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Central Banks' Role in Responding to Climate Change: Monetary Policy and Macroprudential Regulation

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The purpose of this paper is to investigate the modalities of a possible role for central banks in the context of climate change and to create a taxonomy that categorizes three different positions - conventional, progressive and unorthodox - that central bankers and academicians might have on this topic. I briefly analyse fiscal policies as a current channel of response to reduce carbon emissions, highlighting the main limits of them. After introducing the concept of systemic risk and analyzing the conventional mandates of central banks, the paper introduces the two major channels through which central banks might face this risk and favor the transition to a low-carbon economy: monetary policy and macroprudential regulation. I present green quantitative easing (GQE) and carbon quantitative easing (CQE) as monetary policies and also discuss the case of Green Overt Monetary Financing. In the context of macroprudential policies, I discuss the effect of differentiating capital requirements, increasing those for carbon-intensive investments. In the discussion section, the different policies are compared in terms of macroeconomic performance and the characteristics of the taxonomy are outlined by categorizing the three positions mentioned above.
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UNIVERSITY OF PADOVA
DEPARTMENT OF ECONOMICS AND MANAGEMENT
"M. FANNO"
BACHELOR’S DEGREE IN ECONOMICS
FINAL DISSERTATION
CENTRAL BANKS' ROLE IN RESPONDING TO CLIMATE
CHANGE: MONETARY POLICY AND MACROPRUDENTIAL
REGULATION
SUPERVISOR:
PROF. LORENZO FORNI
GRADUATE: GUGLIELMO ZAPPALÀ
ACADEMIC YEAR 2017 - 2018
2
Abstract
The purpose of this paper is to investigate the modalities of a possible role for central banks in the
context of climate change, recognized as one of the most important sources of risk for today and future
generations, and to create a taxonomy that categorizes three different positions: conventional,
progressive and unorthodox.
The paper contextualizes the growing institutional awareness on this issue, which culminated with the
2015 Paris Agreement. I proceed to a brief analysis of fiscal policies as a current channel of response
to reduce carbon emissions, highlighting the main limits of it.
After introducing the concept of systemic risk and analyzing the conventional mandates of central
banks, the paper introduces the two major channels through which central banks might face this risk
and favor the transition to a low-carbon economy: monetary policy and macroprudential regulation.
The unconventional monetary policy adopted in response to the 2008 financial crisis, quantitative
easing, is discussed, providing evidence of its asymmetry towards carbon-intensive sectors and
derivatives, and its two environmental variants, green quantitative easing (GQE) and carbon
quantitative easing (CQE). In the context of macro-prudential policies, it is discussed the effect of
differentiating capital requirements, increasing those for carbon-intensive investments.
In the section devoted to the discussion, the different policies are compared in terms of
macroeconomic performance and the characteristics of the taxonomy are outlined by categorizing the
three positions mentioned above.
How sad to think that nature speaks and mankind does not listen V. Hugo
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INDEX
1. INTRODUCTION ..................................................................................................4
1.1 UNITED NATIONS FRAMEWORK CONVENTION ON CLIMATE CHANGE AND PARIS
AGREEMENT .................................................................................................................6
1.2 FISCAL POLICY........................................................................................................7
2. BACKGROUND ON CENTRAL BANKS’ RESPONSE TO CLIMATE RISK 8
2.1 CLIMATE SYSTEMIC RISK .....................................................................................10
2.2 FINANCIAL STABILITY BOARD..............................................................................14
2.3 CENTRAL BANKS MANDATES ...............................................................................14
3. MONETARY POLICY ...........................................................................................16
3.1 SECTOR NEUTRALITY ............................................................................................16
3.2 QUANTITATIVE EASING ........................................................................................18
3.3 UNCONVENTIONAL QUANTITATIVE EASING .........................................................20
3.3.1 Green Quantitative Easing..........................................................................21
3.3.2 Carbon Quantitative Easing........................................................................24
3.4 ADDITIONAL UNCONVENTIONAL MONETARY POLICIES ......................................28
4. MACROPRUDENTIAL REGULATION .............................................................30
4.1 DIFFERENTIATED CAPITAL REQUIREMENTS .........................................................32
5. DISCUSSION ...........................................................................................................33
5.1 ANALYSIS .............................................................................................................34
5.2 TAXONOMY ...........................................................................................................38
6. CONCLUSIONS ......................................................................................................40
7. RECOMMENDATIONS ........................................................................................42
APPENDIX...................................................................................................................44
REFERENCES ............................................................................................................46
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1. Introduction
Climate change is recognised to be one of the most important sources of risk for today's and
future generations. The Global Risks Report (2018), published by the World Economic
Forum, states that extreme weather events and failure of climate change mitigation and
adaptation are in the top five risks for the next ten years.
In this paper, I present a dissertation that relates to the potential role of central banks in
managing the risks connected to climate change and I include the various policy options in a
framework that embeds monetary policy and macroprudential regulation.
The argument proposed here is the identification of a gap in policy communication and I
categorize three general positions in a taxonomy for defining the role of central banks when
responding to climate risks and for financing a transition to a low-carbon economy. The three
positions are (i) conventional, (ii) progressive, (iii) unorthodox, with each position having
specific characteristics. The paper describes this taxonomy and summarizes strengths and
weaknesses of each position and makes recommendations for further investigating
progressive and unorthodox policies.
The starting point is that impacts of future global warming will range between dangerous to
catastrophic and could even pose an existential risk (Xu and Ramanathan, 2017). The
scientific consensus, as concluded by the Intergovernmental Panel on Climate Change
(IPCC), is that climate change is human caused and that the economy must be decarbonized to
avoid exceeding the available carbon budget that corresponds to unwanted levels of global
warming. Furthermore, the IPCC (2014, p.55) reports that
Continued emission of greenhouse gases will cause further warming and long-lasting
changes in […] the climate system, increasing the likelihood of severe, pervasive and
irreversible impacts for people and ecosystems. Limiting climate change would require
substantial and sustained reductions in greenhouse gas emissions which, together with
adaptation, can limit climate change risks.
There is a growing awareness of climate risks’ implications not only among academics, but
also amongst politicians and institutions. Recently, central bankers and regulators have
become more concerned about financial system exposure to climate risks and its
consequences on prices and financial stability (Carney, 2015). This has led to the formation in
December 2015 of an industry-led task force by the Financial Stability Board: the Task Force
on Climate-related Financial Disclosure. This has the declared assignment to develop
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voluntary, consistent climate-related financial disclosures […] useful to investors, lenders,
and insurance underwriters in understanding material risks” (Financial Stability Board, 2017,
p.4).
A focus of this dissertation is the financial risk associated with climate change. The
methodology of this dissertation is to provide literature evidence and theoretical arguments
for three general positions on the potential role of central banks in responding to climate
systemic risk. For background on the topic, I review in Section 1.1 the Paris Agreement of the
21st Conference of Parties, under the United Nations Framework Convention on Climate
Change and in Section 1.2 a brief overview of economic thought about fiscal policies to
address decarbonization. In Section 2, background is given on the topic of central banking and
their established roles in responding to climate change. Section 2 also discusses the meaning
of climate systemic risk, the role of the Financial Stability Board and the conventional
mandates of central banks.
The main body of the thesis is presented in two sections that examine the two major channels
for central banks to respond to climate change risk: Section 3 covers monetary policy and
Section 4 discusses macroprudential regulation.
In Section 3, under the topic of monetary policy, I will examine the issue of sector neutrality.
I will focus on the quantitative easing (QE) implemented by central banks in the aftermath of
the 2008 financial crisis and its application in managing climate systemic risk. This includes
the topic of unconventional QE, involving Green Quantitative Easing and Carbon
Quantitative Easing; other unconventional monetary policies will also be discussed.
In Section 4, under the topic of macroprudential policy, I will examine in more detail the
various kinds of macroprudential regulation that can help manage climate-related financial
risk and preserve financial stability. One such macroprudential approach that relates to
climate change is to differentiate capital requirements for carbon-intensive investments.
In Section 5, I combine the main findings from Sections 3 and 4 analysing with qualitative
comparison the policy options under the two main channels: monetary policy and
macroprudential regulation. I also justify the proposed taxonomy of the positions - (i)
conventional, (ii) progressive, (iii) unorthodox - in relation to central bank policies. In Section
6, I provide concluding remarks about central bank policies for managing climate risk. In
Section 7, I give recommendations for further research and policy decisions.
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1.1 United Nations Framework Convention on Climate Change and Paris
Agreement
The institutional debate on climate negotiations has its roots on the first United Nations
Framework Convention on Climate Change (UNFCCC) in 1992 and 1994 respectively in
Kyoto and Rio de Janeiro. They had the objective to reduce greenhouse gas emissions, being
the main cause of global warming. Further progresses were not made in 2009, during the
Copenhagen Summit, where participating countries could not achieve an agreement for
legally binding emissions reductions (Wynn, 2009). The financial crisis, occurred the
previous year, diverted the attention and the finances of governments from the promise to
mobilize US$ 100 billion per year to help developing countries shifting from carbon-based
economies burning fossil fuels to use cleaner energy.
A major step forward in climate negotiations was recorded with the Paris Agreement - signed
during the 21st Conference of Parties (COP21) under the UNFCCC in 2015 - which set a
target to keep global warming below 2°C above pre-industrial levels and to pursue an upper
limit of 1.5°C of warming, stating that these goals would significantly reduce the risks and
impacts of climate change” (UNFCCC, 2015).
The Paris Agreement combines the top-down system of United Nations climate agreements
and a bottom-up process according to which countries outline their post-2020 climate actions,
called Intended Nationally Determined Contributions (INDC), pledging their mitigation
targets. These actions, however, are demonstrated not to be sufficient to reach the goal of
holding the increase in global average temperature below 2°C and they are estimated to emit
55Gt of carbon within 2030, where the threshold to limit global average temperature increase
to 2°C would be 40Gt (UNFCCC, 2015). The same opinion is shared by Rogelij et al. (2016)
who have alerted that these targets do not comply with the objectives of the Paris Agreement
and would imply a median global warming of 2.6-3.1°C by 2100.
Moreover, ambitions of the Paris Agreement are not enforced with compliance and cannot
prevent defections. The current President of the United States, Donald Trump, is pleading
Article 28 of the agreement and intends to withdraw the country from the agreement by
November 2020. Unexpectedly, this should not trigger free-riding and a domino effect in
withdrawals, but there is evidence of a higher commitment by China and India in this
challenge, given the awareness of the damage that a climate change worsening would cause
and the consideration of this stance as a possibility to revenge and educate the West
(Mahbubani, 2018, p. 52).
