ON A SPRING day in 2021 some visitors to the ECB made an unusual entrance. Just before its governing council was due to meet, two paragliders landed on one of its buildings in Frankfurt, unfurling a banner reading: “Stop funding climate killers!” Another banner urged the bank to “Act on climate now!” Implicit in the stunt, timed to mark the release of a Greenpeace report on the bank’s bond-buying, was praise. Politicians might dither but central banks have the power to get things done.

Most central bankers wish to do their bit for the green cause. Christine Lagarde called embedding climate into the ECB’s framework “mission critical”. Andrew Bailey of the Bank of England talked of “tackling climate for real”. Over 100 central banks and financial regulators have joined the “Network for Greening the Financial System”. The Fed is cautious, given the political backdrop in America, its mandate and its tools. But other central banks are considering how to favour green firms over polluters. Even the Fed is working out how climate change may affect the soundness of the banks, the overall financial system and inflation.

The impact on lenders and the financial system may come from two sources: physical damage to property or businesses, which could mean losses for insurers and banks; and transition risks as climate policy pulls capital away from dirty sectors towards cleaner ones, creating “stranded” assets. Mark Carney, a former governor of the Bank of England, talks of a potential “Minsky moment”: an abrupt reassessment that leads to a collapse in asset prices. To help understand how bad things could get, at least 30 regulators worldwide are conducting stress tests of the impact of a range of transition paths towards net-zero emissions.

Physical risks already mean losses for insurers and lenders in places like northern Australia. More will be affected. In a stress test in 2020, the Banque de France concluded that insurers in some regions, such as the Mediterranean, would face heavy losses by 2050. But the conclusion of most stress tests is that the impact of climate risk is likely to be moderate. Last year staff at the Reserve Bank of Australia reckoned that 1.5% of houses in the country would lose a tenth of their value by 2050 because of climate risk. (By comparison, the median sale price fell by around 20% during the financial crisis in America.) And research by the New York Fed finds that banks usually make new loans as local economies recover from natural disasters, offsetting initial losses.

What about transition risks? The Australian researchers look at lenders’ exposure to dirty industries, such as energy and agriculture. These are deemed “manageable”: they make up about a fifth of banks’ business loans, but most have a duration of less than five years, allowing banks to adapt lending practices to avoid being stuck with stranded assets. In its stress test last year the ECB found that big banks would make 8% more credit losses in 30 years’ time in an extreme case, compared with an orderly transition to net zero. That seems modest, the more so since data limitations mean that it assumes banks do not adjust their loan books over time.

Even in a worst case modelled by the Dutch central bank, where climate policy becomes stricter overnight, and GDP falls by 7%, lenders make losses equivalent to about four percentage points of core capital ratios. Stress tests by the European Banking Authority find banks sufficiently well-capitalised to survive. Insurers’ solvency ratios could decline by up to 16 percentage points in the worst case, but that is “relatively small”, said the Dutch, considering that they are currently way above the regulatory minimum.

Money to net zero

Climate change may also impinge on monetary-policy decisions. The prices of petrol and air travel will rise. Economists see such changes as reflecting shifts in relative prices within a basket of goods, rather than a sustained rise in inflation that requires monetary-policy action. But in a situation where shocks feed through only slowly, say as a carbon price is raised, inflation expectations may change, forcing central banks to move. Climate change could affect the policy room that central banks have. The surge of investment needed to reach net zero could reduce the imbalance between global saving and investment, giving central banks more scope to raise interest rates. A badly managed transition could also lead to more uncertainty and higher saving.

Put all this together and climate risks seem more “mission vigilant” than “mission critical”: worth studying and keeping on banks’ radar screens, but not requiring drastic action today. To that end, the ECB is urging lenders to improve disclosure to supervisors, and demanding more information from them.

Should central banks penalise polluters and subsidise green firms? The Fed’s answer is no. It is caught in a political row over climate change. Last autumn some Democrats argued against the reappointment of Jerome Powell as chairman for failing to recognise climate change as an “urgent and systemic” risk (he was still reappointed). Senate Republicans objected to Joe Biden’s nomination of Sarah Bloom Raskin as a board candidate partly because she had called for bail-outs in the pandemic to exclude polluting firms. “That’s not a decision to be made by unelected vice-governors who never faced the voters…the Fed has already been wandering outside of its lane,” declared Pat Toomey, a Senate Republican. Ms Bloom Raskin has since withdrawn from the nomination.

