25.02.2020
Economic and financial policy geared to climate goals
Club Español de la Energía
Pablo Hernández de Cos
Governor
Ladies and gentlemen, good morning.
I should like to thank the organisers and, in particular, the President of the Club Español de
la Energía, Miguel Antoñanzas, for the invitation to participate in this seminar on such an
important subject as sustainable financing for climate goals. Climate change and the
transition to a more sustainable economy are undoubtedly becoming one of society's main
concerns. One of the reasons for this is that the impact of this transition will affect virtually
every social and economic agent. The financial sector is no exception to this. Nor obviously
is the energy sector.
In my address today I wish to focus on three specific questions related to this issue. First, I
will propose some basic principles which, in my opinion, should inform the economic policy
deployed to guide the process of structural change entailed by the transition to a more
sustainable economy. Second, I will describe the challenges that climate change and this
transition pose for supervision and financial regulation. Finally, I will discuss what central
banks can do to encourage the transition to a more sustainable economy. In particular, I
should like to dedicate a few words to the role that monetary policy can play in achieving
this objective.
General principles that should inform economic policy in the face of climate change
The optimal economic policy strategy to guide the transition to a more sustainable economy
requires striking a balance between, on one hand, encouraging decisive action before it is
too late and, on the other, mitigating the social costs associated with the transition process.
And this requires an appropriate sequence of measures to be adopted. "Early"
intervention would mitigate Mark Carney's "tragedy of the horizon".1 But, there is no way of
hiding that this strategy also comes at a cost, since the economy would have to go through
the process of becoming more sustainable with current technology. This would make it
impossible to exploit all the potential cost savings and effectiveness improvements of future
innovations that are currently not available, but would be if the timing of measures was more
orderly and less hasty.
With regard to this balance between speed of action and the costs associated with the
transition process, the European Union as a whole appears to have decided to take the lead
on early action.2 In the case of Spain, some sociological studies3 suggest that most of
society is aware of the risks of failing to act and seems to be prepared to accept some of
the possible costs that may arise from starting to intervene now. That said, this is a collective
decision that can only be legitimately taken by our political representatives. Governments
and parliaments, as guardians of the public's trust, have the necessary legitimacy to set the
path for this transformation process. And, moreover, they have the most appropriate
instruments to make it happen. Specifically, within the ambit of public policy, fiscal policy
can and should play a leading role in the management of the transition to a more
sustainable economy.
Indeed, from the standpoint of economic theory, the origin of the problems associated with
climate change is clear: economic agents pursue their activity taking into account only their
private benefit or cost, while ignoring the social cost (in this case, environmental) that they
generate. As a result, the emission into the atmosphere of greenhouse gases exceeds the
socially optimal level. This is what is known in the economic system as a negative externality
which needs to be internalised. The traditional answer provided by economic theory to this
type of market failure is none other than "Pigouvian taxes" which equalise marginal private
and social costs and cause emissions to be reduced to their socially optimal level.4
However, as we all know there is a big gap between theory and practice and, moreover, the
"devil is in the detail". This is true not only of the most technical matters, but also of the
political ones. Deciding, for example, how to use the revenues raised is of crucial importance
to the success of the transition to a more sustainable economy. This is so both from an
economic perspective, promoting technological innovation and the adoption of clean
technologies, and also from a social perspective, compensating the losers in the transition
process. I will be referring to this issue later on.
In my opinion, fiscal policy should play a leading role in the management of climate change,
to deter the most environmentally damaging activities and to stimulate the investment
needed to develop cleaner technologies and, also, to alleviate the social costs of the
transition.
This is the thrust of various initiatives currently under discussion. For example, those that
seek to reconsider or supplement the EU emissions trading system (EU ETS) so that the
price of carbon approaches that consistent with the Paris agreements. And, likewise, those
designed to reduce environmentally harmful subsidies (EHS).
At the same time, we should not forget the truly global dimension of the climate change
challenge. This underlines the importance of policy coordination at international level
for effective reduction of greenhouse gas emissions and to reduce the magnitude of
the transition costs. Obviously a world with differing sensibilities and environmental
policies poses significant challenges. In particular, there is a risk of a significant "carbon
leakage" towards countries that decide to adopt a more gradual transition path. Also, in the
absence of sufficient coordination, there is a risk that unilateral measures may hamper trade
and the functioning of the world economy, with the consequent loss of global welfare.
In this respect, in the sphere of central banks and bank supervisors, I wish to highlight the
coordination carried out by the Network for Greening the Financial System (NGFS), which
the Banco de España joined in 2018. Meanwhile, the Basel Committee on Banking
Supervision, which I have the honour of chairing, decided last October to commence work
on the financial risks associated with climate change, while the Single Supervisory
Mechanism has decided to include climate risks in its Risk Map for 2020, the basis for
defining supervisory priorities.5 Also of note is the work carried out by the Financial Stability
Board (FSB) to promote the publication by businesses of consistent and comparable
financial information relating to climate change.6
Apart from international coordination, a high degree of coordination between the various
economic policies is also fundamental. Allow me to illustrate this with an analogy,
particularly relevant to the Banco de España and the Eurosystem.