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A hypothetical central bank response to climate risk can be understood by certain paragraphs
of the Paris Agreement that invite policy makers to use financial instruments to make the
financial system more resilient. First, giving a social, economic and environmental value to
emission reductions (Paragraph 108) and carbon pricing (Paragraph 136). Additionally, article
8 refers to the Warsaw International Mechanism for Loss and Damage associated with
Climate Change Impacts and addresses the parties involved as responsible for the reduction of
the risk of loss and damage and for the conduction of risk assessment and management
procedures (UNFCC, 2015). These tasks are notable for the prosecution of the dissertation as
some countries have already implemented these methodologies. By this evidence, it could be
hypothesized a rethinking of monetary or macroprudential policies integrating environmental
externalities and social values into it.
1.2 Fiscal Policy
Conventional economic thought has addressed carbon pricing as the most effective solution to
reduce carbon emissions and global warming. Carbon price is the amount associated to the
right for an agent to emit one tonne of CO2 into the atmosphere. The narrative on carbon
pricing appears to be divided into two main categories. It can be price-based, called carbon
tax, or quantity-based, where the regulator sets an emissions cap and allows economic agents
to trade their emission rights. The policy is called Emission Trading System (ETS), or cap-
and-trade, and the price of the carbon is determined by the market. This vision internalizes the
negative externality created by greenhouse gases emissions. Pricing negative externality with
a tax is a solution advanced by Arthur Pigou (1920) and for this reason the carbon tax is an
example of Pigouvian Tax. The ideal carbon tax should approach the Social Cost of Carbon
(SCC) under cost-benefit analysis to maximize economic welfare. If the carbon tax is at its
optimal level, it will incentivize global abatement efforts by increasing the private costs of
production to equal the social cost of production.
Nordhaus (2016), however, provides evidence that the current optimal carbon tax effect on
temperature would not be adequate to reach the targets set by the Paris Agreement, unless the
discount rate is very low. A target of 2.5°C would be technically feasible but would require
extreme […] policy measures (Nordhaus, 2016, p.4).
Additionally, carbon prices are too low to ease a low-carbon transition. Currently in Europe,
price is slightly below €10 per tonne while, to comply with Paris Agreement goals, it is
estimated that it should be at least €40 per tonne and rise towards €100 within 2030 (Stiglitz
and Stern, 2017). For this reason, in 2017, the European Parliament and Commission have
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reformed the EU-ETS for the 2021-2030 period to reach Paris Agreement objectives. The
annual reduction of emissions follows the Linear Reduction Factor (LRF), equal to a
reduction of 1.74% of the amount of allowances in 2010. This will be raised to 2.2% from
2021 on. However, to reach the 1.5°C target, the LRF should be at least 4.2% (de Jong, 2016).
Furthermore, Campiglio (2014) points out that pricing carbon is not sufficient to guide
resources towards green investment. He writes about an additional market failure linked to
the process of creation and allocation of credit, given by the pursuit of private interests by
commercial banks that might direct excessive credit towards carbon-intensive industries in
their lending decisions. This point is further developed when discussing sector neutrality of
policies.
An approach that deviates from the classical economic theory is elaborated by Stern and
Stiglitz (2017). They advance the proposal of implementing a carbon tax that is higher than
the SCC to reach Paris Agreement targets, that standard fiscal policies could not address.
Boyce (2018, p. 2) agrees and states that carbon prices needed to meet this constraint are
likely to be considerably higher […] than existing prices and conventional measures of the
social cost of carbon". A framework for these measures regards the role of central banks and
their tools to face in a more effective way the challenges posed by climate risks.
2. Background on Central Banks’ Response to Climate Risk
An intense debate has arisen since the 2008 financial crisis to discuss central banks’ mandates
and their objective to safeguard financial stability (Eichengreen, 2011). Specifically, a G30
report (2015: xi) stated that important questions about roles and duties of central banks were
emerging. Nevertheless, even though climate change may be considered a systemic risk
undermining financial stability, little attention has been devoted to central banks’ role in
responding to climate challenges. It should be noted that central banks are just one type of
financial regulatory authority, and various kinds of financial institutions are focused on
market efficiency and macroprudential regulation. However, central banks are the focus of
this analysis because they are generally entrusted with the implementation of monetary
policies.
The UN Environment Programme (UNEP) Inquiry (2015) identifies existing connections
between the mandates of financial regulatory authorities - including central banks - and
sustainability concerns. It finds that central banks are generally focused on monetary and
financial stability and they should care more about climate impacts that could cause volatility
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and market disruptions. Disruptions include floods, droughts and associated impacts on
agricultural output and physical damages, that would reduce capital stock and also impact on
food prices. With a 2°C of warming, climate damages are estimated to cause a loss on global
GDP ranged between 0.2%-2.0% per annum (IPCC, 2014). Climate change and
environmental damages might also affect energy prices and have adverse consequences for
price stability, which is the primary issue for central banks. A decrease in capital supply and
consequent increase in overall prices might boost inflation. For these reasons financial
regulatory authorities should consider climate change in their mandates.
A watershed moment in the narrative of central banking is the speech of the Governor of the
Bank of England, Mark Carney, regarding the “tragedy of horizons” (Carney, 2015, p.8).
Carney, also Chairman of the Financial Stability Board (FSB), sees a temporal mismatch
between the financial regulator’s agenda, characterized by monetary and financial stability
policies, with time spans between 2 and 5 years and the much longer-term constraining
physical climate change process, counted in decades. The long-term perspective of the climate
change issue leads to an underestimation of the problem and its consequences in the financial
world, including firms’ cash flows and asset revenues. His speech already fostered new policy
initiatives, including the G20 meeting held in Shanghai in 2016. This meeting saw the Bank
of England and the People’s Bank of China as leaders in the Green Finance Study Group,
established to examine climate change as a financial risk.
Central banks in emerging economies have been more active than their developed economies
counterparts in the design of monetary policies and regulations sustainable development, for
example by requiring commercial banks to implement sustainability ratings to their assets and
their loan processes. Emerging and developing countries are the object of the study by Dikau
and Ryan-Collins (2017) who reported that the central banks of six countries that cover
almost half of the global population Bangladesh, Brazil, China, India, Indonesia and South
Korea have already implemented green policies. Their interventions have occurred through
three different channels, two of which are case studies of this dissertation. Central banks have
addressed climate change challenges through credit allocation instruments, macroprudential
regulation for preserving financial stability, and monetary policies, building green bond
markets.
Among developed countries, France is notable because the Prime Minister’s think tank,
France Stratégie, has investigated the role of monetary policies supporting low-carbon
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investment, starting from the inclusion of climate factors into the quantitative easing
implemented by the European Central Bank (Aglietta et al., 2015).
There are other real-world examples of central banks’ concern for climate change. De
Nederlandsche Bank (DNB, 2016) conducted a study of its domestic financial system finding
out that the financial sector is sufficiently exposed to carbon-intensive sectors to pose
potential systemic risks. Similarly, the Bank of England’s Financial Policy Committee is
monitoring climate risk undertaking a review of the exposure of the UK banking sector to
climate-related financial risks, after having conducted the same procedure for the insurance
sector (Bank of England, 2017).
The impact on financial stability of a low-carbon transition is of interest to the European
Systemic Risk Board (ESRB, 2016), while Sweden’s Finansinspektionen is examining the
impact of climate change on financial stability (Bowen and Dietz, 2016). Outside Europe, the
Bangladesh Central Bank is supporting rural enterprises and green finance for its financial and
monetary stability. Banco Central do Brasil (2011) introduced specific requirements for the
banks to have socio-environmental risk management systems. People’s Bank of China (2016)
is working towards the direction of greening its financial system adopting new guidelines and
introducing a set of policy incentives that include a connection between green finance and re-
lending operations.
2.1 Climate Systemic Risk
Central to this analysis is a reliable definition of climate systemic risk. Risk is defined as the
“effect of uncertainty on objectives” (ISO, 2009). This already denotes the extent to which
risk is involved in any human action. Climate change is not exempt from risk and the growing
awareness around this topic has implied speculating research on risk management. Higgins
(2014, p.1) categorizes climate change risk management approaches into four main
categories: (i) mitigation, (ii) adaptation, (iii) geo-engineering, (iv) knowledge expansion.
Mitigation involves the “efforts to reduce greenhouse gas emissions” and the policies
discussed in the dissertation are focused on this category, being the unique alternative for
avoiding irreversible climate change. The term climate systemic risk was coined by Aglietta
and Espagne (2016). They found analogies between climate-related risks and systemic
financial risks. Reasons that allow to consider climate change as systemic risk are confirmed
by Chitiba (2012, p. 1), that defines systemic:
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“[those] risks imposed by inter-linkages and interdependencies in a system or market, where
the failure of a single entity or cluster of entities can cause a cascading failure, which could
[…] bring down the entire system or market.”
Climate change shares three main features of the general notion of systemic risk (Preventable
Surprises, 2016):
Pervasive effects not focused on a specific sector
Non-linear effects with unpredictable tipping points
Inter-related effects and the scale of tail risks is unquantifiable
Among the three characteristics, the first is the most important: the nature of climate change
impacts is systemic as it affects the entire Earth and has repercussions on the financial system.
Aglietta and Espagne (2016) point out three essential elements that help labelling climate
change as systemic risk, as generally done in the financial world. A systemic event is a shock
that can affect simultaneously several institutions, or be limited and spread through a domino
effect. This domino effect occurs through a network and has endogenous human causes
(Pachauri et al., 2014). The intertwining of the current global economy, social systems and
networks inextricably connected can expose society to climate-related disruptions, which
could create systemic risk by influencing supply chains and trade networks (Mourad and
Luers, 2017).
The interpretation of climate risks as systemic to the financial system is crucial for the ideas
supporting this dissertation. In fact, systemic risk has been widely reclaimed as central in
financial stability due to the fragility of this sector after the 2008 financial crisis and this
interpretation is necessary to build the concrete argument that central banks could play a
specific role in managing climate change risk. Relevant is the caveat by Leaton et al. (2013,
p.23) who stated that
the banking system and regulators are not yet watching for the warning signals [of climate
change] leaving a financial system that is still not fit for purpose. The rules that guide and
govern the operation of financial markets need to evolve to address this systemic risk”.
Traditional economists might question on the premises of this work, which discusses the
implementation of monetary policies and macroprudential regulation for a low-carbon
transition through incentives to the private banking system without imposing any “sector
specific goals” to financial institutions (Aglietta et Espagne, 2016). The objections against
this idea can be summarized by the response of the Governor of the Banque de France,
François Villeroy de Galhau (2015, p.3), right before the opening of COP21:
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“[…] we must bear in mind the ultimate aim of monetary policy. It is designed to achieve
macroeconomic objectives, not sector-specific goals. The underlying assumption for direct
monetary policy intervention is that the central bank is better equipped than private agents to
ensure an efficient allocation of resources […]”
However, in April 2018, during the opening of the International Climate Risk Conference for
Supervisors held in Amsterdam, Villeroy de Galhau himself recognized climate change as
“one of the determinants of financial stability” (Villeroy de Galhau, 2018, p.1) and
acknowledged a role for central banks in responding to climate change. Furthermore, he
praised the establishment under his mandate in December 2017 by the Banque de France of
the Network for Greening the Financial System (NGFS). This shows that there is some
political support for central banks to address climate risk management in the financial sector
and to foster the transition towards a sustainable economy (Banque de France, 2017).
