Climate change is the most pressing issue of our time, affecting every sector of our economy and putting them at higher risk of physical harm due to the increased frequency of climate-related disasters and transition risks resulting from policy responses. Recently, a slew of ambitious net-zero commitments, from governments and companies alike, have been announced. Even as we continue to deviate from our targets under the Paris Agreement, our knowledge and policies remain insufficient. What is the present state of discussion about the role of central banks in such circumstances? What can they do to prevent the tragedy on the horizon? This article outlines the discussion about green quantitative easing, an unconventional monetary policy in which central banks contribute directly to decarbonisation efforts through their purchases of longer-term securities.
Central banks and climate change
Central banks typically receive mandates that are relatively well defined by lawmakers. Keeping prices stable is the principal role of most central banks in developed economies, such as the Federal Reserve and the European Central Bank. As global climate change has precipitated a disorderly transition, monetary policymakers have been debating how to handle the reality of global climate change in recent years. This has sparked a debate over transition risk and its implications for macroeconomic and financial stability.
We have reached the stage where central banks are no longer debating whether they should address climate-related risks but rather how they should do so without compromising their independence or diverting attention away from price stability. Some central banks have secondary objectives such as supporting economic policies (e.g., the European Central Bank) or ensuring full employment (e.g., the US Federal Reserve). However, the only one that has explicitly considered climate change is the Bank of England, which has done so since 2021 by supporting the transition to net-zero emissions by 2050. Even if they do not overtly consider climate change or encourage the low-carbon transition, most central banks today recognise the phenomenon of climate change.
Physical climate hazards, such as extreme weather occurrences, are generally considered to be more likely to occur in the medium to long future, according to the common understanding. However, as we have already seen, today's severe weather circumstances may make it more difficult for central banks to achieve their price stability objectives in the future. Transition policies, such as carbon taxes, may also impact short-term inflation fluctuations, resulting in swings in the price of goods and services.
Green quantitative easing
The rising recognition that climate change is a significant source of financial instability has shaped how monetary policy integrates climate risks and how central banks align sustainability considerations into their investment decisions. Since 2017, the Network for Greening the Financial System (NGFS) has encouraged central banks and supervisors to lead by example and integrate sustainability factors in their portfolio management according to their primary mandate. Asset purchase schemes to support green industries, sometimes known as "green quantitative easing," are included in the proposals of the NGFS.
Central banks are not comparable to other capital providers as their investment practices are guided by legal policy mandates, principles of liquidity, safety, return, and the prevention of conflicts of interest to safeguard institutional independence. Therefore, to maintain their market-neutrality, central banks have exercised caution in how they incorporate climate change into their investment decisions. However, market-neutral policies may have an unintended structural bias against carbon-intensive industry incumbents, slowing the transition to a net-zero economy.
Green quantitative easing, like market-neutral asset purchase programmes, appears to have the capacity to stimulate the economy. The downside of this technique is that it may politicise central bank decisions, compromising their independence. Additionally, the limited supply of green assets has resulted in exploring alternative mechanisms such as the requirement of climate-related disclosures in the eligibility criteria for issuers in the asset purchase programmes.
The Bank of England’s transition finance approach
After the United Kingdom decided to leave the European Union in 2016, the Bank of England's Monetary Policy Committee (MPC) outlined a series of actions to boost growth and achieve inflation objectives. The Corporate Bond Purchase Scheme (CBPS) was a critical initiative to purchase up to £10 billion in sterling-denominated corporate bonds over an 18-month period. The MPC recently incorporated climate factors into the CBPS in November 2021 to incentivise enterprises to undertake a net-zero transition without jeopardising the fundamental monetary policy objective. As a result, corporations will now be required to meet climate-related eligibility requirements for the CBPS to acquire their bonds, with purchases "tilted" toward eligible issuers that are the best climate performers in their sectors.
The CBPS has been hailed as a watershed moment for reversing corporate bond purchases' historical carbon bias and contributing to an increase in the cost of capital for carbon-intensive sectors by diverting financial flows to transitional and green activities. Rather than focusing exclusively on green assets such as green bonds, the Bank of England has chosen a transition finance approach that recognises the critical role of capital in advancing realistic and ambitious decarbonisation policies in carbon-intensive industries.
The CBPS framework is made of four mechanisms aimed at (1) achieving decarbonisation objectives, (2) establishing eligibility requirements for enterprises, (3) shifting purchasing toward higher-performing climate actors, and (4) escalating the intensity of activities in response to an annual assessment of the CBPS. The first tool assumes a net-zero emissions objective for the CBPS portfolio by 2050. The second tool establishes that businesses are eligible if they meet climate governance requirements associated with public climate disclosure following the UK Government requirements beginning in 2022 and public emissions reduction targets for higher-emitting sectors (energy and utilities). Coal mining is specifically excluded. The asset acquisitions are based on a scorecard that considers the most current emissions intensity level, historical reductions in absolute emissions, climate disclosure, and third-party verification of an emissions reduction objective. Finally, the calibration of the CBPS will consider advances in metric coverage and robustness.
How can we evaluate the CBPS's effects? We may need to examine whether the issuance of bonds by higher-performing climate issuers increases following the November 2021 announcement of the CBPS. Additionally, it is feasible to evaluate the sterling corporate bond market's liquidity improvement. Although the magnitude of each of these benefits is unknown, the available evidence suggests that the CBPS has benefited the sterling corporate bond market and decreased borrowing costs for issuers. Addressing such issues will enable us to evaluate the CBPS's transmission to the real economy and the transition to a net-zero economy.
Related Contents:
