Climate Change and Central Banks: Case ECB

Climate Leadership Coalition

Climate Change and Central Banks: Case ECB Timo Tyrväinen Chief Economist, Climate Leadership Coalition Banque de France & Global Interdependence Center Paris Louvre 6.5.2022

MY BACKGROUND: Bank of Finland – almost 25 years (with sidesteps OECD, LSE, Banco de España) Aktia Bank, Finland – Chief Economist – almost 20 years Climate Leadership Coalition – Chief Economist - 5 years

CLC: Organisational members

• 89 organisational and 54 personal members – companies, cities, associations, trade unions, universities and think tanks – largest climate business network in EU

International network

MY FOUR HIGHLIGHTS: According to the ECB, ”Climate change and the transition towards a more sustainable economy affect - the outlook for price stability through their impact on macroeconomic indicators such as inflation, output, employment, interest rates, investment and productivity; - the outlook for financial stability; - the transmission mechanism of monetary policy in a way which may weaken it’s efficiency.

- the value and the risk profile of the assets held on the Eurosystem’s balance sheet, potentially leading to an undesirable accumulation of climate-related financial risks into ECB’s balance sheet.”

THE SLOW JOURNEY OF CLIMATE CHANGE INTO CENTRAL BANKING 2008-9 Financial Crises: Mispricing of US Subprime housing loans due to opacity. Ownership of the poisoned assets not known.

2009 Financial Stability Board (FSB) was established, or rather redisigned, to enhance promote international financial stability. FSB´s membership consists of G20 countries with their central Banks as well as all important international organisations (IMF, World Bank, OECD,BIS, EU-Commission etc.).

2011 Carbon Tracker Initiative published a simple calculation. 1) How much CO2 is in the atmosphere? 2) How much more can be emitted before 2o is exceeded? 3) How much CO2 will be emitted, if all known reserves will be burned?

Conclusion: appr 70% of known fossil fuel reserves need to be left unburned.

Anomaly: The market values these reserves in full. So, there is a CARBON BUBBLE in the market pricing.

2015 FSB invited Michael Bloomberg to lead a Task Force for Climate Related Disclosures, TCFD. The task force consisted of 32 members from all continents. No politicians, no climate-scientists. Only business-people. Half from financial sector, the rest from various branches.

2016 TCFD published it´s first report in December 2016. A guide for implementation was released in June 2017. In the summary, TCFD wrote: “The financial crisis of 2007-2008 was an important reminder of the repercussions that weak corporate governance and risk management practices can have on asset values.

One of the most significant, and perhaps most misunderstood, risks that organizations face today relates to climate change…

Accordingly, many organizations incorrectly perceive the implications of climate change to be long term and, therefore, not necessarily relevant to decisions made today.

Because this transition to a lower-carbon economy requires significant and, in some cases, disruptive changes across economic sectors and industries in the near term, financial policymakers are interested in the implications for the global financial system, especially in terms of avoiding severe financial shocks and sudden losses in asset values.”

Note that the latest statement is not by the ECB, but of the global financial authority FSB/TCFD.

ECB AND CLIMATE CHANGE: IT’S ALL ABOUT MANDATE ECB was born in a political process with contradicting positions of it’s founding members. Given this, it is only natural that when the ECB considers Climate Change, it need to consider it’s mandate. Every move must fit the mandate.

The PRIMARY objective of the ECB is to deliver PRICE STABILITY in the euroarea. It may support other objectives of the European Union – given that this does no harm to the primary target.

In early years of the ECB, the secondary target was considerd to cover employment and economic growth.

In the aftermath of financial crises new issues entered the the list of secondary targets: stopping contagion eurocrises from one country to another, safeguarding european banking sector and solving the sovereign debt-crises.

Now, the new isssue is climate change. However, this time is different! According to the ECB, Climate Change is not an issue related to the secondary target. It very much relates to the primary target – as well as the secondary target.

This time really is different.

In line with all said, ECB´s press release July 8th 2021 stated: ”ECB presents action plan to include climate change considerations in its monetary policy strategy”. ”The ECB’s Governing Council is strongly committed:  to further incorporating climate change considerations into its monetary policy framework;  to expanding its analytical capacity in macroeconomic modelling, statistics and monetary policy with regard to climate change;  to including climate change considerations in monetary policy operations in the areas of disclosure, risk assessment, collateral framework and corporate sector asset purchases;  to implementing the action plan in line with progress on the EU policies and initiatives in the field of environmental sustainability disclosure and reporting.” ”Addressing climate change is a global challenge and a policy priority for the European Union. While governments and parliaments have the primary responsibility to act on climate change, within its mandate, the ECB recognises the need to further incorporate climate considerations into its policy framework”.