Mark Carney (2015) highlights three main types of climate risk that affect financial stability:
Physical Risk
Liability Risk
Transitional Risk
The physical risk is linked to the increase in severity and frequency of those human-driven
weather and climate events that include floods, droughts and storms. The 2017 has been a
record year counting 710 natural disasters (Munich Re, 2018) and this undoubtedly has
repercussions on the financial stability, causing damages to properties and obstructing trade.
The liability risk arises from parties seeking compensation for losses suffered from the effects
of climate change. The transitional risk is considered as the most challenging and it can occur
when moving suddenly and disorderly to a low-carbon economy, for example with abrupt
changes in market dynamics. An example is the exposition of companies to the risk of
stranded assets. The financial system is mainly exposed to carbon-intensive assets and fossil
fuels companies and, to meet Paris Agreement objectives, McGlade and Ekins (2015)
estimated that around 35% of current oil reserves, 50% of gas reserves and nearly 90% of coal
reserves should become unusable and not be extracted. The total exposure to this risk of EU
financial institutions amounts to more than €1 trillion. If these assets ended up stranded, we
would assist to €350-400 billion losses which in turn could harm the whole financial system
with cascade effects (Weyzig et al., 2014).
Below, I present a table (Table 1) that proposes a taxonomy of the risks. The identification of
climate-related financial risks as systemic gives way for the hypothesis of implementing
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macroprudential regulation whose aim is to safeguard financial stability. This is discussed in
section 4 and underpins the progressive position.
Risks
Core Topic
Target
Market
Agents,
Stakeholders
Policies,
Instruments
Financial
Idiosyncratic
Risk
Uncorrelated to
market risk and
diversifiable
Decarbonization
Portfolio;
Stranded Assets
Risk
Banks,
Companies
Diversification in
investments
Financial
Systemic Risk
Financial risks
related to physical
impacts of
climate change,
liability, low-
carbon transition.
Financial
Stability
Society,
Companies,
Banks,
Institutions,
Countries
Macroprudential
Regulation
Climate
(Physical)
Individual
Risk
Global Warming,
Extreme Weather
Events
Paris Agreement
Goals
Individuals,
Households,
Companies,
Corporations
Private, Business,
Commercial
Insurance
Climate
Systemic Risk
Systemic Risk
[Physical;
Liability;
Transitional]
Financial
Stability,
Collective
Insurance
Approach
(Aglietta and
Espagne, 2016)
Society,
Countries
Macroprudential
Regulation
Climate
Damages,
Efficient
Market
Hypothesis
Negative
Externality,
Social Cost of
Carbon (SCC)
Optimality of
carbon tax and
internalization
of externality
and SCC
Society
Fiscal policy
[Carbon tax, Cap-
and-trade];
Government
regulations
Table 1. Proposed Taxonomy of risks related to climate change. (Source: Author)
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2.2 Financial Stability Board
Central banks and financial regulators are concerned with the disclosure in addressing
climate-related risks to support an orderly low-carbon market transition. In December 2015, at
the request of the G20, the FSB established the Task Force on Climate-related Financial
Disclosure, to implement a coordinated assessment made of recommendations and principles
to advance disclosure of climate-related risks. As highlighted in the first report (TCFD,
2016a, p.9), “inadequate information on risk exposures can lead to a mispricing of assets
and/or misallocation of investment and can potentially give rise to concerns about financial
stability”. Thus, the task force aims to improve transparency by setting mandatory disclosure
requirements for all financial organizations in their public financial filings (TCFD, 2016b).
This will be useful for a more reliable pricing of climate-related risks and allocation of
capital, that impact on financial stability and attract the attention of central banks, responsible
for financial stability. This statement will be the basis for the discussion of macroprudential
regulation in section 4.
The FSB and its task force are leading the international scenario to advance governing
architecture in both areas of converging sustainability disclosure standards and implementing
a climate-related stress test methodology to overcome the tragedy of horizons (Carney, 2015)
embedding it into financial decision-making.
2.3 Central Banks Mandates
The primary mandate of all central banks is to maintain price stability. There can be, however,
additional mandates that differ between countries, usually financial stability, full employment
and output growth. For instance, the Federal Reserve states in its mandate the goal of
achieving maximum employment and moderate long-term interest rates.
Other examples of broader objectives are given in the Bank of England (BoE) and European
Central Bank (ECB) mandates. The BoE defines that the goals shall be to maintain price
stability and subject to that, to support the government’s economic policy which, in turn,
aims to achieve strong sustainable and balanced growth that is more evenly shared across the
country and between industries” (Bank of England Act, 1998, p.11). Therefore, the BoE
mandate provides the policy space to consider issues beyond price stability and explicitly
strives to do so. The BoE and its Governor Carney - has a cutting-edge role in responding to
environmental issues and has been a global leader among central banks in investigating links
between financial stability and climate-related risks.
15
Likewise, the primary objective of the ECB mandate is price stability and the European
System of Central Banks shall also support the overall goal of the European Union which,
according to Article 3 of the Maastricht Treaty, includes a high level of protection and
improvement of the quality of the environment(Treaty on European Union, 1992, art. 3.3).
The mandate, even though it is rarely mentioned, explicitly asks the ECB to go beyond the
quantitative price stability objective expressed by keeping inflation close to 2%, exploring
policy linkages between monetary policy and environmental protection for a sustainable
development. If price stability is not at risk, the ECB should look for an integration of
sustainability principles into its monetary policies.
To pursue price stability the ECB must also consider the evolution of real and financial
markets that aims at financial stability. Within this framework, ECB is explicitly assigned two
tasks in the field of financial stability that involve identifying and assessing systemic risks.
Since the implementation of the Single Supervisory Mechanism Regulation on 4th November
2014, ECB has also macroprudential regulation as financial regulatory tool aimed to support
financial stability and tackle potential systemic risks. The ECB covers an essential role in the
institution responsible of managing systemic risk the European Systemic Risk Board - and
supports it with analytical support for financial stability.
It might also be the case that the macroprudential supervisory authority is not explicitly
attributed to central banks. However, interconnections between macroprudential and monetary
policies have been advocated by a significant part of economic research. An example is the
US institution responsible of mitigating systemic risk, the Financial Stability Oversight
Council, that numbers in its commission the Chairman of the Federal Reserve System.
Macroprudential regulation as a regulatory tool is a focus of this dissertation on central bank
policies, and will be kept distinguished from monetary policies. This choice follows the
traditional argument according to which monetary policy should pursue the goal of price
stability and let financial stability be the objective of macroprudential policies (Bernanke and
Gertler, 1999). There is also a share of the literature (Cecchetti et al., 2000), though, that
proposes the inclusion of financial stability as a permanent monetary policy goal and so does
not provide a clear distinction between the two policies. This occurs in an economy where
supply shocks can threaten financial stability and there is no distinction among
macroprudential and monetary policiesobjectives.
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3. Monetary Policy
The academic literature about central banks and their mandates has largely neglected the idea
that monetary policies could be used to manage climate systemic risk and support the
transition to a low-carbon economy. While in other policy fields - tax, energy, trade - the
impact of climate change and a policy platform for a low-carbon transition are carefully
considered, monetary policy is reputed to stick to a limited set of objectives and focused on
the exclusive goal of price stability.
Central banks might adopt monetary policy operations to address sustainability challenges,
purchasing assets to stimulate markets or encouraging lending to specific sectors providing
lower rates that market ones. These instruments have their bases on unconventional monetary
policy measures whose implementation has widely spread in the aftermath of the 2008
financial crisis.
In this chapter, I will present two policies based on quantitative easing: Green Quantitative
Easing (GQE) and Carbon Quantitative Easing (CQE). The former has been widely
researched by scholars also with quantitative studies through simulations, while the latter does
not have literature about it yet due to its unorthodox approach in monetary and market
matters.
The implementation of the first policy might be considered a non-neutral policy that
advantages low-carbon sectors. For this reason, before moving to the description of GQE, I
will introduce the concept of sector neutrality in the mandates of central banks and provide
evidence of policies tilted towards carbon-intensive sectors.
3.1 Sector neutrality
Central bank mandates are based on the principle of sector neutrality, meaning they should
avoid market distortions. Practitioners usually design policies to comply with this view.
However, there can still exist some sector biases of monetary policies. This section considers
existing examples of monetary policies - especially among those unconventional policies
implemented after 2008 - that are not sector neutral.
There are mainly five examples of non-neutral policies implemented in recent years that also
Barkawi (2016) refers to. The first is about refinancing operations - open market operations
implemented in response to 2008 financial crisis and a key instrument of unconventional
monetary policies through which commercial banks obtain funds from central banks. The
17
common structure of these refinancing operations is the use of repurchase agreements in
which commercial banks provide collateral to the central banks to receive reserves in return
and they commit to repurchase back the collateral. In the Euro-Area, ECB can purchase Asset
Backed Securities (ABS) which can be based on car loans and leasing contracts, such as the
€1 billion worth ABS issued by Volkswagen financial services in 2015 which securitized
receivables from around 73.000 car leasing contracts. This feature is clearly not market
neutral and not aligned with the objective of a low-carbon economy. Furthermore, the
requirements for the eligibility of the collateral purchasable by the ECB are indicated not to
be met by green ABS (Matikainen et al, 2017).
A second example is the Targeted Longer-Term Refinancing Operation (TLTRO) whose first
series was announced in 2014 and the second in 2016 by ECB. The second series of the
operation provides banks with financing for periods up to four years for loans issued to the
non-financial private sector, excluding loans to households for house purchases. The
exclusion of loans to the financial sector is aligned with ECB’s goal to ensure growth and
credit to the real economy. Excluding mortgages, the ECB reflects its concern about housing
bubbles but also introduces sector biases in its instruments. These exclusions can influence
credit allocation and imply that central banks might direct private credit creation to specific
sectors and encourage alignment with the objective of a low-carbon economy.
Sector bias also occurs in the Funding for Lending Scheme (FLS) - introduced in 2012 and
extended in 2015 by BoE and UK Treasury - which incentivizes banks and building societies
to boost their lending to the UK real economy. The price and the quantity of funding provided
to these institutions are both connected to their lending performance and, remarkably, the
incentives to boost net lending will be heavily skewed towards small and medium sized
enterprises” (BoE, 2013, p.1). This is further evidence of a bias towards specific sectors of the
economy.
A fourth example regards the large-scale asset purchase program implemented by the US Fed
in late 2008 which led to a quadrupling of the Fed’s balance sheet to $4.5 trillion with the Fed
buying more than $1.7 trillion in mortgage-backed securities. It goes without saying the bias
of this policy tilted towards the housing sector in order “to provide support to mortgage
lending and housing markets” (Federal Reserve Bank of New York, 2010).
