Notwithstanding such considerations, the global dimension of capital markets arguably presents an opportunity for central banks and financial regulators to make a difference where others might not be able to. National climate policies operate on territorial emissions defined by national geographical boundaries, and do not necessarily factor in the carbon emissions associated with a country’s domestic financial institutions holding high-emitting assets located abroad. GHG emissions mitigation policies in some developed economies have excluded the financing and insuring of fossil fuel assets abroad, even though the latter contribute to climate change and may be a large source of national income. In the EU, for example, emissions cuts in the real economy are not matched by efforts on the part of EU companies and financial institutions to reduce the emissions profiles of their global investment portfolios. More prosperous economies are, in effect, ‘outsourcing’ high-emitting activities to other jurisdictions in order to keep profiting financially from such activities without recording a corresponding increase in territorial emissions.
One way to start addressing this problem would be for central banks and financial regulators worldwide to adopt the TCFD’s recommendations on climate-related financial reporting to improve investors’ ability to assess and price climate-related risk and opportunities, and to increase transparency across jurisdictions. This would be consistent with most central banks’ primary mandates, which (with some variation between jurisdictions) are typically to preserve monetary and financial stability. It would also be consistent with the mandates of financial regulators where they are not embedded in central banks.
However, such a move would not automatically compel capital reallocation or break the ‘path dependency’ of investments in fossil fuels and energy-intensive assets. If reporting is not accompanied by the mandatory incorporation of climate risk criteria into financial institutions’ risk assessment processes, it is unrealistic to expect a large-scale reallocation of capital from high- to low-carbon assets. In current industry practice, assessment of investment risk usually considers climate risks as exogenous to the financial system. This needs to change, given that the finance sector is critical to determining the speed and scale of the net zero transition.
Institutional mandates and climate change
Further research is needed to determine how central banks and financial regulators can best promote investment in the net zero transition. Nevertheless, there is already a growing consensus that climate change should be considered an intrinsic factor in such authorities’ decision-making. Many central banks recognize that climate change and the transition to a net zero economy have substantial implications for macroeconomic indicators such as inflation and employment. The climate crisis also has material implications for financial markets (vital for monetary transmission), the stability of financial institutions (which central banks or financial regulators often supervise), and the integrity of the financial system (relevant to macroprudential mandates).
However, there is substantially less agreement on how far the existing mandates of central banks and financial regulators allow for proactive measures to tackle climate change – or what the appropriate measures should be. For example, a central bank with an embedded financial regulator could conceivably adopt any or all of the following measures: incorporating climate risk criteria into prudential regulation; adjusting capital requirements in accordance with the emissions profiles of investment portfolios (e.g. requiring financial institutions to set aside more capital for high-carbon assets); directly purchasing climate-friendly assets through quantitative easing (QE) programmes; adding climate criteria to the collateral frameworks used in lending; and providing additional liquidity for climate-friendly activities.
A complication is that the use of these measures potentially raises concerns over central banks’ ability to maintain their market neutrality and independence. There is also the question of where climate-specific mandates or ‘sub-mandates’ would rank in relation to traditional mandates such as those related to price stability.
The NGFS has created a series of workstreams, led by specific central banks and financial supervisory agencies, to try to address these questions. Its 2020–22 programme of research included a workstream on ‘microprudential regulation and supervision’ and a ‘macrofinancial’ workstream. Through these, the NGFS aimed to develop climate scenarios for central banks and supervisors, integrate climate risk analysis into macroeconomic and financial stability surveillance, and estimate climate-related risks and their macrofinancial impact. An additional workstream, on ‘scaling up green finance’, focused on promoting the adoption of climate-related financial disclosures by central banks. Finally, a workstream on ‘bridging data gaps’ identified a list of data still needed; determined the availability and sources of such data, and any access limitations; and produced a public list of missing data items along with a call for help from external stakeholders to fill in the gaps.
The workstreams announced for 2022–24 cover the following topics: (i) supervision, (ii) scenario design and analysis, (iii) monetary policy and
(iv) net zero for central banks.
The need for common definitions of net zero-consistent assets and their characteristics
To facilitate international flows of private finance from high-carbon into low-carbon assets, one of the most important steps will be to develop a consistent global framework of climate investment standards, definitions and reporting requirements. This is needed to provide clarity on which financial products can be treated as net zero-consistent, and on the technical characteristics of such instruments, so that banks, insurers, pension funds, asset managers and other institutional investors can adjust their portfolios accordingly.
Central banks and financial regulators can help to lead this process. Through the NGFS as well as non-climate-specific economic forums, central banks and financial regulators should cooperate on establishing high-level principles on the net zero transition. These principles could then inform the design of consistent taxonomies of climate investments, with definitions harmonized across jurisdictions to create a consistent and comparable framework.