THE PRIMARY TARGET: PRICE STABILITY This is where the ECB does a splendid work. The analysis can be found in the September 2021 published 190 page ECB Occasional Paper no 271 titled Climate Change and monetary policy in the euro area.

In this paper, the ECB presents a carefully written, reference based, detailed analysis of the channels through which Climate Change influences inflation, productivity, output and employment. Analysis gives special attention to aspects relevant during the transition period, ie. the decades during which fossile industries are fading and clean industries are rising.

During the transition period there are physical risks related to global warming, but also risks related to policy process. Both may have an impact on inflation and it´s volatility on investments, and on output. Employment is a particularly important issue, here. In a disruptive process certain localities will be much more severely hurt than some others. This creates a risk on social cohesion, feeds populism and uproar.

According to ECB, Climate Change has an impact on the natural rate of interest (r*). It also influences the transmission mechanism of monetary policy. The climate change and it’s consequences may weaken the efficiency of monetary policy - particularly during the transition period.

We are now wittnessing a starting point of ECB´s further, ambitous research.

TRANSITION PERIOD: 3 scenarious As far as the impact on inflation, real economy and equity market is concerned, the ECB gives a detailed description of three scenarios. The first is called orderly transition, the second Sudden transition and the third Delayed transition (Figure 2). The first, a gradual, consistently proceeding policy minimizes the cost of adjustment. If the action is delayed, inflation will be higher, output growth weaker, investment risks higher and employment weaker. On aggregate level, impact on equity market may be modest but in certain sectors and locations it may be dramatic. This may cause shocks with contagion effects jeopardizing market stability.

CLIMATE CHANGE CENTRE The ECB has established a climate change centre which coordinates the relevant activities within the ECB, in close cooperation with the Eurosystem. These activities will focus on the following areas: Macroeconomic modelling and assessment of implications for monetary policy transmission. The ECB will accelerate the development of new models and will conduct theoretical and empirical analyses to monitor the implications of climate change and related policies for the economy, the financial system and the transmission of monetary policy through financial markets and the banking system to households and firms.

Statistical data for climate change risk analyses. The ECB will develop new experimental indicators, covering relevant green financial instruments and the carbon footprint of financial institutions, as well as their exposures to climate-related physical risks. This will be followed by step-by-step enhancements of such indicators, starting in 2022, also in line with progress on the EU policies and initiatives in the field of environmental sustainability disclosure and reporting.

Disclosures as a requirement for eligibility as collateral and asset purchases. The ECB will introduce disclosure requirements for private sector assets as a new eligibility criterion or as a basis for a differentiated treatment for collateral and asset purchases. Such requirements will take into account EU policies and initiatives in the field of environmental sustainability disclosure and reporting and will promote more consistent disclosure practices in the market, while maintaining proportionality through adjusted requirements for small and medium-sized enterprises.

Enhancement of risk assessment capabilities. The ECB will start conducting climate stress tests of the Eurosystem balance sheet in 2022 to assess the Eurosystem’s risk exposure to climate change, leveraging on the methodology of the ECB’s economy-wide climate stress test. Furthermore, the ECB will assess whether the credit rating agencies accepted by the Eurosystem Credit Assessment Framework have disclosed the necessary information to understand how they incorporate climate change risks into their credit ratings. In addition, the ECB will consider developing minimum standards for the incorporation of climate change risks into its internal ratings.

Collateral framework. The ECB will consider relevant climate change risks when reviewing the valuation and risk control frameworks for assets mobilised as collateral by counterparties for Eurosystem credit operations. This will ensure that they reflect all relevant risks, including those arising from climate change. In addition, the ECB will continue to monitor structural market developments in sustainability products and stands ready to support innovation in the area of sustainable finance within the scope of its mandate, as exemplified by its decision to accept sustainability-linked bonds as collateral.

Corporate sector asset purchases. The ECB has already started to take relevant climate change risks into account in its due diligence procedures for its corporate sector asset purchases in its monetary policy portfolios. Looking ahead, the ECB will adjust the framework guiding the allocation of corporate bond purchases to incorporate climate change criteria, in line with its mandate. These will include the alignment of issuers with, at a minimum, EU legislation implementing the Paris agreement through climate change-related metrics or commitments of the issuers to such goals. Furthermore, the ECB will start disclosing climate-related information of the corporate sector purchase programme (CSPP) by the first quarter of 2023.

In 2015/7 the TCFD/FSB took a major step within the financial sector. In 2021 the leading role was taken by the ECB. The IFRS is about to continue the process.

I´m convinced that other major banks will follow the ECB. This is what ZEITGEIST is about.