Similarly, in October 2014 the ECB announced plans for asset purchases and bought more
than €1 trillion in government and corporate bonds among which are, as seen, ABS based on
car loans. It is relevant that Bloomberg (2014) reported that commercial banks specifically
18
Santander were seizing the opportunity to provide more car loans issuing more ABS,
relying on the announcement of the ECB. In the Euro-Area, central banks are not obliged to
reveal the names of the companies of which they are holding bonds or ABS, therefore sector
bias cannot be immediately proved. However, they can be deduced from the International
Securities Identification Number (ISIN) that they must disclose. Hence, it is possible to
observe that Deutsche Bundesbank has purchased bonds from Daimler AG/Mercedes, BMW
and Volkswagen more frequently than from any other company for a total of 37 purchases. It
is straightforward to notice that the purchase of private debt such as corporate bonds eases
those companies to raise money in the capital markets and to invest them in their businesses.
Regardless of the justification for the above-mentioned policies, there is sufficient evidence to
doubt that certain policies of central banks are sector biased. Economy is still carbon-
intensive, however the huge investment by central banks skewed towards automotive and
fossil fuel sector does not reflect market-neutrality in purchasing operations. Despite being a
small fraction of bond market, renewable energy companies are not present at all in ECB and
BoE purchases. It is the objective of coming chapters to explore whether sector biases that are
tilted towards the objective of a low-carbon economy and green finance would be considered
conventional, progressive or unorthodox in terms of central bank mandates.
3.2 Quantitative Easing
Quantitative easing is an unconventional expansionary monetary policy underpinning the
monetary policies I will discuss. The term was coined by Richard Werner, who has also been
a researcher at the Bank of Japan. This institution was the first to implement this policy in
March 2001 to combat deflation but was then abandoned since it was ineffective. However,
the popularity of quantitative easing was reached when it was implemented by United States,
United Kingdom and Eurozone as a response to the 2008 financial crisis.
The aim of this unconventional policy is to stimulate the economy after a period of recession
or deflation, and foster spending to reach the inflation target generally set by central banks to
2%. To do so, central banks expand their own balance sheet, purchasing government bonds
and other financial assets, injecting money directly into the economy and increasing liquidity.
This leads to an increase of asset prices and a decrease of yields. Those who sell the asset will
be incentivized to use the money received to buy other financial assets, like company shares
and bonds. As the purchase of assets increases, their yield will be lower too, creating a general
environment of low interest rates. This will reduce also the cost of borrowing for households
and business, and commercial banks will be able to offer additional loans with new money
19
created and deposited by consumers in their bank accounts, thus boosting spending and
investment.
It has been provided evidence of the sectoral effects of this policy. The choice of the assets
class has a tangible impact on the environment as it involves mainly carbon-intensive sectors,
such as automotive, fossil fuels and utility companies (Matikainen et al., 2017).
The ECB has undertaken the quantitative easing policy in March 2015 injecting in the
economy €60 billion monthly through the purchase of private and public sector’s securities
until March 2016. This pace has increased to an average of €80 billion injected monthly from
April 2016 to March 2017 and returned to €60 billion until December 2017. From the
beginning of 2018, ECB is pursuing a reduction of the net purchases with a monthly pace of
€30 billion until the end of September 2018. These amounts listed are much larger than the
monthly average of 24 billion in 2015 and €23 in 2016 invested in global clean energy
(Bloomberg, 2018).
As part of QE, the ECB conducted the Asset Backed Securities Purchase Programme
(ABSPP), requiring collateral to comply with specific criteria. Since green ABS are indicated
as a growing sector in the coming years (OECD, 2016), central banks could help developing
this area, like the Federal Reserve did to boost the housing sector purchasing mortgage-
backed securities. To do so, it should be necessary a more precise design of eligibility
requirements for ABS. Currently, green ABS are mostly not eligible. This is not because of
their nature: loans underlying ABS should come from a pool that includes loans to small and
medium-sized enterprises or consumer finance loans, and low-carbon investments could fit to
these categories (Matikainen et al., 2017). It is, though, due to the insufficient number of
homogeneous loans that would be bundled and securitized (Kidney et al., 2017). Therefore,
instead of changing collateral eligibility requirements, Matikainen et al. (2017) suggest policy
efforts to support the bundling of homogenized green loans prudently and judiciously,
considering the risks that securitization might cause.
The same situation holds for the Corporate Sector Purchase Programme (CSPP) undertaken
by ECB in June 2016 and the Corporate Bond Purchase Scheme (CBPS) adopted by BoE in
September 2016. Under the CSPP, the 35% of ECB holdings at the first quarter of 2018, equal
to €52 billion, belong to sectors - utilities, infrastructure and transportation, automotive and
parts (Figure 1) that are responsible for 51% of greenhouse gases emissions in Europe
(Eurostat, 2016. See Appendix). The purchase of bonds in the energy sector came exclusively
from oil and gas companies, namely Apetra, ENI, OMV, Petrol, Shell, Repsol, Sagess,
Schlumberger, Total, Transport ET, Vier Gas for the ECB; BG Energy, BP, Rio Tinto, Shell,
20
Total for the Bank of England (Matikainen et al., 2017). Concurrently, the amount of
purchases of bonds issued by renewable energy companies is equal to zero.
Figure 1: Distribution by sector of ECB Corporate Sector Purchase Programme Purchases as at Q1
2018. Total invested in the programme: 148.7 billion. See Appendix for details. (Sources: ECB
(2018), and author’s calculations)
The growing awareness among institutions (OECD, 2016) that in the next ten years green
bonds will face their most successful period in terms of issuance should be considered by
central banks to shape quantitative easing to support capital flows towards low-carbon
projects, topic of the next section. This policy might fight the structural bias tilted towards
carbon-intensive sectors and reduce the current green investment gap, that needs 180 billion
of capital flows in renewable energy technologies per year in the only EU to meet Paris
Agreement goals (Monasterolo and Raberto, 2017).
3.3 Unconventional Quantitative Easing
The next section will present two variations of quantitative easing, with focus on
environment. Quantitative easing is considered an unconventional monetary policy per se,
however, the two models discussed present features that deviate from the main reason
underpinning the implementation of this policy. They both propose two different ways to
address climate systemic risk and give a role to central banks to support a low-carbon
transition. Therefore, I address these policies as unconventional.
21
3.3.1 Green Quantitative Easing
The first unconventional monetary policy discussed is Green Quantitative Easing (GQE). It
belongs to those Smart Unconventional Monetary” (SUMO) policies, thus defined by Ferron
and Morel (2014), that might support a low-carbon transition and include the use of Special
Drawing Rights issued by the IMF and the issuance of Carbon Certificates.
The process underlying this policy is the same as the general quantitative easing. Here, central
banks inject liquidity in the economy through the purchase of green bonds at the key interest
rate currently close to zero - and release great quantities of money that would be used to
finance low-carbon projects. This procedure is classified by Ferron and Morel (2014) among
those interventions in the “supply side” of low-carbon finance directed to increase the funding
supply to support the allocation of capital to green investments. Central banks in emerging
economies such as Morocco and China already started to purchase green bonds and
support green repurchase agreements.
There is not a single definition for the term green bonds. We conventionally refer to those
tradable debt securities that are directed to finance investments with environmental benefits or
focused on raising finance for climate change mitigation. This broad definition complies with
the Climate Bonds Taxonomy provided by the Climate Bonds Initiative (2018), an investor-
focused NGO, that lists eight main categories among which there can be found green bonds.
These are energy, buildings, transport, water, waste/pollution control, land use, industry and
ICT and include a wide set of low-carbon projects. For example, a road that reduces journey
time might be included among them as investment in the transport sector. Making investments
climate compatible would globally cost USD $0.6 trillion per year, and these costs would be
contemporaneously offset by savings from lower fossil fuel expenditures amounting to US$
1.6 trillion (OECD, 2017). Green bonds differently than traditional ones - must comply with
a monitoring system to check if the funds raised were really destined to investments expected
and if they adhere to the objective of limiting global warming to 2°C.
The first issuer of a green bond in the world was the European Investment Bank in 2007.
Since then until the first quarter of 2018, the number of issuers of green bonds in Europe
amounts to 145 for a cumulative issuance of €122 billion, which constitutes around the 37%
of the global total. Issuers can be found among energy companies, the largest share, financial
institutions, property companies, local governments and three sovereigns. Poland was the first
sovereign to issue a green bond in 2016, followed by France in January 2017 and Belgium in
February 2018 (Climate Bonds Initiative, 2018).
22
These green bond purchases by central banks must obviously comply with the existing
regulation: in the Euro-Area, ECB can purchase private bonds during the refinancing
operations of commercial banks but cannot buy public debt on the primary market (Art. 123,
2007/C 306/01). It can, however, buy public securities, e.g. government bonds, on the
secondary market. Ferron and Morel (2014) point out a solution that respects the Treaty of
Lisbon and allows ECB redeeming the green bond - issued by governments and purchased by
a commercial bank during the refinancing operations of the bank. The same procedure
occurred under the Securities Market Programme (SMP) first and then under the Outright
Monetary Transactions (OMT) program, when the former was discontinued in 2012. It is
noticeable that in this case there would be an additional stage with the introduction of an
intermediary and therefore a loss of efficiency for the government, as the commercial banks
would indeed buy the green bonds at a rate higher than the key interest rate, which is the one
at which central banks would subsequently redeem it. Despite the loss of efficiency, the
advantage of green bonds issued by the government would be that the new money created
would remain in the hands of the government.
A better hypothesis would involve central banks purchasing private green bonds in the
secondary market, checked for their eligibility in refinancing operations of private banks.
Though, staying in the primary market, central banks could buy green bonds when issued by a
public investment bank or the European Investment Bank (EIB), case that is allowed by the
regulation for the ECB (ECB, 2009). This latter case is relevant because as mentioned above
the EIB has already issued green bonds.
As it happened with the implementation of the Corporate Sector Purchase Program, the large-
scale asset purchase could be an incentive for private firms to increase the issuance of green
bonds, with central banks being buyers of last resort.
The emergence of speculative bubbles in the case of green quantitative easing is less likely
than in the general quantitative easing because the issuance of bonds and the employment of
liquidity has the predeclared purpose of financing low-carbon projects and this would thus
prevent the creation of a “green bubble” with an overrating of assets value, limiting the
recourse to the financial markets (Murphy and Hines, 2010; Grandjean, 2012). The risk of a
bubble may appear only if the demand is inelastic and does not adjust to changes in the
financing supply, which means if there is expectation of continuous growth in assets value.
This might be prevented by a controlled implementation of GQE that would allow for a sound
development of green bonds market. For this reason, the pace of the injection of monetary
23
mass should not be too fast and central banks might consider implementing a tapering policy,
meaning a gradual slowdown of quantitative easing.
