Shall the ECB Be Painted Green?

ARTICLES - 4 February 2020

By Eric Chaney

Christine Lagarde was convinced even before taking office as President of the European Central Bank (ECB): the bank ought to be involved in the fight against climate change. It seems like a no-brainer. But a central bank is not an actor like any other. It acts on behalf of States that have delegated their responsibility over currency, according to the terms of a mandate. The ECB's mandate is to guarantee price stability and, subordinately, to support Member States’ economic policy. If this clause is generally understood as an objective of full employment, could it be extended to climate policy?

Since financiers and corporations are being urged to reduce CO2 emissions by many, why not include the ECB, a technical but nonetheless influential decision-maker? This deserves some thought, however. First of all, injunctions to economic decision-makers risk leading to politicians shirking their own responsibilities to actually reduce emissions. Secondly, if the ECB were to make a concrete commitment to help reduce emissions, it could be led to consider politically explosive decisions.

Are greening policies an excuse for not acting on the price of carbon?

The climate change we are currently experiencing is existential, to paraphrase Mark Carney's words. Reducing greenhouse gas (GHG) emissions, and doing so quickly in developed societies, are imperatives on which there is broad agreement, including in the United States. The vast majority of academic economists have agreed – for once – that the most efficient and least costly economic lever is setting a high and rising price on GHG emissions, we shall call carbon for simplicity's sake. The call by American economists (see their statement in the Wall Street Journal, 16 January 2019) as well as the Economists' Declaration on Carbon Pricing launched by the European Association of Environmental Economists chaired by Christian Gollier, and signed by 1,700 economists, go in this direction, including the principle of taxing imports’ carbon content. Specific proposals have been made to implement such a policy in the European Union, such as the creation of a Carbon Central Bank by Jacques Delpla and Christian Gollier, or a decentralized policy underpinned by the principle of subsidiarity (How Europe Can Lead the World to Reduce its Carbon Footprint, Institute Montaigne, January 2020).

However, political resistance to carbon pricing is strong, particularly in France. There is a strong temptation to rely on subsidies to renewable energies, despite the much higher costs than what carbon pricing would imply, as Christian Gollier shows in his excellent book Le climat après la fin du mois or Climate at the end of the month, as well as on calls for green finance including the ECB or corporate responsibility. The risk is that politicians, and ultimately voters, see this as a way of absolving themselves of their own responsibilities.

Let us distinguish three potential areas of intervention or reaction on the part of the ECB: supervision of banks, economic and monetary research, and monetary policy itself.

Aware of this risk, Benoit Cœuré, then member of the ECB's Executive Board, noted that influencing consumers and producers’ carbon choices was not a matter of monetary policy but of political responsibility, and that carbon pricing remained a first best option. He added that this did not preclude central banks from considering their own contribution (Monetary policy and climate change, Berlin 2018). To clarify the debate, let us distinguish three potential areas of intervention or reaction on the part of the ECB: supervision of banks, economic and monetary research, and monetary policy itself, including the choice of the financial assets it mobilizes.

Climate stress tests for banks and insurers? Patience!

Banking supervision cannot continue to ignore the ongoing climate crisis as it has, and will continue to impact increasingly the quality of the banking system's assets, that is, mostly its lending to the economy. The IMF has pointed out that the standard approach to financial risks does not reflect the negative risks associated with climate change or the positive risks associated with decarbonation activity, proposing that climate-related stress tests should be designed. Unfortunately, beyond a litany of calls for "green finance", a catch-all concept that everyone can adapt as they please, there is still a long way to go. For example, the European Banking Authority, which has the upper hand on banking regulation in the EU, has just published an action plan of which the first phase will be to analyze the risks created by climate change – it was about time! – with stress tests and a full report not due until June 2021. Better late than never, of course, but until the chief regulator has set the rules of the game, supervisors, starting with the ECB, will be on politically sensitive ground. Let us therefore not expect too much from this side, at least in the short term.

An ambitious research policy could inform decision-makers and public opinion

Economic and monetary research offers a more promising avenue, since it is not constrained by political considerations. Over the years, the ECB has built up a state-of-the-art economic and financial research capacity, thereby encouraging the development of such capacities within national banks, as shown by the Banque de France’s remarkable example. Both the ECB and national banks have taken up this task. For example, a recent research paper by Ralph de Haas and Alexander Popov ("Finance and Carbon Emissions", ECB WP No. 2318), examines the financing structure of companies in relation to the decarbonation objective and comes to the interesting conclusion that equity financing is more favourable to decarbonation than debt financing. This can probably be explained by the fact that shareholders, often pension funds that are sensitive to environmental and social issues, exert more effective pressure on management teams than lending banks can. The Banque de France’s Governor recently announced that his research teams are working on models to assess the impact of transition policies, such as carbon pricing, at the national or European level, in line with the DICE (Dynamic Integrated Climate-Economy), models developed by William Nordhaus since the 1990s.

