City Week - London, 24 April 2023
The role of central banks in the "macroeconomics of climate change"
Speech by François Villeroy de Galhau,
Governor of the Banque de France
Ladies and Gentlemen,
It is once more a great pleasure and honour for me to give a keynote speech
today at the City Week in London, held in the venerable Guildhall. It is no longer
possible to seriously question the severe effects of climate change, but the role
of central banks in this area has become an increasing focus of discussion. Let
me start by two very great temptations that have become typical pitfalls here.
Neither magic wand, nor ostrich policies
We could call the first of these the « magic wand temptation » in which central
banks are seen as being able to curb climate change on their own. I want to be
crystal clear on this: central banks cannot be the only green game in town, they
cannot replace sound public policies and corporate transition plans. One
necessary step for public policies is to put a price on carbon: it is the only signal
capable of aligning climate imperatives with economic agents' decisions. It is
the only way to make more green projects profitable; and green finance without
enough green projects risks running idle. It can take various forms, including a
carbon tax, in which case part of the resulting public receipts should be invested
in low carbon alternatives, and another part redistributed to households in order
to mitigate its social effects. A price on carbon should be supplemented with
other climate regulations and subsidies to help develop alternatives sufficiently
early.
The second and opposite temptation is that of "ostrich policies", which consist
of burying our head in the sand to avoid seeing or hearing what is going on. This
is not an option either. We are directly concerned, in two different ways [slide 2].
First as supervisors, insofar as climate-related risks are clearly among the long
term risks to which financial institutions are exposed: monitoring these risks is
not a "nice to have", or part of a CSR policy, but a "must have". Second, we are
concerned as central banks in charge of price stability. Just to clarify, we
shouldn't waste too much time here in the legal and political debate on central-
bank mandates. Central banks' core mandate worldwide is price stability, and
climate change already affects the level of prices and activity - think of severe
drought in Argentina which cost 3% of GDPi, of floods in Pakistan with losses
and damages equivalent to 8% of GDPii, or of the recent rise of food prices
everywhere -: hence we have to deal with the effects of climate change on the
economy. It's not mission creep, it's not a politicisation of our mandate, it is our
core business and core duty. As regards the Eurosystem, in addition to our
primary objective of price stability, it just happens that environmental protection
is among our secondary objectives: but this is only an icing on the cake, if I may
put it this way. So I would like to focus today on what I will call the
macroeconomics of climate change. I will not spell out everything we do as
supervisors: first disclosure of risks, climate stress tests at present and financial
institutions' transition plans tomorrow. I would instead like to talk about what is
at least as important - modelling the economic effects of climate change - but
about which we currently know less. I will first acknowledge a veil of uncertainty,
before nevertheless establishing four firm convictions.
A veil of uncertainty
As we try to understand and figure out how climate change will shape
macroeconomic changes, the "veil of uncertainty" is primarily due to future
political decisions regarding climate change mitigation. For instance the initial
level and evolution of a carbon price, or the amount of green investment and
public subsidies will be particularly relevant. This is why we are currently working
on several scenarios, both over short and longer term.
Six long-term scenarios, that is to say with a 2050 horizon (and even the end
of the century for some variables), have been developed and will continue to
evolve under the aegis of the Network for Greening the Financial System
iii
(NGFS) [slide 3 for a focus on 3 scenarios], to whose 144 institutions the
Banque de France provides its global secretariat.
The current scenarios, which are consistent with the various physical scenarios
of the IPCC, will soon be supplemented by a seventh scenario of "net zero 2050"
achieved through greater energy sobriety; the publication of the updated NGFS
scenarios is expected next autumn. In their current version, they are already
used by a great number of supervisors - the majority of the 36 jurisdictions that
have conducted a climate stress test (for instance France, the EU, the UK and
the US).
Our pilot stress tests also pointed to a need for shorter-term scenarios with a
five-year horizon as the transition is accelerating: the NGFS is currently
elaborating on them by leveraging the work of its Members, including by Banque
de France researchers iv. We at NGFS will publish a conceptual framework at
end of this year, and are aiming to release a first vintage of these short-term
scenarios by the end of 2024. In particular, they should display more adverse
developments, and incorporate tougher shocks. They should also be tailored to
explore the potential impacts of climate change, not just on activity but also on
inflation.
This quadrant [slide 4] shows four categories of possible shocks linked to the
transition.
They can have a positive versus negative impact on supply, and a positive
versus negative impact on demand respectively. They are not mutually
exclusive, and may combine or succeed one another. Their stand-alone
probability is hard to assess at this stage, but there are reasons to believe that
the upper-left one (the negative supply shock) is slightly more probable than the
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others. However, given the large range of shocks, their sources and
macroeconomic effects - which could include a positive scenario of large green
private capexv - [slide 5], we must continue our modelling, in line with our first
commitment in relation to the ECB's climate agenda: we committed in July 2022
to "assess the macroeconomic impact of climate change and mitigation policies
vi
on inflation and the real economy".