Monasterolo and Raberto (2017) and Dafermos et al. (2017) have undertaken analytical
studies of GQE, which are of relevance by providing basic quantitative macroeconomic
predictions. These authors do not use Dynamic Stochastic General Equilibrium model
(DSGE) because DSGE does not consider the microfoundations of complex systems and the
behaviours and interactions of agents (Fagiolo and Roventini, 2017). For this reason,
Monasterolo and Raberto (2017) use the EIRIN Stock-Flows Consistent flow-funds
behavioural model that combines Stock-Flows Consistent (SFC) and Agent-Based Model
(ABM) and these models provide the balance sheets of all agents. The same methodology is
used by Dafermos et al. (2017). Both modelling studies have quantitatively analysed climate
change impacts on the financial system, including the climate Value at Risk (VaR) assessed
by Dietz et al. (2016).
Monasterolo and Raberto (2017) and Dafermos et al. (2017) use this procedure in their
computational simulations over a 100-year time horizon. The environment of these single
country models involves (a) workers, (b) capitalists, (c) a government that issues brown and
green bonds, (d) a central bank that either sets interest rates according to the Taylor rule or
implements QE, (f) a mining company that extracts fossil fuels, (g) a brown company that
produces electricity from fossil fuels, (h) a green company that produces electricity with
renewable energy sources, (i) a commercial bank that represents the credit sector and provides
loans, (j) the foreign sector that provides natural resources for brown investments.
In Monasterolo and Raberto (2017) three different scenarios are compared:
Conventional monetary policies (CMP) is the issuance of green bonds by the
government to boost private investments in renewable energy production. The central
bank sets the interest rate for inter-bank lending, following the Taylor rule.
Unconditioned QE (UQE) which envisages the issuance of green bonds by the
government. The central bank undertakes asset purchases by buying sovereign bonds
green or brown from the commercial bank, the only financial intermediary in the
model.
Green QE (GQE) envisages the issuance of green bonds by the government. The
central bank undertakes assets purchases by buying only green sovereign bonds.
24
A remarkable finding in the GQE scenario is the smooth development of the green bond
market and the avoidance of a ‘green bubble’, a faster pace and a higher number of green
investments, which in turn creates new green jobs and a boost in consumption demand.
Furthermore, portfolios of asset holdings of CBs and investors are decarbonized, avoiding the
financial risk of stranded assets for capitalists. It is worth noting that GQE results in the
lowest profits for the foreign sector compared with the CMP and UQE scenarios, because the
foreign sector is dependent on oil production. GQE helps the government to balance its
budget with a lower-level of taxation compared with the CMP scenario. In turn, this leads to
higher production and consumption of renewable energy. Differently, the CMP scenario
shows the lowest level of green investment and related green employment.
CMP, UQE and GQE have a common weakness: they create income inequality and a
concentration of wealth. The commercial bank and the capitalist agents are the major
beneficiaries of the three policies, being the only ones who can purchase green bonds and take
advantage of their increase in value. Fountan and Jourdan (2017) underline how also QE
undertaken by ECB helped the wealthiest agents with the increase in financial assets’ prices
and damaged lower-income households. Therefore, further research should focus on the
elaboration of a tax system that could reduce the damaging distributive effects of GQE.
3.3.2 Carbon Quantitative Easing
The second unconventional monetary policy discussed is Carbon Quantitative Easing (CQE).
The inclusion of policy in this dissertation represents an example of those radical models that
are being studied in this framework but whose theoretical assumptions have not been widely
validated yet.
It is a combined monetary-and-market policy theorized by Chen, van der Beek and Cloud
(2017) that presents original features never discussed before in the framework of climate
mitigation: a global carbon reward issued as a parallel currency to internalize the Risk Cost of
Carbon (RCC). The authors also call this policy Global 4C Risk Mitigation Policy (or Global
4C), however in this dissertation I refer to Global 4C as CQE for reasons of clarity.
The theoretical foundation of this model is the Holistic Market Hypothesis, which introduces
the RCC as the complementary cost of greenhouse gas emissions with the Social Cost of
Carbon (SCC). The latter is the traditional cost identified as the net present value of marginal
damages to society caused by an additional tonne of CO2 and is internalized usually by carbon
taxes or other fiscal policies.
25
Chen, van der Beek and Cloud (2017) also introduced the Total Cost of Carbon (TCC),
defined as the sum of these two components:
TCC = SCC + RCC (1)
where RCC is the market price of mitigation actions measured in US$ per tonne of carbon
dioxide equivalent (CO2-e) that can reduce climate systemic risk to a certain benchmark. As
the two externalized costs in equation (1) embody two different policy objectives, according
to Tinbergen’s Rule (1952), there must be as many tools as policy objectives. If equation (1)
is correct, then according to Tinbergen’s Rule, a single fiscal policy is insufficient to address
the whole climate change mitigation issue.
Chen, van der Beek and Cloud (2017) theorize the implementation of the CQE with the
introduction of a parallel currency named Complementary Currencies for Climate Change
(4C) as a global carbon reward and instrument to internalize the RCC into the economy.
This is a sort of positive carbon price, with an exchange rate managed by central banks over a
rolling 100-year planning horizon. The 100-year timeframe is needed because most of the
atmospheric CO2 concentration adjustment occurs about 100 years after CO2 emissions (IPCC
2013) and because it corresponds to the general horizon for the Global Warming Potential
(GWP) of greenhouse gases (IPCC, 2014).
The 4C currency will be issued for climate mitigation actions that include abatement,
reduction of emissions, and sequestration, taking carbon out of atmosphere. 4C will be
assigned to market actors who accomplish these objectives. It is measured in 100 kg of CO2-e
mitigated, while the RCC has units of US$ per tonne (1000 kg) of CO2-e mitigated.
Therefore,
4Ci(t) 0.10 x RCCi(t) (2)
where t is time and i is the year of the risk assessment. According to equation (2), a mitigation
of a tonne of CO2-e would imply the issuance of 10 units of 4C and an expansion of the 4C
money supply by 10 units.
For this reason, there is the need to quantify the ex ante RCC. To do so, there is a specific
annual risk assessment procedure proposed by Chen, van der Beek and Cloud (2017).
Before undertaking any risk assessments, an international agreement is needed to define the
policy objective. The objective will include a set of average global temperature rises, ΔTj, and
26
associated risk tolerance thresholds, Rj, in percentages, where j denotes the jth risk limit that is
proposed concurrently. For example, (ΔTj, Rj) could be set equal to (1.5°C, 50%) over the
rolling 100-year time horizon. The next step is to undertake the assessment of the Systemic
Risk of a Climate Mitigation Failure (SRCMF), for each ΔTj. After the SRCMF is estimated
for each ΔTj, the target mitigation rate, ΔQt, can then be estimated to reduce the SRCMF
values for each ΔTj to below the various Rj tolerances of the policy objective. Next, the RCC
can be estimated from the target mitigation rate, ΔQt, and a Systemic Risk Abatement Cost
Curve (SRACC) for international markets. The SRACC gives the average cost of mitigating
through abatement or sequestration of carbon using available technologies plus the cost of
administration - to meet the ΔQt target rate: this is the RCC.
The financial value of the 4C reward will be equal to the current exchange rate of 4C, and
market actors will receive the seigniorage income (SI) equal to the 4C exchange rate (USD
per 100 kg of CO2-e) multiplied by the mass of CO2-e mitigated, less administrative costs, μ.
SI = 4C(t) * tonne CO2-e mitigated μ (3)
The concept of seigniorage income is traditionally associated with the revenue made by
central banks when printing money and earning the face value of that money minus the cost of
physically producing it. In relation to equation (3), the concept of seigniorage income is
similar, but the income is given to market actors. An example is the seigniorage income of
Bitcoin mining given to the miners themselves.
The issuance of 4C would be connected to a measurement reporting and verification (MRV)
process to record mitigation services, and to determine how much 4C should be given to
market actors. 4C payments would be given conditionally on the fulfilment of service
agreements.
The institution needed to manage the 4C price and supply is called Carbon Exchange
Standard (CES), whose main duty is to set the “100-Year Advance Price Alert” (Figure 2)
and to coordinate the CQE amongst central banks. The policy approach is to incentivize the
demand for 4C according to its future yield Y4Ct expressed as a percentage, and defined
ex ante to be:
  
 (4)
The price of 4C would follow a path that ensures the target mitigation rate, ΔQt, is achieved,
whereby ΔQt is set by the risk assessment procedure of the CES. The 4C reward would
27
increase the profitability of low-carbon projects globally. During the phase of rising climate
risk, holders of 4C are in a similar situation to holders of green bonds because 4C has a
positive yield, defined by Y4C. Central banks guarantee to uphold the 4C prices for the 100-
year planning horizon to ensure a risk-free return for 4C holders. The main difference
between green bonds and 4C is that the trading of 4C currency is possible in small or large
quantities at low transaction costs, and 4C is available to the public and institutional investors.
A positive yield on 4C in the rising climate risk phase would generate a bull market in 4C
trading, while a negative yield would generate a bear market (Figure 3).
Figure 2: A hypothetical example of the ‘100-year Advance 4C Price Alert’ that discloses the global
carbon reward for climate mitigation. The 4C price reflects the Risk Cost of Carbon (reproduced with
kind permission of Chen, van der Beek and Cloud, in press).
Figure 3: A hypothetical example of the path of the yield based on the ‘100-year Advance 4C Price
Alert’. Positive yield corresponds to a risk-free return opportunity on 4C holdings. This is how climate
risk is priced into the global financial system (reproduced with kind permission of Chen, van der Beek
and Cloud, in press).
28
A key responsibility of the CES is to give instructions to central banks to coordinate currency
trading interventions to support the 4C price, so that the prices recommended in the 100-Year
4C Advance Price Alerts are achieved in the marketplace, with reasonable price stability. The
aim of the CQE is to peg the 4C price to mirror the RCC over the rolling 100-year planning
horizon. The combined role of central banks, under the instructions of the CES, is like that
seen with GQE: they will act as buyers of last resort whenever private demand for 4C is
insufficient to achieve the prices presented in the 100-Year Advance Price Alerts. Central
banks will retain their 4C purchases in holding accounts to ensure that 4C has scarcity and the
status of a currency asset.
The CES would coordinate CQE and 4C trading to apportion the financial contributions of
each national economy to achieve globally uniform changes in the floating exchange rates of
national fiat currencies. This would spread the cost of CQE as uniform monetary inflation,
ceteris paribus. This approach would negate the need for taxes to fund the 4C carbon reward.
4C would be a parallel currency for peer-to-peer exchanges and trading between national fiat
currencies. It could be an official currency with some national governments giving an
additional status for legal use in domestic trade or paying taxes. or just a digital token,
necessary to be exchanged for a national fiat currency before they can buy local goods and
services and it would not require legal tender status in any country. The world market for low-
carbon projects would perceive the 4C reward as a long-term stimulus package for abatement
and sequestration of carbon.
3.4 Additional Unconventional Monetary Policies
I have described two unconventional monetary policies based on quantitative easing with
different approaches to this instrument. However, there might be other monetary policies
under study to address climate change risks.