Contrary to some perceptions, EMDEs rather than advanced economies are currently leading the way in establishing climate investment principles. The central banks of China, Malaysia and Mongolia were among the first to create regulations or guidance on low-carbon investment. The South African Reserve Bank has a draft version of a green taxonomy under consultation. The ASEAN Taxonomy Board and the central banks of Bangladesh, Chile, Colombia, the Dominican Republic, India and Kazakhstan all have taxonomies under development. Discussions on a possible climate investment taxonomy are also under way at the Banco de México.
EMDEs rather than advanced economies are currently leading the way in establishing climate investment principles. The central banks of China, Malaysia and Mongolia were among the first to create regulations or guidance on low-carbon investment.
These developments underline the interest central banks have in clarifying the opportunities for green or net zero-aligned investment. A key challenge, however, is that most current regulations focus on generating disclosures in relation to the corporate assets held by financial institutions. Disclosure should serve not only to produce data but also to feed into investor decision-making. At the same time, systems of prudential disclosure on climate-related risks – meaning the risks to financial institutions themselves – are only in place in the EU, the UK and a few countries in Asia. Expanding prudential regulation to a more extensive geographical area is an important agenda item for future consideration
in the NGFS and other global forums.
Data quality considerations
Central banks and financial regulators can play a key role in improving information gathering. They can work collectively to systematize climate data production in the financial system, and to ensure the accumulation of high-quality, granular, reliable and comparable climate-related data. The NGFS’s creation of a climate scenario repository for the financial system, and its efforts to identify data gaps through a dedicated workstream, are examples of early progress in this area.
Central banks and financial regulators can also promote cooperation between financial institutions and other stakeholders to improve data quality and actionability. This could involve integrating climate-related risks into prudential supervision. The Financial Stability Board (FSB) has been working to identify the relevant metrics – based on the materiality of climate risks and their cross-border and cross-sectoral relevance – for inclusion in its global surveillance framework. There is an opportunity here for global coordination that could involve central banks and financial regulators building a climate information architecture that aligns with FSB surveillance.
Are mandatory transition plans the way forward?
The FSB has also identified mandatory disclosure of financial institutions’ net zero transition plans as an area for future work. Transition plans would measure reporting institutions’ progress towards net zero alignment, and the impact of different climate scenarios on their investment strategies. A UK government proposal, released in late 2021 when the country became the first to announce it would make the publication of transition plans mandatory, illustrates the sort of details that might be included: (i) high-level targets for mitigating climate risk, including a net zero commitment; (ii) interim milestones; and (iii) actionable steps which the reporting organization plans to take towards meeting its targets.
Transition plans should also provide transparency on the economic and climate change assumptions behind long-term targets, and on the scenarios and tools used to generate financial and climate-related estimates. The UK’s system – which was due to come into effect in 2023 but has been delayed – will initially apply to the entire portfolios of asset managers, regulated asset owners and publicly listed companies. However, some commitments under the UK scheme cover only parts of financial institutions’ portfolios.
By making the publication of net zero transition plans mandatory for financial institutions, especially if such an approach is globally coordinated, central banks and financial regulators have an opportunity to establish a ‘gold standard’ for climate disclosures. They could set specific requirements on the scope and timing of reporting, and also oblige reporting entities to identify transition risks and declare roll-out schedules of relevant measures. (The latter would specify how financial institutions plan to rebalance their portfolios according to the principles laid out in the investment taxonomies.)
‘Active’ measures: prudential regulation and monetary policy
While enhancing information disclosures and coordinating data regimes globally can be considered ‘passive’ measures for promoting decarbonization, central banks and financial regulators can make more active interventions in markets to accelerate the net zero transition. The two main areas for potential action are in prudential regulation and monetary policy.
Prudential regulation: adjusting capital requirements in line with climate factors
In theory, central banks and financial regulators might usefully promote net zero alignment by establishing disincentives and incentives around different types of investment depending on each financial product’s climate impact. A so-called ‘brown’ penalizing factor, in the policy jargon, would increase minimum capital requirements for loans to projects directly exposed to GHG emissions or associated with systemic climate risks. The increased capital requirements would, in effect, categorize such loans as having a higher risk weighting, making it costlier to finance the investments in question.
In contrast, a ‘green’ supporting factor would lower capital requirements and reduce the risk weighting of loans or investments for low-carbon projects. However, the viability of such an approach remains uncertain. The lowering of capital requirements for low-carbon investments could have the unintended consequence of undermining financial stability if the risks of such investments are not properly accounted for. Moreover, although exposure to high-emitting assets can increase financial risk (as portfolios would be more susceptible to changes in valuations associated with physical climate impacts and transition risks), it is unclear whether increased portfolio exposure to ‘greener’ investments would necessarily reduce non-climate-related financial risks sufficiently to justify lower capital requirements. An easing of capital requirements for low-carbon assets could also unintentionally increase exposure to other risks. This underlines the importance of having a climate investment taxonomy that systematically separates ‘green’ from ‘brown’ assets, and of fully integrating climate risk considerations in the broader risk framework.