Even if it wanted to act, the Fed would be limited by its mandate, which requires it to focus on price stability and employment. It does not have the tools to target clean firms over dirty ones. It is banned from buying private-sector assets except in “unusual and exigent circumstances”, and with permission from the Treasury secretary. And it can hardly do much with interest rates that affect wind farms and coalmines alike.

By contrast, central banks in Asia have been more active. They have often played a role in developing markets and guiding credit before. The PBoC launched its own green lending operation in November and has developed the market for green bonds and pressed forward an environmental labelling scheme. In December Japan extended more than ¥2trn ($18bn) in interest-free loans for climate-linked loans. And the Reserve Bank of India has added green projects to its quota for “priority lending”, which banks must hit when they make loans.

It is in the European Union that the dilemma of greener monetary policy is most acute. The ECB’s mandates offer more leeway than the Fed’s. Both the Bank of England and the ECB are tasked first with price stability and only then with supporting the government’s wider economic strategy. In the EU, that includes everything from protecting the environment to promoting scientific advances, combating social exclusion and ensuring gender equality. Last March the Bank of England’s remit was amended to state that government policy now included a transition to net zero.

Both banks have tools that can be tweaked for green ends. The Bank of England and the ECB have bought corporate bonds as part of their QE schemes. The ECB’s collateral framework classifies 25,000 securities against which it is willing to lend through refinancing operations. The terms of both programmes could be used to make climate disclosures a condition of eligibility, exclude fossil-fuel companies, or value polluters at a discount. A plan to study such tweaks featured in the ECB’s strategy last summer. “Climate change is a key issue that should be considered. It has an impact on the transmission of monetary policy, economic indicators and financial stability,” says Ms Lagarde.

Central banks follow the principle of “market neutrality” when buying assets: they buy in line with issuance in the market, so as not to distort the relative prices of bonds. But because dirty firms are more capital-intensive, they are more likely to issue bonds. Yannis Dafermos and co-authors from the New Economics Foundation, a think-tank, find that more than half the ECB’s holdings of corporate bonds are concentrated in the dirty manufacturing and electricity industries, even though they account for only 14% of euro-area employment. The authors urge the bank to dump holdings of fossil-fuel firms to remove this “carbon bias”.

It is in Europe that the dilemma of greener monetary policy is most acute

The Bank of England’s experience of tweaking its purchases serves to illustrate the difficulties that are involved. In November it announced a framework to make its corporate-bond purchases climate-friendly. It would exclude thermal coal assets, but excluding anything else would shrink the universe of bonds it could buy too much. It would rank firms based on their recent emissions record, and their plans for reducing emissions further. The greener the firm, the higher the price the bank would be willing to pay for its bonds.

What followed was a triple let-down for activists. Because the Bank of England still bought some dirty firms, the carbon footprint of the portfolio, according to Mr Dafermos and colleagues in another paper, fell by only 7%. And the purchases ran the risk of subsidising prospective investors in dirty bonds: research by economists at the Sustainable Finance Lab at Utrecht University compares yields of bonds eligible for a purchase programme with those that are ineligible, and finds that the gap between them has tended eventually to narrow, or even disappear, as investors who sell the eligible bonds to the central bank then buy cheaper non-eligible ones. The kicker came in February. With the recovery on track and inflation rising, the Bank of England decided to run down its stock of corporate bonds. Having applied its green framework just once, there would be no more purchases to tweak.

The bank’s hope is that it offers a useful example. “We did it to show it could be done,” says Mr Bailey. But this fevered activity still raises some concerns. Even if their mandates give political cover, central banks are in effect designing their own climate policy. The EU’s economic policy is wide-ranging enough that the “ ECB’s secondary objective could be hundreds of things,” says Markus Brunnermeier of Princeton University. If it were to pick and choose which to support, its lack of accountability might be problematic. Although it has to provide reports to the European Parliament, it is not accountable to national governments. Changes to its powers require votes by each of the euro area’s 19 members.

Tackling climate change may be less divisive in Europe than in America, but it is hardly a settled question, says Mr Brunnermeier, recalling the gilets jaunes protests in France in 2018. If public sentiment on the green transition were to sour because energy prices stayed high, central banks could quickly look as if they were picking sides, rather than staying above politics. That would ensnare them in debate and cast doubt on their neutrality, damaging the public credibility that is so vital to their taming inflation. ■