An example is Overt Monetary Financing (OMF), also called helicopter money, thus defined
by Milton Friedman, and proposed by Positive Money, an English research group focused on
promoting sustainable economy. Lord Adair Turner, former head of UK Financial Services
Authority, advocated the implementation of a Green OMF that focuses on UK and its
impending exit from European Union (Macquarie, 2018). In this scenario, the violation of the
article 123 of the Lisbon Treaty not binding out of EU - would allow the BoE to buy
directly debt bonds from the government and to finance its deficit. This policy is said to be
more beneficial during a recession where money finance would have greater impact than debt-
29
financed deficit spending and would be more effective than QE, given the absence of the
financial sector as an intermediary. Green OMF might take the shape of helicopter money
with direct distribution of new money to citizens or the use of new central bank money to
finance green public investments.
In the table below (Table 2), I summarize the green unconventional monetary policies
presented related to quantitative easing.
Monetary
Policy
Goal
Use of Money
Central
Bank
Balance
Sheet
Effect
Private
Sector
Balance Sheet
Effect
Counter-
policies
QE
Increase
asset prices
and lower
interest rates
to boost
investment
Injection of
new money into
financial
markets
Temporary
Boost private
sector income
increasing
corporate debt
Restrictive
monetary
policy selling
bonds to
private sectors
GQE
Finance
low-carbon
transition
and green
projects
Finance lending
for green
projects
Temporary
Boost green
investments
increasing
private sector
debt
Restrictive
monetary
policy selling
green bonds to
private sectors
CQE
Reward with
4C green
projects and
mitigate
climate risks
Management of
4C price with
injection of
liquidity
Temporary
Boost green
investments
without
increasing
private sector
debt
Restrictive
monetary
policy selling
4C currency in
Forex market
Green
OMF
Create new
money given
directly to
individuals,
or used to
finance
public green
investments
Provide them to
citizens or use
them to finance
public green
investments.
Permanent
Boost green
investments
without
increasing
private sector
debt
Reduction in
fiscal deficits;
increase in
bank reserve
ratios
Table 2: Types of green expansionary monetary policies described based on QE (Source: Author,
based on van Lerven (2016))
Expansionary monetary policies lower interest rates. This plays a critical role in the transition
to a low-carbon economy because of the impact that interest rates have for the implementation
of different energy technologies. This finding by Monnin (2015) is based on the ex ante
estimation of the levelized cost of energy (LCOE), the price at which a plant sells electricity
to break even, gauged in $/kWh. The comparison between green and brown LCOE shows that
30
in a low interest rates environment at most 2% - green energy technologies are more
competitive than brown because both minimum hydroelectric - and maximum - solar
technologies - LCOEs are less expensive than their brown counterparts, respectively nuclear
and gas-based fuel cell energy. As interest rates go down, competitiveness of renewable
energy technologies increases. However, green energy technologies have an estimated
elasticity to interest rates higher than brown ones. Therefore, they are subject to higher
volatility of their costs and this implies higher uncertainty in investment decisions, but more
benefits than with brown investments in a stable interest rates environment.
4. Macroprudential Regulation
The second major channel for central banks to respond to climate change risk is
macroprudential regulation. This refers to a set of policies that address the presence of
possible systemic risks in the financial system; its objective is to preserve financial stability
and the resilience of the financial system (Kohn, 2015). ECB (2018) provides three different
dimensions that macroprudential policies should approach: (i) time, (ii) cross-section, (iii)
structural. The aims of these policies are, respectively, preventing the accumulation of
excessive risk due to market failures and external factors, preserving the resilience of the
financial system and narrowing domino effect, encouraging economic agents to have a
holistic view of financial regulation.
Policy tools labelled as macroprudential regulation can be capital and liquidity requirements,
ceilings on credit growth and changes in the structure of specific markets. In some countries,
it is also possible to modify legal terms of lending, hence affecting intermediary costs and
availability of credit (Kohn, 2015).
Climate change might create a systemic risk to financial stability and the credit worthiness of
a carbon-intensive credit might threat the stability of the financial system at a macroprudential
stage. For these reasons macroprudential policies might be considered to safeguard financial
stability.
In the Euro-Area, ECB and ESRB oversee the implementation of macroprudential policies.
The latter has published a report (ESRB Advisory Scientific Committee, 2016) in which it
argues the possible responses to address climate systemic risk and distinguishes them between
short-term and long-term policy responses.
The first scenario involves an improvement in collecting information and disclosure to
increase public awareness about the threats that climate change can pose to the financial
31
system. This direction has been already undertaken with the establishment of the Task Force
on Climate-Related Financial Disclosure, discussed above. A directive from the EU (Directive
2014/95/EU) is also pursuing this direction. Large public-interest entities (enterprises with
more than 500 employees on average) should disclose
“environmental matters, details of the current and foreseeable impacts of the undertaking's
operations on the environment, and [on] the use of renewable and/or non-renewable energy,
greenhouse gas emissions, water use and air pollution.”
(Sect. 7 of the preliminary articles)
Another short-term policy response suggested by ESRB is the inclusion of climate-related
prudential risks in stress tests when assessing risk. This would help to gauge different
financial instability scenarios and to measure the exposure of financial institutions to carbon-
intensive assets.
With respect to medium-term policy responses, the ESRB advances three main categories of
macroprudential policies to mitigate systemic financial risk and its impact on financial system
and credit exposure:
Building up countercyclical capital buffers
Adding capital overloads on highly carbon-intensive of individual exposures
Setting exposure limits to investments in assets considered very sensitive to a sudden
transition to a low-carbon economy.
The focus of the dissertation is on the first category of macroprudential tools, introduced as
part of a wider set of capital buffers by the EU’s Capital Requirements Regulation and Capital
Requirements Directive IV, described by the Directive 2013/36/EU.
This tool addresses the first of four intermediate objectives set by the ESRB (2014) to prevent
or mitigate systemic risks for financial stability, namely (i) excessive credit growth and
leverage; (ii) excessive maturity mismatch and market illiquidity; (iii) direct and indirect
exposure concentrations; (iv) misaligned incentives and moral hazard.
A macroprudential tool that found a concrete implementation in Lebanon (Banque du Liban,
2010) is the reduction of obligatory reserve requirements on loans for low-carbon projects.
These ratios are obtained by banks’ reserves over the stock of deposits. Lower reserve ratio s
would allow commercial banks to increase their lending towards low-carbon sector, favouring
green investments. Campiglio (2015) underlines the implementation of this policy in an
32
emerging economy where central banks can directly intervene on private banks’ lending
dynamics, while in developed countries the only monetary instruments are interest rates.
People’s Bank of China (2016) is another central bank that has recently applied reserve
requirements as monetary policy tools different than interest rates.
The safeguard of the financial stability and the resilience of financial markets are an objective
of Basel III Accord of 2013, formulated by the Basel Committee on Banking Supervision, that
for this reason introduced specific standards for the liquidity of the assets of the banks and for
the regulation of their capital (BIS, 2013). The regulation, however, does not consider climate
risk as a threat for banks’ capital and financial system and this might dampen the transition to
a low-carbon economy, setting a reduction in banks’ long-term financing. Liebreich and
McCrone (2013) point out that green projects would be the most harmed because of their high
initial costs and need for long-term credit, despite lower operating costs than carbon-intensive
investments. The perception of green investments as too risky, illiquid and long-termed might
be a reason of the limited credit flowing to low-carbon sectors.
Among the three pillars of the Basel accord, the first concerns capital requirements and it is
discussed in the following section. Pillar 2 risk management and supervision might give
room for the integration of environmental risks perhaps through stress tests; Pillar 3 market
discipline might be enhanced with standard requirements for sustainability disclosure.
4.1 Differentiated Capital Requirements
Pillar 1 of Basel III addresses microprudential regulation and supervision in terms of quality
and level of capital for example by raising common minimum equity and a capital
conservation buffer of risk-weighted assets - and it also introduces a new macroprudential
category of capital requirements, countercyclical capital buffers. These should help mitigating
risks associated to excessive credit growth and they are used to oppose procyclicality in the
financial system due to overgrowth of credit. Their role is to dampen the financial cycle and
stabilize the financial system, for this reason they are built up during the financial boom and
drawn down during the bust (Borio, 2014). The introduction of countercyclical capital buffers
would reduce the risk that, during potential credit crunches, regulatory capital requirements
limit the supply of credit causing additional credit losses in the banking system and even
lower performances of the real economy. Hence, the tool would be more effective if the
impact of excessive credit growth for carbon investments was system-wide, in a similar way
to what happened for the housing sector.
33
Adjusting capital requirements to include environmental factors would mean setting higher
requirements for loans on carbon-intensive investments and would increase the cost of
lending to carbon-intensive projects for banks that would therefore be incentivized to lend
relatively more to low-carbon firms. The issue stands in finding the right balance in the
implementation of this policy for the adequate provision of loans of both kinds by the banks.
Monnin (2018) highlights the benefits of this policy that would increase the resilience of the
financial system through the introduction of capital buffers to catch climate-related risks and
it would also give an incentive to banks to change the mix of loans aligning it with low
greenhouse gas emissions target and the objective of a low-carbon transition. This change in
macroprudential regulation would clearly state the intention of financial entities of moving
towards greener finance. The interim report of the EU High-Level Expert Group on
Sustainable Finance (2017, p.32) shares this position stating:
“A ‘brown-penalising’ factor, raising capital requirements towards sectors with strong
sustainability risks, would yield a constellation in which risk and policy considerations go in
the same direction. Moreover, it would be […] easier to [capture] the risk of sudden value
losses due to ‘stranded assets’.
Van Tilburg and Boot (2017) highlight that the inclusion of climate-related risks among the
risk weights for determining capital ratios would make brown investments less attractive for
financial institutions. This reasoning seems to support the idea of increasing capital
requirements for carbon-intensive investments rather than lowering those for low-carbon
projects.
There is empirical evidence (Budnik and Kleibl, 2018) that supports the idea that higher
capital requirements would limit credit growth and dampen risks for financial stability. For
this reason, Bangladesh Central Bank is establishing 5% of banks’ loans to be allocated to
green projects that include renewable energy technologies, energy efficiency and waste
management and the Financial Service Authority of Indonesia is also working towards the
reductions in capital provisioning for green lending (UNEP Inquiry, 2015).
5. Discussion
The dissertation described the main features of the debate around the challenges that central
banks face in mitigating climate-related risks. Monetary policies and macroprudential
regulation were examined as policies that central banks could implement for managing
climate systemic risk. Following on from previous sections, I discuss these policies in terms
34
of their qualitative features, and their strengths and weaknesses. In section 5.2, I explain my
proposed taxonomy for defining the role of central banks when responding to climate risks
and for financing a low-carbon transition.
