SOAS Research Online

Abstract

Climate change has wide-ranging effects on society and the economy, presenting challenges for central banks. These challenges encompass both physical risks stemming from climate change and transition risks related to the shift toward a more sustainable economy. On one side, central banks need to respond to fluctuations in the general price level caused by climate-related factors like “climateflation,” “fossilflation,” “greenflation,” and “RE-disinflation.” On the other side, both physical and transition risks pose threats to financial stability. To effectively address these challenges, central banks must adapt their monetary policies and macroprudential tools. Failing to do so could hinder their ability to achieve their core objectives, which include maintaining price stability and often promoting sustainable economic growth. This focus paper offers specific suggestions as to what these adaptations might look like. First, it proposes the introduction of targeted green refinancing lines. Second, it argues for an adjustment of central banks’ eligible collateral frameworks. Third, the authors propose excluding bonds issued by carbon intensive companies that lack credible green transition strategies from bond purchase programs. In addition, central banks should incorporate climate risks into their regulatory activities within financial markets. For example, this could include mandatory disclosure and reporting requirements regarding the sustainability of the portfolios held by banks, as well as the performance of regular stress tests focusing on climate risks. Moreover, in the realm of banking regulation, capital requirements should be adapted to account for climate and environmental risks. In principle, alterations in the use of policy instruments can lead to goal conflicts for the central bank. For example, an excessively loose monetary policy aimed at encouraging sustainable investment could result in a central bank failing to achieve its objective of price stability. In addition, some observers fear that the transition to a green economy might lead central banks to take over tasks that are primarily the responsibility of national governments. This could undermine a central bank’s independence and thus its ability to guarantee stable prices. However, this focus paper shows that with an appropriate choice of instruments, central banks need not expose themselves to goal conflicts, and that they can pursue their price stability mandate while also factoring in climate risks and impacts. Indeed, Indeed, the adjustments to a central bank’s policy instruments proposed here would actually help, for example, the ECB pursue its primary mandate while simultaneously fulfilling its secondary mandate of supporting EU economic policies.