Central Banks Going Green to Questionable Avail

By Michael Collins | More Articles by Michael Collins

Finland’s forests are the subject of a continent-wide debate on how to halve EU carbon emissions by 2030. The clash is over whether the forests should remain untouched, and thus absorb carbon, or be used as biomaterial.

Environmentalists want the woodlands in Europe’s most-forested country to remain pristine carbon ‘sinks’. Most others want to find commercially viable solutions that alleviate warming risks.

 Perhaps the European Central Bank could sort it out? During the dispute over the forests in the euro-member Finland, the ECB declared mitigating climate change was a priority. The central bank said it will embed environmental goals within monetary policy because wild and warmer weather can affect “inflation, output, employment, interest rates, investment and productivity; financial stability; and the transmission of monetary policy”.

Other major central banks are mixing sustainability and monetary goals to different extents. While calling for net-zero-emissions targets, central banks are seeking to use their regulatory powers to enforce climate-risk-based capital standards on banks, conduct climate-change stress tests on financial institutions and force companies to disclose carbon risks.

Many ask whether it’s wise for central banks, which style themselves as above politics, to charge into an issue that governments are struggling to solve. Amid such discussions, two questions arise.

The first is: Will central banks accomplish anything? Advocates say central banks standardising and making mandatory climate disclosures could improve the pricing of climate risks. Central banks highlighting the long-term financial risks of climate change can only help the public swing behind a solution towards net-zero emissions. They say central banks can embolden the stability of the financial system by limiting banking crises caused by a sustained change in weather patterns. Central banks elevating climate risks would make commercial banks more wary of adding to (and they might even reduce) the US$3.8 trillion major banks have committed to the fossil-fuel industry.

Some factors, however, suggest central banks might achieve less than they hope. First, it can be argued that climate change poses little risk to financial stability. Disastrous weather has never in modern times triggered a systemic financial crisis. The industries that lose from the shift to a low-carbon economy are unlikely to imperil the financial system either. It’s excessive debt (often backing the next big thing) that triggers financial instability.

The second (surprising) reason is that banks don’t appear to have been threatened by climate change and they seem capable of judging such risks for themselves. A 2021 Fed Bank of New York study concluded as such while noting its findings “are generally consistent” with other studies on bank stability and disasters even one on the hurricane-prone Caribbean.

Third, a central-bank effort to publicise climate risks is unlikely to be a telling blow to fossil-fuel companies. If commercial banks were to restrict lending to or increase interest-rate charges for fossil-fuel companies, private firms are likely to buy these businesses cheaply, especially in the absence of a price on carbon.

Fourth, central banks have little legal basis on which to act on green lines. And last, there appears to be no link between interest-rate settings and a long-term meteorological event. “When it comes to saving the planet, central banks do not have a magic wand,” says Jens Weidmann, former head of the Bundesbank (2011-2021).

The other overarching question is: What are the risks? The first is that central-bank climate risk management could clash with their mandates to keep inflation tame. The conundrum they confront is the shift to net-zero-emissions stirs ‘greenflation’ – when fossil-fuel prices jump because investment in climate-harming energy has fallen but demand for dirty power hasn’t.

The second hazard is that central banks might be allocating capital, which breaches their principle of ‘market neutrality’. While central banks control the quantity of money, the allocation of money is a political choice for governments. Smudge the role of central banks and politicians and central-bank credibility and independence could be lost.

A theoretical risk is that central banks might encourage a green investment bubble that could metastasise into a systemic threat. A fourth concern is that central banks might be in danger of ‘mission creep’ at the cost of their focus on inflation. What is stopping central banks pursuing other worthy social goals?

Setting aside the debate about what central banks might accomplish, the risks show the use of public regulatory powers is a poor substitute for political solutions, even when none are appearing. The problem arising when government institutions step in because politicians can’t sort out competing rights is that these bodies become politically tainted. It is best that central banks don’t let climate-change priorities get in the way of their traditional tasks, which are hard enough to get right.

To be sure, central banks recognise that governments and parliaments have “primary responsibility” to act on climate change. Central banks certainly have a role in managing the short-term costs of combating climate change. Government policies to mitigate climate change could hurt the economy to the point of creating financial instability. But that’s different from saying changed weather and stranded assets could. Plenty of studies warn that climate change poses “an emerging and increasing threat” to financial stability.

What is more certain is the solutions to achieving net-zero emissions need to come from the political process – where they are being thrashed out for Finland’s forests.

About Michael Collins

Michael Collins is an investment specialist at Magellan. Since 2000, Michael has worked as an investment specialist/commentator for money managers, AMP Capital, IOOF/Perennial, Barclays Global Investors (now BlackRock) and Fidelity International.

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