5.1 Analysis
The first policy analysed is Green Quantitative Easing. Due to the current low-interest rates
environment and inflation targets of major economies, many central banks have considered
large-scale asset purchases. The injection of liquidity in the economy had skewed effect by
favouring carbon-intensive sectors of the economy, as revealed by scholars (Matikainen et al.,
2017) who also suggested the revision of this policy, prioritizing purchases of low-carbon
assets. These policies might have the unwanted effect to expose public and private
investments to stranded assets risk.
It is noteworthy that this risk does not involve only a low-carbon transition but is a sort of
trade-off. The objective of fiscal regulation aimed at reducing carbon emissions is to
internalize the negative externality. Therefore, the carbon tax should equal the SCC, foreseen
to increase substantially in the next 100 years, to maximize economic welfare. In this sense,
the goal of any regulation is to make coal and oil gas enough expensive to discourage their
use. This would imply the raise of the risk of stranded assets. If we aim to reduce carbon
emissions, whatever regulation might be applied, we will need these materials to be unusable
and thus stranded.
The second policy presented is Carbon Quantitative Easing. This policy is socially justified
with the Beneficiary Pays Principle, whereas the standard carbon tax is justified with the
Polluter Pays Principle. The disclosure and information gathering and sharing of CQE would
be at its maximum due to the implementation of an internet-based public ledger. The action of
central banks would occur with the control of the 4C price and yield using currency
interventions. These central bank actions would improve the profitability of green projects
and this would incentivize market actors to invest in green projects. As in the case of GQE,
this would create new green jobs, decrease unemployment and therefore incentivizing cleaner
economic activities through new infrastructures and R&D.
CQE presents some unique features in the implementation of blockchain technology. The
blockchain is a safe distributed public ledger that controls individual 4C accounts and
transactions to guarantee the protection of individuals. Blockchain technologies of a similar
nature, are currently being used by at Sweden’s Riksbank to implement digital money called
35
e-krona. Another example is the referendum held in Switzerland in June 2018, which referred
to using digital money at the Swiss National Bank.
Both GQE and CQE involve the expansion of money supply and trading of securities (i.e.
green bonds and 4C) in open market operations (OMO). I describe 4C as a “security” and not
a regular “cryptocurrency”, which is sometimes classified as a commodity. The major
difference between GQE and CQE is the type of security being traded: green bonds are
financial assets, while 4C is a special type of currency that has a managed yield as part of an
internationally coordinated monetary policy. Another difference is that 4C is very liquid, has
no limitations for maturity and can be traded in any amount very cheaply in foreign exchange
currency markets. The administrative costs for 4C trading are negligible and traders can buy
or sell 4C at any time. The high liquidity of 4C will make it attractive to institutional investors
and currency traders. On the other hand, GQE is based on green bonds that have maturity like
traditional bonds, ranged between 3 and 25 years, typically with maturity of 7-8 years (Ehlers
and Packer, 2017).
A requirement for GQE will be establishing standards for green bonds, so that central banks
can assess the value of green bonds based on the benefits of low-carbon projects. Similarly,
standards are needed for the allocation of 4C currency to market agents. For this reason, the
new Carbon Exchange Standard institution is recommended with the introduction of CQE.
4C would provide a clear and transparent accounting system as the supply of this currency
would equal the total mass of carbon that has been mitigated, like a gold-backed currency
represents the amount of gold held in reserves; differently, green bonds do not underpin
transparent carbon accounting.
GQE and CQE differ from green OMF and helicopter money, according to which printing
money and giving it to citizens can be done to boost the economy. They also provide an
ability to stimulate the economy, especially during a recession and when there is a need to
boost consumer demand.
A challenge that GQE might face is the involvement of private sector in investing in low-
carbon projects and moving large quantities of capital from carbon-intensive to green sectors,
that do not have standard risk profiles. This challenge would be overcome in CQE where 4C
succeeds in attracting private money and mobilising finance into low-carbon projects because
of the 4C bull market with a positive yield, Y4C. This model might work more efficiently
than just relying on central banks for the creation of new money with regular QE.
36
An alternative implementation of green OMF would concern the creation of public green
investment banks or funds, as it already happened in UK with the Green Investment Bank.
However, this possibility already showed its limits as this institution has been privatised in
2017, five years after its launch. The creation of this institution was in line with the proposal
by Richard Werner (2012), who recognized the failure of QE in UK that did not boost
spending, but contracted lending. He suggested the allocation of public money into low-
carbon projects through the purchase of equity underpinning these projects issued by an entity
and guaranteed at no cost against default by the government itself. These projects would be
very productive, not inflationary, and would create new jobs and reduce climate emissions.
The sector bias of this policies would not be a real issue for central banks as seen in section
3.1.
Another issue that these policies might face is the hyperinflationary process caused by
excessive injection of liquidity. Like the risk of stranded assets, this argument would not be
specific of unconventional monetary policies. Climate change is the main cause of these
issues, and any kind of environmental policies would raise prices of carbon and derivates,
making them more expensive. There is evidence of this scenario in Canada with the
implementation of the carbon tax (Parkinson, 2017).
It would be interesting to study if the CQE might have remedy to the hyperinflation risk
communicating 4C prices 100 years in advance. Investors might plan their business strategies
and, trading 4C, they would diversify their portfolio out of fossil fuels and be also guaranteed
a return. This might safeguard them financially and at the same time finance a low-carbon
transition.
I have presented the harmful distributive effects in terms of income inequality and wealth
concentration for GQE and CQE. In fact, these policies might benefit respectively the holders
of green bonds and the investors in low-carbon projects rewarded with 4C. Income inequality
is currently a debated topic that would deserve a wider discussion. I limit myself to indicate
that the evolution of the actual society does not ensure any sort of income equality: the
world’s richest 1% holds more than half of global wealth. Therefore, I think that this critic to
GQE and CQE would go beyond the objective of environmental regulation. However, it
might be interesting to consider the fact that wealth of the poorest in emerging countries
consists mainly in natural resources: the inaction on climate change issues might undermine
even more their wealth with environmental damages.
37
Central banks will need to be more responsive and adaptive in their managing of price
stability, inflation, employment, as they will be juggling more objectives, including a low-
carbon transitions with GQE, and managing climate systemic risk with CQE. They will need
to consider the Tinbergen Rule in which each policy objective should be matched with a
unique policy tool. Similarly, for inequality, there might be the need to introduce another tool.
There are some other concerns that if solved might help to understand which policy would
be the most effective. First, there is discrepancy among practitioners whether a low-carbon
transition lacks funding demand or supply. The former means availability of funds and
investors willing to invest but absence of green projects, while the latter supposes profitable
green projects that cannot obtain funding. We can define GQE as a supply-side policy, while
CQE would match demand and supply, rewarding who undertakes green projects.
The second issue distinguishes between a lack of debt capital and equity of green projects. In
the latter case, an increase in the provision of debt capital by the European Investment Bank
(EIB), in the Euro-Area, would not be helpful. GQE is mainly based on debt capital, through
the issuance of bonds, while CQE and OMF are policies premised on equity.
Moreover, a better understanding of institutional capacity should be needed. In 2015, the EIB
lent €77.5 billion: less than the €80 billion that ECB had been injecting into financial markets
every month. The EIB devotes at least 25% of its lending to climate mitigation projects (EIB,
2016). This is relevant for GQE because EIB has already issued green bonds and the Public-
Sector Purchase Program (PSPP) undertaken by ECB includes bonds from international
institutions, like EIB. In this sense, an indirect implementation of GQE might have already
occurred and a further regulation of the issuance of green bonds by this authority could boost
this market.
The third type of policy concerns macroprudential regulation aligned to environmental and
sustainability goals for the transition to a low-carbon economy. This is perhaps the policy
most likely to be implemented because there are real-world examples and because these
policies are more conventional and are covered by existing central bank mandates. An
example of macroprudential regulation is given by the Banque du Liban (2010) that reduced
the mandatory reserve requirements on loans by an amount equal to 100-150% of the loan
itself for green projects, related to energy savings, renewable energy or aimed to abate
pollution or improve recycling. This is not the only case: Banco Central do Brasil (2011)
required commercial banks to include the evaluation of social and environmental risks arising
from their activities when computing their capital needs. Moreover, People’s Bank of China
38
(2018) has in its plans the inclusion of green financing in its macroprudential assessment
framework.
Referring to macroprudential regulation, Campiglio et al. (2018) point out two major
challenges that this might face. First, climate-aligned prudential policy would not work if
applied to commercial banks’ exposures to entire productive sectors, as it would not be able to
discriminate between carbon-intensive and low-carbon investments within the company. The
second challenge is that estimating the capital requirements of banks based on the greenness
of specific investment projects might overburden banks with assessment exercises they are
not familiar with. Also, macroprudential regulation will need to be international, otherwise
carbon-intensive companies will seek finance from commercial banks and investors in foreign
markets, and this would bypass macroprudential policies. These challenges explain why no
examples of such macroprudential policies in developed economies were found. It appears
that there is need for quantitative macroeconomic modelling of macroprudential regulation to
investigate how they could manage climate and financial systemic risk.
5.2 Taxonomy
The hypothesis of the dissertation is that a three-class taxonomy describes the policy positions
of central banks: (i) conventional, (ii) progressive, (iii) unorthodox. These positions are also
adopted by academicians in their research, as should be of interest to central banks and
financial regulators who may wish to align their environmental and financial governance
objectives.
(Position 1) Conventional
The conventional position assumes that governments will use fiscal policy to address climate
risk and damages, such as with Paris Agreement. The responsibilities and objectives allow
central banks to implement monetary policies and macroprudential regulation only for
managing financial systemic risk (not climate systemic risk). This mindset sees no change in
the central bank mandate regardless of the climate change problem. In this position monetary
policies are considered effective in the short run and focused on business cycles lasting two or
three years and not on financial cycles, as they should not be concerned by long-term
structural issues. The conventional point of view also envisages that low-carbon transition is
not part of the mandate of central banks. For this reason, decisions about the low-carbon
transition should be deferred to governments that should intervene with environmental
policies or regulations, providing infrastructure investments, or through the fiscal channel. A
39
leading example is the Scandinavian zone, where carbon taxes have been introduced in
Finland, first in the world, and Sweden, respectively in 1990 and 1991 (Akerfeldt and
Hammar, 2015).
(Position 2) Progressive
In the progressive position, central banks consider climate change within their assessment of
financial systemic risk, and this includes three types of climate-related financial systemic
risks: (i) physical, (ii), liability, (iii) transition. In the progressive position, central banks
respond to these risks using macroprudential regulation to safeguard and guarantee financial
stability. The progressive position is open to the possibility that central banks could use green
macroprudential regulations (but not green monetary policies) to manage financial systemic
risk and assist a low-carbon transition. In the progressive position it is assumed that climate
change can undermine financial stability.
There is some evidence of the progressive position by central banks and financial regulators.
Mark Carney, who introduced the tragedy of horizons, and other central bankers have
considered progressive policies. Other examples include Villeroy de Galhau (2018), Luigi
Federico Signorini (2017), Deputy Governor of the Bank of Italy, but also the Bank of
Canada (2017), the Deutsche Bundesbank (2018), and De Nederlandsche Bank (2018).
