Why central banks must now become the saviours of the climate crisis

Cometh the crisis, cometh the central bank. Each of the major financial shocks of the past two decades has been met with cuts in interest to close to zero and the release of trillions in quantitative easing (QE).

The sharp impacts of the global financial crisis, the eurozone debacle, the fallout from the Brexit referendum and post-Covid turbulence have all been blunted by monetary policy.

Now the masters of the financial universe will be called upon to become the saviours of the environment as well.

As the world moves on from the Cop26 leaders’ summit – described by its president Alok Sharma as “disappointing” but by the Maldives as a “death sentence” – central banks will doubtless need to play a key role in getting the financial system to support the climate effort.

It was Mark Carney, as governor of the Bank of England, who took the lead as far back as 2015 when he identified the “tragedy of the horizon”: the idea that once climate change becomes a defining issue for financial stability, it may already be too late.

There are two issues here – moves that central banks and regulators can take to minimise the threat of climate change, and more proactive steps they can take to use the financial system itself to tackle climate change.

The first batch is less controversial and means working against three threats to stability. One comes from defaults as tough government policies lead to capital to flee dirty industries towards clean sectors.

The second is physical risk from financial firms’ exposure to volatile weather conditions. Finally, there is the risk that people who have suffered loss from the effects of climate change sue those whom they hold responsible.

Central banks have already responded by setting “stress tests” for financial institutions under various scenarios and issuing dark warnings about the potential devastating impact.

A survey last year by OMFIF, the independent think-tank for the central banking world, showed 70 per cent of central banks and regulators consider climate change a “major threat” to financial stability.

But there are signs others want to go further, worried about the future impacts of inaction now to actually join the fight. In March, chancellor Rishi Sunak gave the Bank of England a duty to support the government’s net-zero carbon ambition alongside its longstanding responsibility to keep inflation in check.

The Bank of Japan will begin disbursing loans in late December under a new scheme targeting activities aimed at combating climate change. The European Central Bank said in July it was committed to further incorporating climate change considerations into its monetary policy framework and may start changing the way it buys corporate bonds but not until next year.

At the other end of the scale, in the US progressive Democrats have urged Joe Biden not to reappoint Jerome Powell to the Federal Reserve because they think he has fallen short on climate.

But some believe central banks have gone far enough and should go no further because they are unelected, technocratic institutions, operating within strict legal frameworks whose primary task is, typically, price stability. Any involvement in climate policy must, therefore, be based solely on mandates handed down by elected politicians.

Indeed, the OMFIF survey showed one central bank and regulator in eight said that, while it considers climate change a major risk, action should come from other institutions such as government departments.

Last week, Ethan Harris, global economist at Bank of America Securities, argued against central banks shifting their assets away from dirty ones and towards clean ones, saying they had not the resources, skillset, nor mandate to “pick winners and losers”.

Central banks have also acquired enemies among those who believe QE policies have rewarded those with assets, whose prices have soared, or debts, whose interest payments have shrunk, versus the poorest in society with few assets and a fixed income such as a benefit or a pension.

The sad truth, however, is that governments’ failure to make firm spending pledges on climate mean that, once again, the only game in town is the central bank and its cousin the financial regulator.

The new arrival at the ECB, Germany’s Isabel Schnabel, has set out the intellectual basis of this shift to a more active role. Rather than working towards “market neutrality”, where its €270bn (£230bn) bond purchase programme should only reflect the overall market, it should move towards what she calls “market efficiency”. This would allow the ECB to shun bonds in polluting companies because of the damage to the wider economic system caused by that pollution.

The more fundamental justification is that central banks are justified in supporting the stated climate policy priorities of their respective governments. It should not labour under “market neutrality” as that will work against those goals.

Now that governments failed to take the action needed at Cop26, then, to quote former ECB boss Mario Draghi, central banks must do “whatever it takes”. The bottom line is that countries that have empowered their central banks to help pursue climate objectives must let them exercise that power.