But being uncertain about the combined macroeconomic effects does not mean
being passive or inert on action now. What we can already derive from these
scenarios is a set of four firm convictions and prescriptions.
1. A shock that is global and certain >>> an orderly transition
- First, climate transition entails structural changes to the global economy
that are both universal and certain, with an overall and possibly negative supply
shock that will generate frictions and costs in terms of the necessary reallocation
of production factors. Climate change is comparable to globalisation as seen
several decades ago: we knew that it would have significant effects, inevitably
and everywhere, while not knowing their magnitude ex ante. This means we
should organise our transition to make it as early, predictable and orderly as
possible; this is not always an easy task in our democracies, but disorderliness
would be costly [slide 6]. According to NGFS scenarios, for the same Paris-
aligned emission reduction, a disorderly transition would imply a carbon price
more than three times higher by 2050 compared to an orderly transition with a
commensurate negative impact on global GDP. And for sure, the cost of inaction
would exceed the cost of transition.
As another consequence of this universal shock, we need to enhance
international coordination: as not all countries made the same commitments,
and face the same consequences and responsibilities, some could be tempted
by free-rider or "beggar my neighbour" behaviour. Hence climate change must
be the number one priority of the "focused multilateralism" I am calling forvii, be
it in the G20 or in the IMF and the World Bank.
2. Higher volatility >>> strong commitment of Central Banks
- Second, higher volatility is likely, which means shocks on both activity and
inflation. This is where we central banks have to do our job in order to maintain
a solid anchoring of long term inflation expectations despite higher volatility. We
cannot just look through it, since it is not an unexpected and transitory shock
[slide 7].
The impacts of the climate transition could last throughout the decarbonisation
of our economy. If we looked through it, we would overburden fiscal policy in
cushioning these shocks.
3. Market alignment >>> signalling through Central Banks' operations
- Third, appropriate market incentives are necessary. This is where carbon
pricing is needed, as I mentioned earlier, to align firms' behaviour and private
financing, but also (and maybe primarily) a fair pricing of climate risk on financial
markets. This is where central bank operations and their greening have a key
role to play, giving the right market signals and inducing changes. With Christine
Lagarde, we at the ECB are already implementing a greening of our corporate
sector purchase programme, as well as adapting our collateral framework.
4. Funding green investments >>> solvable through blended finance
- Last but not least, if these conditions are met, the question as to how to
finance investments is solvable. Different estimates have been computed, and
their amounts may look impressive especially when presented in gross and
absolute terms, for instance around EUR 500 billion per year in the EU until
2050.viii. However, when you consider net and relative financing needs, which
represent between 2% and 3% of current GDP be it for the EU or Franceix
according to the reports quoted, this turns out to be manageable. Under one
important prerequisite: the private sector should play its part in the effort, and
we should unlock cross border capital flows for the transition; this is the
strongest argument in favour of a Green Capital Markets Union, which I
advocated with my German colleague Joachim Nagel x). Except in 2022 and the
exceptional energy shock, the euro area had a structural excess of savings to
investment of 2% of GDP. Hence, provided we have the right economic
incentives, Europe can finance its ambitious climate transition; this final and
fundamental conviction is a good piece of news.
*
* *
Good news is also important in what could seem like an ocean of alarming
information on climate change. Our natural tendency to shut our ears when
faced with pessimistic announcements was best captured by Homer with
Cassandra. She repeatedly tried to warn that Troy would fall should they let
Ulysses' Trojan horse get into the city. I don't claim to be Homer or even
Cassandra. I tried this morning to sum up in a fair way what we know and don't
know yet about the macroeconomics of climate change, but above all what we
can and must do as soon as possible - we are already in "money time". I thank
you for your attention.
i
The cost of the 2022/23 drought already amounts to more than US$ 14.14 billion for soybean, wheat and corn
producers, Bolsa de Comercio de Rosario, 10 March 2023
ii
World Bank, Flood damages and economic losses over USD 30 billion and reconstruction needs over USD 16
billion, October 2022
iii
NGFS scenarios portal
iv
The English version of a recent publication will be available within the next few days; in the meantime, you
can refer to the French version of the Bulletin de la Banque de France n°243, Transition vers la neutralité
carbone : quels effets sur la stabilité des prix ?, 5 April 2023
v
Capital expenditure
vi
ECB Climate Agenda, 4 July 2022
vii
Villeroy de Galhau, F., How central banks should face instability and fragmentation, speech, 12 April 2023
viii
European Commission, « Fit for 55 impact assessment », Commission Staff Working Document,
no SWD(2020) 176 final, September 2020
ix
Pisani-Ferry (J.) and Mahfouz (S.), « L'action climatique : un enjeu macroéconomique », La note
d'analyse, no 114, France Stratégie, November 2022
x
Villeroy de Galhau, F., and Nagel, J., Fostering European unity: time for a genuine Capital Markets Union,
published in French in Les Echos and in German in Handelsblatt on 14 November 2022