The Role of the ECB in the Fight Against Climate Change

Copyright to the European Commission: https://ec.europa.eu/newsroom/fisma/items/645336.

Abstract

Discretionary State interventions are not sustainable solutions for fighting climate change and even though carbon regulation, pricing and taxing have been responsible for decreasing the presence of carbon dioxide in the atmosphere, they cannot do much alone. There needs to be coordination between monetary and fiscal policy to observe significant results. The ECB can provide incentives within the banking system for a smooth transition to happen, while protecting banks from it, and governmental actions can slowly point people and businesses towards the direction of transitioning.

Introduction

In February 2020, the President of the European Central Bank (ECB) delivered a powerful speech on sustainability within the monetary policy framework. In her speech, she called for preparation against climate-related risks such as insurance and economic loss, a rough transition to carbon neutrality due to belated coordination of public authorities and sustainable finance to mitigate the transition to a carbon-neutral society.

In this article, we will be stating past efforts to contain climate change, such as the Paris Agreement that, even though was crowned successful, cannot provide sustainable solutions in the long term. This article advocates that only through the inclusion of monetary policy significant results can be observed and it mentions policies that could potentially help in the fight against climate change.

A higher frequency of extreme weather events is likely to cause price fluctuations, for example floods, catastrophes and rising sea levels that diminish productive land (physical risks), and therefore threaten price and financial stability, one of the main objectives of the ECB. Moreover, costs related to transitioning to a low-carbon economy could lead to supply shocks (transition risks).

The Paris Agreement

Through the Paris Agreement of 2015, common objectives to fight climate change were imposed in a transnational cooperative spirit. The binding and universal objective was the limitation of greenhouse gas emissions so that global temperature does not increase more than 2 degrees Celsius above the Industrial Revolution level. The following graph demonstrates the parties that joined the signing of the agreement as well as whether they submitted proposals or not.

Subject to copyright: https://www.carbonbrief.org/paris-2015-tracking-country-climate-pledges

Policies followed vary per country, but common practices included the reduction of the share of coal in national energy consumption, the introduction of an Emissions Trading System (ETS) and a mandatory renewable energy certificate scheme, under which businesses would have to follow seminars on climate change. An ETS is based on the cap-and-trade principle, under which each state sets a cap of total gasses emitted by a sector and the companies in that sector trade emission allowances between them.

The Paris Agreement was considered a success in tackling climate change, as it promoted collaboration between countries and pointed out the importance of ex-ante actions by institutions.

However, production and price regulation policies that are currently implemented by countries are not enough to tackle climate change. Even though following pure economic intuition higher prices should lead to lower demand for carbon intensive activities we observe that this is not the case, due to the inelastic and anchored preferences of the society towards changing their way of living and routine. Secondly, they prove to be inadequate as climate change is not just a market failure but the biggest market failure we have ever seen, according to leading climate economist Nicholas Stern.

For the ECB and the European Union to be successful in their objective towards fighting climate change they need to start thinking of ways to act proactively and for their policies to be based on commitments. In the rest of the article, it is explained how the role of the ECB in fighting climate change is both advisory and practical.

Advisory role of the ECB

The ECB can develop stress tests to integrate climate risks into the already existing credit risk assessments. An accurate assessment of credit risk is essential to all creditors as in case of underestimation they bear financial losses.

The ECB is indeed developing a framework for climate risk assessment but should include several factors that affect the whole continent. The Dutch stress-test was only assessing transition risks while physical risks institute a danger to the assets of banks as well. Another factor that they could potentially include is increasing prices in agricultural goods deriving from floods and other catastrophes or even the transition risks for households. After the completion of the stress tests the ECB can use its supervisory role to integrate climate risks into credit risk assessments.

Practical role of the ECB

The ECB can implement the following policies to fight climate change.

Firstly, in coordination with the rest of the Central Bank ecosystem, the ECB can expand the Assets Purchase Programme (APP) on the market for green bonds. A green bond is broadly defined as an investment that has an environmental impact. The graph included below demonstrates the increasing trend of green bond issuance in Europe from 2012 to July 2021.

Source: https://0-www-statista-com.lib.unibocconi.it/statistics/1109092/value-of-green-bonds-listed-on-euronext-stock-exchage-by-venue-europe/.

Secondly, the ECB could follow the example of the Bank of Lebanon (BDL), which has promoted a scheme to finance the transition to a low-carbon economy. In case a bank grants an environmentally friendly loan, the BDL supports its efforts by mitigating the level of required bank reserves by 100-150% of the loan. In such a case, the bank would include the loan in its reserve requirements, increasing its portfolio by the amount of money that it “unlocked”.

A similar solution involves the ECB implementing different capital requirements in the European banking system, that would mean having diverse capital adequacy ratios depending on the investments that exist in a bank’s portfolio. Under this framework, banks that lend to low-carbon sectors would have to follow looser requirements. Moreover, the ECB could induce soft pressure to many parties using its announcements and speeches as well as international banking forums.

Lastly, the ECB could apply climate related considerations in its framework for collateral acceptance. The current framework clearly favors carbon-intensive industries, creating problems with the mandates of the ECB in the medium and long-term.

Conclusion

To conclude, there is contradiction in the actions of the ECB. On one hand, it wants to drive the transition to a low-carbon economy while protecting itself from the costs that will arise if it succeeds in doing so. As the governor of the Bank of England put it, the “paradox is that success is failure” in the sense that rapid measures in order to fight climate change and mitigate its consequences might lead to significant losses and instability in the banking system. There is a trade-off between the costs that arise from the transition to a low carbon economy and the benefits that arise from the mitigation of catastrophic events.

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