To be or not to be “green”: how can monetary policy react to climate change?

Lena Boneva, Gianluigi Ferrucci, Francesco Paolo Mongelli

Occasional Paper Series

To be or not to be "green": how can monetary policy react to climate change?

No 285 / November 2021

Disclaimer: This paper should not be reported as representing the views of the European Central Bank (ECB). The views expressed are those of the authors and do not necessarily reflect those of the ECB.

Contents

Abstract		2
Non-technical summary	3
1	Introduction	5
2	Why does climate change matter for monetary policy?	7
	2.1	Impact on key economic variables	8
	2.2	Monetary policy conduct	9
	2.3	Analytical tools	10
	2.4	Climate-related dislocations in financial markets	11
	2.5	Carbon bias in financial markets and central bank portfolios	11
3	How can central banks respond to climate change?	13
	3.1	Reacting to climate change: passive or defensive actions	13
	3.2	Raising awareness of climate risks	15
	3.3	Proactively mitigating climate change	16
4	Criticisms, constraints and trade-offs	22
5	Inflation targeting and climate change	26
	5.1	Target measure: core versus headline	26
	5.2	Point versus range target	27
	5.3	The time horizon to meet the target	28
	5.4	Level of the inflation target	29
6	Final remarks and future research	32
References		33

ECB Occasional Paper Series No 285 / November 2021

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Abstract

Climate change has profound effects not only for societies and economies, but also for central banks' ability to deliver price stability in the future. This paper starts by documenting why climate change matters for monetary policy: it impacts the economic variables relevant to setting the monetary policy stance, it interacts with fiscal and structural responses and it can generate dislocations in financial markets, which are impossible for monetary policy to ignore. Next, we survey several possible ways central banks can respond to climate change. These range from protective actions to more proactive measures aimed at mitigating climate change and supporting green finance and the transition to sustainable growth. We also discuss the constraints and trade-offs faced by central banks as they respond to climate risks. Finally, focusing on the specific challenges faced by inflation-targeting central banks, we consider how certain design features of this regime might interact with, and evolve in response to, the climate challenge.

JEL classification: E52, E58, Q54

Keywords: climate change, monetary policy, environmental economics, green finance, sustainable growth economics.

ECB Occasional Paper Series No 285 / November 2021

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Non-technical summary

Climate change is the greatest challenge humankind is facing this century, and its impact is becoming increasingly evident. The Paris Agreement of 2015 represented a significant milestone in the international response to it. The signatories agreed to limit global warming to well below 2°C above pre-industriallevels. Climate models predict this requires cutting net carbon emissions to zero by around the middle of the 21st century, which makes significant structural transformation of the global economy unavoidable.

Governments and parliaments have the primary responsibility and tools for addressing climate change. But within their mandates, central banks also need to tackle climate change, both to safeguard their ability to conduct policy smoothly and deliver on their mandates, and to ensure that they remain resilient to emerging climate-relatedfinancial risks. Depending on their policy remits, central banks could also consider going beyond a pure risk management perspective and seek to ensure that their operations do not undermine the transition to a low-carboneconomy or actively support it.

While several central banks have recognised the implications of unchecked climate change for financial stability and supervision, the implications for monetary policy have received less attention until recently. Our paper aims to fill this gap by considering various reasons why climate change is an important influencing factor for monetary policy and reviewing the emerging literature on how climate change considerations can be incorporated into the conduct of monetary policy and central banks' operational frameworks.

We start by reviewing the direct and indirect links between climate change and central banks' policies and objectives and survey a wide range of actions that are currently being debated in the literature. These actions range from passive responses deployed to protect central banks' balance sheets from emerging climate- related financial risks, to more proactive policies aimed at supporting the transition to a low-carboneconomy. The distinction between alternative approaches is not always clear cut, as it depends, not least, on how the measures are calibrated.

Differing approaches may also entail potential conflicting aims. For example, a tension may arise between their effectiveness in pursuing the central bank's mandate and supporting the transition, their feasibility and operational complexity, and the risk implications for the balance sheet. Any action will require policymakers to carefully weigh and balance the different trade-offs.These are also analysed, together with the constraints faced by central banks in taking action to deal with climate risks.

Some measures are controversial, since they can be seen as extending central banks' mandate beyond traditional boundaries, encroaching in some cases upon economic policies and raising issues of legitimacy and risks for central bank independence. The exact form central banks' reactions take will depend on their

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mandates, the prevailing institutional setting, legal and technical considerations, societal preferences and how various trade-offs pan out in each individual case.

The final part of the paper focuses on the specific challenges faced by inflation-targeting central banks. We consider how climate change could affect certain design features of this monetary policy regime and how it might evolve as climate risks unfold.

Climate disruptions will pose specific challenges for inflation-targeting central banks. These may require policymakers to re-examinethe relative merits of some design features of the framework, in particular the definition of the inflation target, the type of inflation measure used in central bank communications and how to appropriately calibrate the "medium-term"horizon of monetary policy. However, the slow-moving, long-termnature of climate change and our still limited knowledge of its possible consequences for the economy and financial system suggest that more precise indications of the impact on inflation-targetingcentral banks will only emerge over time.

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