Drastic efforts are needed to reduce carbon emissions and meet the climate goals of the Paris agreement. While governments are the driving force behind the transition to carbon-neutral economies, central banks have an important role to play in identifying and reducing climate-related risks.
These risks are often not accurately priced in financial markets. This is mainly due to inadequate carbon pricing and incomplete information about climate-related exposures. As a result, financial markets do not fully internalise expected costs of climate change and climate-related policies in asset prices. This market failure leads to inefficient allocation of resources and carbon bias in capital markets.
The most direct way to address this is for governments to introduce better carbon pricing measures. This will force markets to internalise climate-related externalities and make sustainable investments more attractive compared to carbon-intensive alternatives.
Global accounting standards for climate risks are needed to foster better transparency and address information gaps in markets. Central banks can contribute to this in two ways.
First, they can disclose the climate-related risks of their balance sheets. This sets an example and could encourage the disclosure of such risks by other financial market participants.
Second, central banks may consider making climate disclosures a requirement in their monetary operations (both in refinancing operations and purchase programmes). This transparency would help central banks improve their assessment of climate risks.
Central banks should also consider addressing carbon bias in their monetary operations, which comes from carbon bias in financial markets. For example, the European Central Bank applies the concept of market neutrality in its purchase programmes. However, market neutrality in the form of a market capitalisation weighted benchmark – as used in the ECB’s corporate sector purchase programmes – may not be appropriate. Market failures that distort relative prices may be a reason to use other concepts of market neutrality that better reflect climate-related risks and externalities.
What is appropriate may differ for each central bank, dependent on its mandate and the type of monetary operations. The ECB has to consider how to take into account climate-related risks in monetary policy, because climate change can directly and indirectly affect price stability.
The ECB also has to support general economic policies in the European Union, one of which is ‘a high level of protection and improvement of the quality of the environment’. In its strategy review, the ECB is exploring how, within the boundaries of its mandate, it can consider climate-related risks in the conduct of its monetary policy.
So, although governments are the primary actors in climate-related policies, central banks have an important role to play in fostering transparency and in the way they shape their monetary policy and operations.
Olaf Sleijpen is an Executive Board Member of De Nederlandsche Bank.
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