A notable example is given by the establishment of the Network for Greening the Financial
System in 2017 that reunites central banks and financial regulators from developed and
emerging economies. Currently, they are involved: the BaFin (German Financial Supervisory
Authority), Bank al Maghrib, Banco de España, Banco de Mexico, Bank of England, Banque
de France and the French Autorité de Contrôle Prudentiel et de Résolution, De
Nederlandsche Bank, Deutsche Bundesbank, Swedish Finansinspektionen, Monetary
Authority of Singapore, Oesterreichische Nationalbank, People’s Bank of China and, as
observer, Bank for International Settlements (BIS).
Included in this category are the scholars and international institutions who are investigating
the link between central banks and climate change.
Central banks’ growing awareness of climate change has only brought small policy changes
for the moment as in the case of Lebanon, Brazil, China and Bangladesh. I interpret that the
progressive position considers the role of central banks in the implementation of green
macroprudential policies and the integration of environmental, social and governance (ESG)
criteria into all kinds of investments. I also argue that the establishment of the Task Force for
Climate-related Financial Disclosures belongs to the progressive position.
40
(Position 3) Unorthodox
The unorthodox position embeds the most controversial policies that have been presented in
this dissertation: Green Quantitative Easing and Carbon Quantitative Easing. The main reason
why these policies are considered unconventional is because quantitative easing is normally
associated with fighting recessions and boosting investment and consumption, as in response
to the 2008 financial crisis. Quantitative easing is traditionally seen by central banks as a
cyclical tool that can provide temporary liquidity in the economy by lowering interest rates
and increasing the money supply, while CQE and 4C currency trading would be a long-term
strategy, based on “100-Year Advance Price Alert”.
Implementing GQE or the more ambitious and radical CQE might compromise the
objective of central banks mandates to safeguard price stability, however no quantitative
modelling or experience is available to comment on the effect on price stability/volatility
because of GQE or CQE.
Throughout the dissertation, I have provided two examples of policies that I label as
unorthodox. However, I do not exclude that scholars and policy makers might advance other
policies or models. These would be included in this category of the taxonomy if they involve
unconventional monetary policies or support the extension of central bank mandates including
the transition to a low-carbon economy and responsibility to mitigate climate change and its
systemic risk with repercussions in financial stability. An example is the briefly discussed
Green Overt Monetary Financing.
6. Conclusions
The dissertation has described the framework in which central banks could play a role to align
their objectives towards a low-carbon transition and the reasons why they might contribute for
the objective of managing climate systemic risk and financial systemic risk. I have discussed
the main features of monetary and macroprudential policies and advanced a taxonomy that
embeds three different mindsets on the potential role of central banks.
The table below (Table 3) summarizes my proposed taxonomy and defines objectives,
strengths and weaknesses for each position.
41
Positions
Policy
Definition
Objectives
Key Strengths
Weaknesses
CONVENTIONAL
Fiscal policy.
Government
regulations.
No role for central
banks
Maximize
economic
welfare,
internalize
negative
externality and
SCC
Unchanged central
bank mandates.
Globally accepted.
Does not comply
with Paris
Agreement goals.
PROGRESSIVE
Green
Macroprudential
Regulation.
Disclosure
Requirements
(FSB).
ESG criteria
Safeguard
financial stability,
undermined by
climate change;
manage climate
systemic risk;
assist a low-
carbon transition
Expands but not
alters central bank
mandates.
Real-world
examples (NGFS,
Carney, FSB,
Lebanon, Brazil,
China).
Tough
implementation in
developed
economies.
Partial resolution
of climate change
issues
UNORTHODOX
Green Monetary
Policies [GQE,
CQE, Green OMF
et cetera]
Mitigate climate-
related systemic
risks, support
low-carbon
transition and
encourage green
investments
Strongest results in
climate mitigation.
Creation green
jobs.
Decarbonization
asset portfolios.
Incentivizing smart
thinking and
policy modelling.
Non-neutral
policies.
Alteration of
central bank
mandates.
Multilateral
agreement for
international
implementation.
Table 3. Proposed Taxonomy of central banks’ role in managing the risks connected to climate
change. (Source: Author)
In conclusion, these policies raised challenges and issues. I have discussed the risk of stranded
assets for GQE and CQE, examples of green monetary policies. A relevant finding is that this
risk does not involve only policies that aim to a low-carbon transition, but I support the idea
that making assets stranded is also the objective of government regulation and fiscal policies
applied to this context. The fundamental tool for a correct decarbonization avoiding the
stranded assets risk stands in controlling for a smooth low-carbon transition without abrupt
changes.
The same issue involves inflation. A risk of any expansionary monetary policy is to cause
hyperinflation through excessive injection of liquidity. Carbon tax is not exempt from this risk
42
either and there is evidence of excessive inflation due to this policy in Canada. Cap-and-trade,
though, would adjust to inflation automatically with no need for regulators to intervene.
Last, I underline the necessity for GQE, CQE and macroprudential regulation to involve
private sector to let private capitals flow to low-carbon projects. To guarantee this, there must
be a multilateral agreement that rules out the possibility for investors to approach international
financial markets in their investment decisions.
7. Recommendations
The dissertation has presented an overview of the framework in which central banks might
operate to support a low-carbon transition and guarantee financial stability. However, there
remain some research gaps and policy questions that I will address.
First, I personally think that those who support the unorthodox position should set a
quantitative objective when modelling new proposals. Up to now, in this dissertation and in
the literature, the various interventions by central banks described have not defined specific
quantifiable objectives. Risk is the “effect of uncertainty on objectives” (ISO, 2009), therefore
I would recommend providing analytical targets for a low-carbon transition more concrete
than the aim of supporting sustainability” and “climate-aligned regulation” that I have
mentioned throughout the dissertation. The incorporation of climate-related risks in monetary
policies might occur through the reassessment of the structure of risk-returns, including
climate risks in credit ratings and in internal risk assessments. This would lead to the
implementation of sustainability criteria for asset purchase policies (Campiglio and
Monasterolo, 2018). An example of a risk-based objective for limiting climate systemic risk
has been provided by the theoretical background of CQE where there are set specific risk
tolerance thresholds and climate mitigation objectives considering Paris Agreement.
For the implementation of GQE, I integrate the guidelines of the Council on Economic
Policies, a Swiss think tank that advances policies to strengthen environmental sustainability,
and two academicians, Monnin and Barkawi.
They suggest that the implementation of GQE shall not involve only those central banks
interested in expanding their balance sheet, ECB and BoJ, but also those that want to keep the
size of their balance sheet intact and reinvest in new collaterals the revenues from the
maturing ones. Therefore, a deeper study of underlying market structures and targeted
refinancing lines would be beneficial for the implementation of similar schemes directed
towards low-carbon funding, perhaps offering them at discounted rates. This feature would be
43
particularly beneficial because renewable energy costs are more sensitive to interest rates
levels and a discount on green investments’ rates would be more efficient than a premium on
brown counterparts (Monnin, 2015).
From an overall perspective, the topic is still lacking coherence and systematic nature:
assessment of climate-related risk is not globally and conventionally defined and there is not a
real definition provided by accountable institutions for green bonds. I opted for the definition
of the Climate Bonds Initiative but it would be reasonable to expect one by an expert
multilateral institution of global governance. This would also help for a correct assessment of
asset portfolios.
In research field, I personally think that the development of an analytical model to define the
socioeconomic consequences of the policies discussed is a topic that requires further research.
The direction taken by the implementation of ABM and SFC models is perhaps correct as it
considers several channels and effects in credit market, real economy et cetera. Furthermore,
it allows modelling different climate scenarios considering the interactions among balance
sheets of the economic agents involved.
Last, I find necessary a lively debate about this topic among research community, financial
regulators and central banks to align research and policy efforts towards the same objective.
This should work in the direction of shortening the perceived long horizon of climate change
issue.
Central banks are fundamental in financial markets, as supervisory authorities and economic
agents. They have the tools to identify risks and shape the debate about unconventional
policies before realizing too late that climate-related risks do affect financial stability. To this
regard, there is the need of high-level policy coordination that involves monetary policy
working with fiscal policy and macroprudential regulation. Central banks must be brave
enough to do whatever it takes to manage the underlying risks to what is more than an
environmental issue.
1
1
[14,994 words]
44
Appendix
Data used in this dissertation is publicly available.
For the computations in Figure 1 I have used data from the ECB (2018). The classification of
economic sector is internal to ECB. CSPP holdings as at end of Q1 2018. Data excludes
bonds with remaining maturity below 6 months: for this and for rounding reasons, the sum is
not equal to 100%.
Economic Sector
CSPP Holdings
Utilities
15%
Infrastructure and transportation
11%
Automotive and parts
9%
Telecommunications
9%
Energy and basic resources
6%
Real estate
6%
Construction and materials
6%
Beverages
6%
Technology
5%
Health care and life science
5%
Chemicals
5%
Food
4%
Insurance
3%
Other sectors
9%
For the computation of greenhouse gas emissions (CO2, N2O in CO2 equivalent, CH4 in CO2
equivalent) in Europe in 2016, classified by sector, I have used data from Eurostat (2016).
Sectors are classified according to the NACE classification, proposed by European
Commission. Using the NACE sectoral breakdown, I attempted to build a link with the
internal sector classification provided by ECB above. I assumed the matching between boxes
highlighted in yellow above utilities, infrastructure and transportation, automotive and parts
- and those highlighted in yellow below (NACE Code: C29; C30; D; E; H).
NACE (Code Label)
Greenhouse gases (in tonne)
A- Agriculture, forestry and fishing
534.586.391,92
B - Mining and quarrying
77.860.862,01
C - Manufacturing
840.971.066,3
C 19 -Manufacture of coke and refined petroleum products
142.919.192,6
C 20 - Manufacture of chemicals and chemical products
152.602.534,57
C 29; C30 - Manufacture of motor vehicles, trailers, semi-trailers and
of other transport equipment
12.495.665,46
D - Electricity, gas, steam and air conditioning supply
1.098.083.546,14
E - Water supply; sewerage, waste management and remediation
activities
161.564.425,09
45
F - Construction
57.811.284,18
G - Wholesale and retail trade; repair of motor vehicles and
motorcycles
77.391.486,34
H - Transportation and storage
503.630.311,73
I - Accommodation and food service activities
18.598.937,77
J - Information and communication
10.346.281,06
K - Financial and insurance activities
7.035.014,1
L - Real estate activities
5.830.066,52
M - Professional, scientific and technical activities
19.439.533,18
N - Administrative and support service activities
23.549.820,72
Q - Human health and social work activities
30.093.334,93
R - Arts, entertainment and recreation
7.145.887,39
Total sum of greenhouse gases emissions (in tonne)
3.473.938.249,38
Sum of NACE sectors C29; C30; D; E; H (in tonne)
1.775.773.948,42
Ratio
0,511170269
46
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