Courtesy of Juliana B. Bolzani
Although some skepticism remains about the causes and effects of climate change, scientists have concluded that human activity is significantly accelerating global warming. In response to this emergency scenario, important voices in the private and public sectors have stressed the need for action, standing in contrast with the US government’s notification of withdrawal from the 2015 Paris Agreement. For example, BlackRock, the world’s largest asset management company, announced remarkable environmental-friendly intentions in its latest letter to chief executives. Christine Lagarde, the European Central Bank’s (ECB) new president, has also made clear that climate change is a crucial theme in the ECB’s ongoing review of monetary policy strategy. According to Ms. Lagarde, climate change should be a “mission-critical” priority for the central bank.
Central banks’ primary legal mandates are limited to achieving price stability, and, in dual-mandate jurisdictions, as is the United States, maximum employment. Other duties assigned to central banks relate to safeguarding financial stability, by regulating and supervising banking institutions and other participants of the financial system. Starting in the 1990s, many central banks became statutorily independent from the government so that they could pursue the long-term goal of price stability without being influenced by short-term pressures or political considerations.
Assuming that independence is a desired feature of central banks, how can they contribute to fighting climate change without going beyond their mandates or getting too cozy with the executive branch? What can central banks legally do to aid governments in complying with the 2015 Paris Agreement, which requires all signatory countries to make “finance flows consistent with a pathway towards low greenhouse gas emissions and climate-resilient development?”
Climate change and monetary policy
When formulating monetary policy, central banks will have to consider factors related to climate change in order to set the base interest rate necessary to achieve their legal objectives. As Federal Reserve (Fed) Governor Lael Brainard has pointed out, the effects of climate change in the US economy will influence the numbers the Federal Open Market Committee (FOMC) takes into account when adjusting the interest rate to enable steady economic growth.
Variables to be pondered include the intensification of natural disasters, such as hurricanes and droughts, and the transition to cleaner energy sources and infrastructure models, with an increasing replacement of fossil fuel energy with other sources of energy, such as solar and wind power. These events may cause supply and demand shocks, which, if persistent, will affect central banks’ estimates of inflation, employment, productivity, and output.
More controversial is the suggestion that central banks incorporate “greener” practices into the monetary-policy framework, favoring “green bonds” in their market interventions, like open-market operations and asset-purchase programs. The concerns are twofold. First, in most jurisdictions, such as the United States and Brazil, central banks are statutorily prohibited from dealing with corporate bonds and other private assets. They can only buy and sell government securities to attain their monetary-policy goals.
Second, even in jurisdictions where the central bank is allowed to transact in private assets, likethe Eurozone and Japan, environmental concerns might not represent legitimate criteria for asset selection. When deciding on which assets to acquire, central banks tend to follow the principle of “market neutrality” in order to minimize the impact of their purchases on the relative prices of financial assets This principle may prevent central banks from revealing a preference for purchasing green bonds or even from excluding from its purchases assets issued by fossil fuel companies. By implementing a “Green QE,” therefore, the central bank could be accused of acting beyond its legal mandate, since it would end up meddling in fiscal policy by unilaterally picking winners and losers in the economy.
Another contentious proposal advocates that central banks should be ready to finance a so-called “Green New Deal.” Those in favor of this idea concede that climate policy is better addressed through fiscal programs and support government issuance of bonds to finance the costs of transitioning to a greener economy and adapting to a warmer planet. But they also claim that central banks should act as back-stop buyers for these bonds, purchasing them if the market does not.
Here, the legal obstacles would be even higher than those encountered by implementing a “greener” monetary policy. As most jurisdictions ban monetary financing, central banks cannot acquire government securities directly from the treasury, but only in the secondary market, from holders of these securities (notably commercial banks).
More than that, unless central banks demonstrate that they are pursuing monetary-policy purposes, any initiative dedicated to advancing the purchase of green bonds will be legally frail. The Court of Justice of the European Union (CJEU), for instance, when examining the compatibility of the ECB’s Outright Monetary Transactions (OMT) program with European law, made clear that the central bank may not adopt a program that is “outside the area assigned to monetary policy by primary law.”