The ECB should move up gears so that, as quickly as scientific rigor allows, it is able to estimate the impact on activity and prices, not only of climate change, but also of the various decarbonation policies, consistent with the EU's 2050 objective of neutrality. A real battle plan would be needed for this, because, unlike traditional economic modelling which can take the Euro area as a single block, climate shocks and decarbonation policies have both supranational, such as the market for CO2 emission rights (ETS), and national dimensions.

Climate shocks and decarbonation policies have both supranational and national dimensions.

There is an objective that matches Ms Lagarde's ambitions: aligning the ECB’s research efforts with those of national banks on the climate-economy link, allocating the necessary human resources and being demanding in terms of results. This would be a good way to enlighten and be heard by public opinion alongside political decision-makers.

Monetary policy in the face of climate shocks

That leaves monetary policy itself. Can it be used to tackle the climate crisis? Benoit Cœuré, in his aforementioned speech, had framed the debate well. Insofar as the climate crisis has economic and financial consequences, the ECB is by definition involved. As climate-related shocks, whether temporary (drought, floods, etc.) or permanent (increase in frequency and/or amplitude), are supply shocks, reducing or increasing the supply of certain goods or production factors via climate migration, they are difficult to tackle through monetary policy. While the central bank can accommodate a temporary shock – for example, a temporary price increase due to an exceptional drought should not trigger a monetary reaction – that is not the case for a permanent shock. Let us assume, for example, that growth is permanently reduced by climate change. In that case, the equilibrium interest rate anchoring monetary policy would itself be reduced, but at the same time prices would deviate from their desired path at a lower level of activity than before. Monetary policy can do little about supply shocks, be they climate related or otherwise, as Jay Powell pointed out in connection with the Trump administration's trade policy.

But what about the choice of assets that are mobilized for monetary policy, mostly sovereign and corporate bonds? Should they not favor climate-responsible corporate debt and punish those that are less so? Christine Lagarde, in calling for a clear nomenclature of assets according to their degree of climate-responsibility by the European Union, made it clear that the ECB would include these elements in its monetary policy operations, be they bank refinancing or balance sheet operations, alongside the traditional criteria of liquidity and risk. The ball is therefore in the political camp. And that is fortunate, because it is not up to the ECB to define these criteria. In its refinancing operations, or in its asset purchase programme, the ECB will incorporate green criteria to determine the choice of private debt instruments. As the ECB's assets are mainly government securities (such as 82% of the assets held in the asset purchase programme), the impact of this new policy will be, beyond the announcement effect, limited. That therefore seems to close the debate.

A "green discount" on public debt?

Does it really though? Christian Gollier often asks: when a motorist emits 32 kg of CO2 by consuming 10 liters of diesel, who is responsible? The company that extracted the oil, the refiner, or the consumer? Perhaps unpleasantly, the answer is that, in the end, it is the consumer. If we accept this analysis, the "greening" of the ECB's assets takes on a completely different dimension. Imposing penalties on the debt securities of an oil company, for example, seems no more justified than exempting the public debt of a country whose residents emit more CO2 than their neighbors. The logic of "greening" the ECB's assets, in refinancing operations for example, should thus lead to the application of a haircut to their country's debt securities, proportional to per capita CO2 emissions. Let us be practical. According to data from the Global Carbon Project, in 2017, Germany's per capita emissions, including those of imported products, at 10.8 tCO2 per capita, were 40% higher than those of Italy (7.7 tCO2), 52% higher than those of France (7.1) and 66% higher than those of Spain (6.5)! Let us imagine for a moment that a "green haircut" policy is applied by the ECB. By increasing the cost of financing the economy, it would create a strong incentive for voters and governments of the most polluting countries to adopt serious policies to reduce their emissions. Let us not dream too much nevertheless, this path would most likely come up against political deadlock.

In conclusion, the hope is for this mental experiment to help visualize that the greening of finance, including at the very source of liquidity, will not go very far in the path of reducing emissions. If we really want to change behavior, production and consumption patterns, we will have to come to carbon pricing, regardless of the source, whether domestic production or imports.