Financing the green transition: Banks vs. equity markets (Background material) ”While climate-related disruption can pose risks to financial stability and the pricing of climate-related risks is currently inadequate, financial markets have a key role to play in financing the transition and helping to reduce the carbon footprint of the economy. There is evidence that the structure of the financial system, including the relative importance of bank and market finance, may influence the effectiveness of efforts to limit environmental pollution. One strand of research is critical about the ability of banks to finance innovative projects, which are an important mechanism for containing environmental pollution. First, banks may be technologically conservative: they may fear that funding new (and possibly “greener”) technologies erodes the value of the collateral that underlies existing loans, which mostly represent old, carbonintensive technologies.Second, banks may also hesitate to finance green technologies if the related innovation involves assets that are intangible, firm-specific and linked to human capital. Such assets are difficult to redeploy elsewhere and therefore hard to collateralise. Third, banks may also simply lack the know-how and human capital to screen and monitor new (green) technologies at the early stages of adoption.Fourth, banks may operate with a shorter time horizon (the loan maturity) than equity investors and hence be less interested in whether funded assets will become less valuable, or even stranded, in the more distant future.

But other research is more optimistic about the role of banks in limiting pollution. There is some evidence that credit-constrained firms reduce emissions if the constraint is relaxed by an increased supply of bank lending.Banks may refuse to lend to a firm if they fear that it may create an environmental liability with financial and reputational repercussions. And there is some evidence that banks are increasingly pricing climate policy exposures in their loan portfolios and reducing their lending to polluting firms.The shift in lending practices appears more marked for those banks that have subscribed to green development objectives, for instance by joining the United Nations Environment Programme Finance Initiative, which aims to mobilise private sector finance for sustainable development. So even if banks may not necessarily be funding the development of green technology, they are increasingly funding its adoption across the economy. In addition, research analysing US interstate banking deregulation has found that more competitive banking markets can be supportive of innovation by young, private firms. To the extent that these results can be generalised, the evidence suggests that more intense competition in banking could also support green innovation.

Compared to banks, equity markets may, on average, be better suited to financing (green) innovations that are characterised by both high risks and high potential returns. Cross-country evidence suggests that high-tech industries dependent on external finance are more likely to file patents in countries with better developed equity markets, but less likely when credit markets are more developed. In particular, equity markets have a comparative advantage in financing technologyled growth, whereas credit markets mainly foster growth in industries that rely on external finance for physical capital accumulation. A majority of the funds that firms raise in public stock issues is invested in R&D. Equity investors may care more about future pollution and therefore be better at pricing long-term risk. On the other hand, a stockmarket listing may lead to short-termism and distorted investment decisions if company managers believe that equity investors do not properly value long-term projects. In that case, stock markets may blunt managers’ incentives to reduce the long-term environmental impact of firms While existing research on banks and stock markets as constraints on industrial pollution is limited and inconclusive, more recent evidence appears to favour equity investors over creditors. Carbon emissions per capita have declined by between 30% and 50% in industrialised economies since the 1970s. Importantly, this decline has been much more pronounced in countries where equity markets are larger, relative to credit intermediation. This effect appears to come through two distinct mechanisms. The first is a faster reallocation of funds away from carbon-intensive sectors and towards green sectors in countries with relatively deeper equity markets. The second is a faster reduction in carbon emissions per unit of output in carbon-intensive sectors in countries with deeper equity markets. In these, the rate of green innovation is also higher, suggesting that equity markets are superior to banks in pushing firms to develop and adopt green technologies. At the same time, as noted above, banks are increasingly lending to green firms, too. This is important for the euro area, since it will need the banking sector to play a key role in implementing the green transition, given the preponderance of banks in the financial system. It also calls for greater urgency in completing the capital markets union to bolster greater use of equity.

Green bonds also provide a financing vehicle to reduce carbon emissions, although there are only a limited number of studies that try to measure the role they have played to date. The question is inherently difficult to assess, and the results are not conclusive. In part, this reflects the continued relatively small size of the market, the lack of clear standards for green bonds and the reporting of the use of proceeds, and the fact that emissions are mostly measured at company level. A recent analysis by the Bank for International Settlements (BIS) finds no strong evidence that green bond issuance is associated with a reduction in carbon emission levels over time at the firm level. Put simply, firms that issue green bonds do not behave significantly differently from firms that do not issue such securities. This result likely arises from the prevailing uncertainty surrounding what qualifies as a green activity, the lack of granular information on activities and the lack of ex post verification and accountability. In other words, what is known as greenwashing appears to remain prevalent.”

Climate Leadership Coalition

Thank you!

Timo Tyrväinen Chief Economist, Climate Leadership Coalition