Under this perspective, it is understandable that the chairman of the Fed’s Board of Governors, Jerome Powell, seems hesitant about the Fed’s engagement with climate-change-related policies, especially regarding monetary-policy implementation. Mr. Powell recently declared, when questioned by members of Congress, that climate change is an “important issue,” but not central to the Fed’s mission. The Board of Governors’ timid engagement with the theme is, furthermore, consistent with the Fed’s absence from the Network of Central Banks and Supervisors for Greening the Financial System (NGFS), an international coalition of 54 central banks and financial regulators established to debate these institutions’ role in the global response to climate change.
Climate change and financial stability
When it comes to the soundness of the financial system, central banks will have to acknowledge that climate change represents a real risk to the stability of financial institutions. Natural disasters, sea-level rise, and ocean acidification, for instance, may cause unprecedented degrees of losses to businesses and individuals, followed by massive defaults of loans, possibly concentrated in some geographic areas and financial institutions. The insurance industry, moreover, may be called to pay benefits in excess to its provisions, and end up depending on heavy subsidies from the government, as already happens in the United States with flood insurance. Contagion might then spread to other parts of the financial system, given the interconnectedness that exists among financial institutions, as made clear by the 2008 financial crisis.
With this in mind, the Bank of England is planning to stress-test the UK banks and insurers for preparedness against hazards caused by climate change and has recently proposed a framework of assessment to address the unique characteristics of environmental risks. This exploratory endeavor will focus on the financial risks posed by climate change and the scale of adjustment that will be needed to build resilience, rather than on evaluating capital adequacy and setting capital requirements.
In the US Congress, Senator Brian Schatz (D-HI) has introduced a bill creating a committee of economists and scientists dedicated to identifying risks to the financial system resulting from climate change and establishing criteria to stress-test financial institutions in light of this kind of risk. The bill is co-sponsored by Democratic presidential candidates Elizabeth Warren and Amy Klobuchar.
While performing the role of financial supervision, central banks can also be statutorily required to aid the government in enforcing environmental policies within the financial system. One example comes from Brazil, where farmers are required to prove that their property is registered in a national environmental database of rural areas, as a condition to obtain loans from financial institutions. The Central Bank of Brazil is the government authority in charge of monitoring whether banks and credit unions are verifying this condition before granting the loans.
In prudential regulation, central banks can be more proactive by, for example, considering elements related to climate change when defining the risk weight of banks’ assets – the “browner” the borrower, the riskier would be the corresponding loan. A rule like this would be consistent with the central bank’s role in safeguarding the stability of the financial system, providing a better measure of financial institutions’ risk exposures. This kind of parameter could also create positive incentives to lend to the green industry, as banks would need to allocate less capital in this case, relative to loans to the “brown” industry.
A “green” tweak in capital requirements would nevertheless demand objective criteria to assess how green a particular borrower is. Investors, asset managers, and banks have expressed concern with a lack of standards to determine how companies get a “green badge.” Efforts in this direction have been made by the NGFS and by the Task Force on Climate-related Financial Disclosures (TCFD), created inside the Financial Stability Board (FSB). The largest accounting firms in the world have also contributed to develop standards regarding the characteristics of green investments, hoping that companies’ disclosures follow a common framework.
Central banks may well be like Swiss-army knives, able to use multiple instruments to engage more fully in the response to climate change, inequality, and other social challenges. Yet it sounds impractical, if not undemocratic, to require central banks to use their ample powers for purposes other than those defined in law.
Confronting the climate-change emergency is not only a legal obligation for the countries that are parties to the Paris Agreement, but a moral obligation for governments and private parties all over the world. Central banks can play a role in fighting this battle, as supporters of the environmental policies embraced by elected governments. If, however, central banks go beyond their legal mandates under the pretext of defending a noble cause, they will hang a cloud over the legitimacy of their actions, and weaken the argument for central-bank independence.
Juliana B. Bolzani is a lawyer at the Central Bank of Brazil and an SJD student at Duke Law School. The views and opinions expressed here are hers and do not reflect the position or policy of any of the institutions with which she is affiliated. For comments, please contact firstname.lastname@example.org.
The Department of Finance Services (DFS) of the State of New York is currently the only member of the NGFS from the United States.