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Why monetary policy should go green

by Alexander Barkawi

Why monetary policy should go green


Monetary policy is rarely a topic for discussion in debates on green finance. It should be.

The €60bn which the European Central Bank is injecting into financial markets on a monthly basis is a case in point. Its intervention is worth almost three times more than the €23bn monthly average of global clean energy investments in 2016.

A transparent review of how better to align ECB injections with the goal of funding a low-carbon economy, and whether some of its asset purchases in fact undermine that objective, is essential.

Several authorities, including the Bank of England, the European Systemic Risk Board and the Dutch central bank are examining the possible effects of climate change on financial stability and how financial regulation can mitigate these effects.

Similar questions need to be explored with regard to the monetary policy remits of central banks. Monetary operations, whether conventional or unorthodox, have several often unseen consequences. Central bankers are careful to ensure their decisions are sector neutral. Nonetheless, explicit and implicit biases abound. These range from the routine acceptance of high-carbon assets, such as car loans, in refinancing and asset purchase programmes, to the deliberate targeting of monetary measures to key parts of the economy, like real estate.

Last September, G20 leaders highlighted the need to augment green finance and expressed their support for ‘clear strategic policy signals’ to pursue this objective. Monetary policy should not be separated from this goal.
The constitutional foundations of many central banks provide a clear mandate to be part of the solution. The ECB mandate states, ‘Without prejudice to the objective of price stability [the Eurosystem] shall also support the general economic policies in the Union with a view to contributing to the achievement of the objectives of the Union,’ including ‘a high level of protection and improvement of the quality of the environment.’
Three steps will be critical to move in this direction.

Reducing high-carbon biases
First, monetary policy measures may unwittingly support high-carbon assets or discourage clean alternatives. The choice of assets that central banks buy and accept as collateral may not be sector neutral. Identifying such biases and mitigating them where they are misaligned with the objective of a low-carbon economy are effective short-term measures.

A good place to begin may be investigating whether central banks should be buying asset-backed securities based on car loans. It would be important, too, to review whether the eligibility criteria in their collateral frameworks are based on an accurate risk assessment, including a robust analysis of carbon risks. Accounting for default risks due to stranded carbon assets in the external ratings and in-house credit assessments of central banks that underpin their collateral rules is critical in this context.

Green quantitative easing
Second, the current environment of ultra-low interest rates and significant asset purchases by central banks creates an opportunity to channel more capital towards a low-carbon economy. Policy-makers could pursue what commentators have coined ‘green quantitative easing’.

This proposal may not be an option only for those central banks, like the ECB and the Bank of Japan, that are still expanding their balance sheets, but also for others, including the Bank of England and the Federal Reserve, which aim to keep the size of their balance sheets unchanged and are forced to re-invest the proceeds from maturing securities into new ones.

Increasing the share of these flows into green investments would be an important promoter for a low-carbon economy, both through the direct provision of public money and as a catalyst for private investment.

Designing a green QE programme requires a thorough assessment of the underlying market structures in funding low-carbon investments. It will demand a detailed analysis of how much money could be absorbed through low-carbon asset purchases and how such purchases could change the funding situation for green investments. Policy-makers would need, too, to decide how best to measure the success or failure of these initiatives.

Designing such a programme would also require a rigorous evaluation of what sort of institutional framework it requires, how to mitigate the risk of greenwashing (misleading claims about the environmental benefits of funding flows), and what role external rating agencies, research providers and auditors would need to play.

Balance sheets and sustainability
Finally, beyond the scope of targeted asset purchases is the need to manage central bank assets appropriately. Best practice approaches should be followed to integrate environmental, social and governance factors in investment strategies.

Institutional investors with more than $60tn in assets pledged to do this. Many of them are developing in-house capacity to account for ESG criteria in their investment processes. Others use external researchers and a broad offering of specialised indices to reflect ESG criteria in their decisions. Central banks should explore similar commitments for the $18tn on their balance sheets.

Central bankers are increasingly clear that addressing the financial risks of climate change is part of their job. Ensuring monetary policy is pointing in the same direction is the next essential step.

Alexander Barkawi is Founder and Director of the Council on Economic Policies. This is based on an article first published by the Financial Times.