide a further push to support equity-based green finance by fostering deep and liquid capital markets across Europe.

Simultaneous progress along each of these three dimensions increases the likelihood of substantial economic change in the near term. That is so because movement along each dimension reinforces progress along the others and magnifies the effectiveness of climate policy.

For example, the economic impact of higher carbon prices depends on the availability of alternative green technologies. In the past, a sudden and substantial increase in carbon taxes could have resulted in an economic downturn, substantial stranded assets and threats to financial stability. Today, however, solar power is not only consistently cheaper than new coal or gas-fired plants in most countries, but it also offers some of the lowest cost electricity ever seen.¹⁶ Green finance and innovation are also developing rapidly. Introducing well-signalled carbon pricing therefore becomes more feasible and could further sharpen incentives both to develop new technologies and to carry out the substantial investment required for the widespread adoption of the green technologies that already exist.

Climate Change and Central Banks

Today, then, central banks face two trends – more visible impacts of climate change and an acceleration of policy transition. Both trends have macroeconomic and financial implications and have consequences for our primary objective of price stability,¹⁷ for our other areas of competence including financial stability and banking supervision, as well as for the Eurosystem’s own balance sheet. Central banks are both aware of those consequences, and determined to mitigate them. Much has already been accomplished and more is under way:

The founding of the Network for Greening the Financial System (NGFS), with membership including all major central banks, is testament to that collective engagement with climate change.

At the ECB, we are now launching a new climate change centre to bring together more efficiently the different expertise and strands of work on climate across the Bank. Climate change affects all of our policy areas. The climate change centre provides the structure we need to tackle the issue with the urgency and determination that it deserves.

In the area of financial stability and banking supervision, the ECB has taken concrete steps towards expanding the financial system’s understanding of climate risks and its ability to manage them. We have issued a guide on our supervisory expectations relating to the management and disclosure of climate-related and environmental risks.¹⁸ A recent survey of the climate-related disclosures of 125 banks suggests there is still a way to go. It evaluated climate disclosures across several basic information categories. Only 3 % of banks made disclosures in every category, and 16 % made no disclosure in any category.¹⁹ ECB Banking Supervision has requested that banks conduct a climate risk self-assessment and draw up action plans, which we will begin assessing this year. We will conduct a bank-level climate stress test in 2022.

The ECB is also currently carrying out a climate risk stress test exercise to assess th...