Monetary policy: collateral frameworks and investor ‘haircuts’
Another policy option could be for central banks to adjust their collateral requirements in line with the GHG emissions profiles of different investments. This mechanism would essentially involve lowering the market value of an asset used as collateral for a loan (i.e. increasing the ‘haircut’ taken by the borrower) if the emissions or climate risks associated with that asset exceed a certain threshold. The same approach could theoretically be applied in the opposite direction: reducing the haircut associated with greener assets. Central banks could arguably even go further and determine the underlying eligibility of assets for use as collateral according to each instrument’s emissions profile: assets associated with higher emissions would be ineligible, while greener assets would be eligible for inclusion as collateral.
There is the potential for synergies between climate-aligned collateral requirements and carbon taxes. Modelling indicates that a carbon tax would be lower if complemented by a parallel collateral framework than would be the case without such a framework.
Increasing collateral requirements according to climate-related criteria would protect central banks’ balance sheets from climate risks. And it should be straightforward, according to the academic literature, to integrate this aspect of a new approach into existing collateral frameworks. There is also the potential for synergies between climate-aligned collateral requirements and carbon taxes. Modelling indicates that a carbon tax would be lower if complemented by a parallel collateral framework than would be the case without such a framework. On the other hand, reducing the haircut associated with greener assets could conflict with the market neutrality principle mentioned above, and is not currently considered broadly implementable.
Monetary policy: asset purchase programmes and central bank
reserve management
One of the most ‘active’ climate finance interventions is to move markets directly. Central banks have the potential to do this through their monetary policy operations, as well as through management of their investment portfolios and reserves. By buying low-carbon assets and selling high-carbon ones, central banks can align their own holdings with net zero-compatible criteria. At the same time, such portfolio changes would send market signals that private investors are likely to emulate – thus creating a multiplier effect in stimulating capital flows to the low-carbon economy.
The debate in this area initially developed around the use of so-called ‘green’ quantitative easing (QE) by central banks in the aftermath of the 2008–09 global financial crisis. It advanced between 2018 and 2020, with policymakers even ultimately considering the use of green QE in response to the COVID-19-related economic crisis. Green QE means prioritizing the purchase of ‘green bonds’ (a type of debt security incorporating a commitment to finance climate-related activities) or other bonds associated with climate-friendly sectors and assets.
However, current global economic conditions potentially render QE less relevant for the time being. QE was developed to tackle deflationary conditions, but many countries are now experiencing high inflation due to global supply-chain problems and the economic impact of Russia’s war in Ukraine, which has raised commodity prices. Central banks are tightening monetary policy in response, so they are not expected to engage in much QE of any kind – green or otherwise. Indeed, a kind of reverse process could start happening as QE asset purchases are unwound, resulting in what is sometimes referred to as ‘quantitative tightening’ (QT).
QT may still fulfil a useful role for the net zero transition, however. While central banks may not be buying as many green bonds as before, the very act of prioritizing which bonds to sell and which to keep in their portfolios is crucial in a period of economic turbulence. By choosing to sell assets associated with high emissions first, central banks could signal their net zero intentions to markets. This could produce a wider international realignment of private institutional holdings around environmentally sustainable financial products.
Central banks could also use management of their foreign exchange reserves to impact international financial flows. Traditionally, such management has sought to balance three objectives: liquidity, safety and returns. However, some analysts and observers have recently proposed adding a fourth objective: climate sustainability. This would oblige central banks to consider climate sustainability as a fundamental investment objective of foreign exchange reserve management. It would almost certainly result in their reserves containing more net zero-consistent assets. For such an idea to make progress, however, the global ‘green bond’ market needs to increase issuance and establish internationally consistent criteria to protect against ‘greenwashing’. Increasing the weighting of climate indicators in the ESG criteria associated with bonds in general – not just green ones – would also be essential.
Reserve managers will need to integrate climate risk – alongside existing factors such as credit risk – into their risk assessment processes. New approaches will have to reflect accurate understanding of the exposure of a bond issuer’s financial position to changes in carbon regulations or physical climate risks. In this regard, Fender et al. highlight the example of De Nederlandsche Bank, the central bank of the Netherlands. The study observes that understanding environmental criteria (along with social and governance factors) enhances the knowledge of long-term risks and opportunities.
Implementation issues
As discussed earlier, a key question in implementing all these possible approaches – both passive and active – will be whether they are sufficiently covered by the existing mandates of central banks and financial regulators. This is likely to vary according to the jurisdiction and the action being proposed.
For example, given the strong link between climate risk and financial risk,
a limited degree of mandatory climate risk disclosure is likely to be covered already in most jurisdictions.
But making the development and disclosure of full net zero transition plans mandatory may require the introduction of secondary climate action mandates in some jurisdictions. This could require a big step politically in some countries. It is therefore possible that such a change may be easier to undertake in systems where financial regulators are not embedded in central banks because it would be more readily perceived as part of regulatory action, which is widely accepted as a means to deliver net zero, rather than macroeconomic policy, where the need for change in response to climate change is so far less widely accepted.