As we all know, the European Central bank (ECB) has in recent years been implementing an
expansionary monetary policy to achieve its inflation target, and thus support economic
growth in the euro area. We on the Governing Council of the ECB have always insisted that
the effectiveness of our measures would be increased if they were complemented by a more
expansionary fiscal policy (where the margin exists) or an ambitious structural reform
agenda.
The situation of climate policy is similar. The necessary investment for the technological
transformation required in our economy will hardly take place if financial conditions are not
favourable or the regulatory environment penalises competition or innovation. Later on I will
refer to the role that can be played by the financial sector and also by supervisors, regulators
and central banks.
For appropriate economic policies to be designed and implemented in the climate sphere it
is also essential to understand that, in the transition to a more sustainable economy, there
will be individuals, sectors and even countries whose welfare will inevitably be reduced (at
least during the phase of transition to a new stationary state).
Our responsibility for economic policy means we must properly identify those who are
most likely to become "losers" and to take measures to mitigate the net negative
impact on them of the transformation into a more sustainable economy.
To illustrate this, let me use an example that I have referred to on other occasions:7 the
globalisation debate. From the standpoint of economic theory there is little doubt that
international trade has a net positive effect on the level of activity and global welfare.
However, we know that in reality this is so when we compare aggregate aspects of the
economy in two different equilibria, one with little international trade and another with a high
level. However, as Professor Alan Blinder reminds us, we need to pay attention to the
transition costs of the reforms and not only their long-run effects, and to analyse the
redistributive implications, as well as the impact of policies on efficiency.8
The fact that economists and economic policymakers have underestimated the importance
of communicating and mitigating the adverse effects that the transition to a more globalised
economy were going to have on certain sectors of the population has been decisive in the
emergence of movements opposing this process. This error, the consequences of which we
are still suffering, should not be repeated in the case of economic sustainability.
The role of the financial sector
The process of transformation into a sustainable economy is somewhat similar to an
industrial restructuring. Some firms and sectors will have to reduce their size and be
restructured, while others will expand. For this to be possible, productive resources,
including financing, need to be reallocated. As a result, the financial sector has a
fundamental role to play in this process.9 Indeed, the sooner resources are reallocated,
the lower will be the costs of the transformation.
To put some figures on the table, the European Green Deal Investment Plan presented by
the European Commission10 aims to mobilise one trillion euro of sustainable investment over
the coming decade. It is worth asking if the financial markets are ready to contribute such a
large amount of funds.
What has been generated in recent years is a flourishing market for "green bonds", with a
primary market exceeding €250 billion,11 made up largely of private issuers.
Although these developments are promising they are not without problems. First, there is
no common denominator to determine which assets are entitled to the green label and
which are not. Private initiative provides a response in the form of market standards12 and
certifying companies, but due to their relative novelty, they still lack a sufficiently established
record and reputation. Also, given the rapid growth of this market, there is some concern
among issuers and investors about the possibility of greenwashing. Certain issuers may be
attempting to appear more conscientious in relation to climate change, for reasons of
corporate image and social responsibility, than their actions really imply, and this may
generate future reputational problems.
Especially useful for harmonising this market and avoiding these risks are the work
performed in the European Union on the adoption of a taxonomy for sustainable activities,
and the recognition of the importance of mitigation actions (investment to reduce the
emissions of the most polluting activities).
The second problem is the price that the markets assign to these assets and the
higher costs associated with their issue. The issue of a green asset involves additional
costs for the issuer, as it is necessary to hire a certifying company for the issue of the green
bond and to pass regular audits to be able to continue to use the label over the lifetime of
the bond. Thus, issuing a green bond will only be worthwhile for the issuer if it can sell such
bonds at a higher price than normal bonds. At the moment, this is the case, given that there
is a negative premium in their favour (greenium), which shows the greater appetite of certain
investors for these assets.
And the third problem arises from the limitations inherent in bond markets. Access to
bond financing, due to its high fixed costs, is restricted to issuers requiring large volumes.
It is currently unimaginable that SMEs or households would issue bonds to make the
transition towards a more efficient economy less based on greenhouse gas emissions. For
this transition to occur it is therefore necessary for a green credit market to be developed,
in which banks will have a fundamental role to play.
This is particularly important in countries like Spain, in which banks intermediate the bulk of
funds between savers and investors. For this purpose, it is crucial that banks include these
types of considerations in their analysis. Only in this way will they be capable of
incorporating into the prices of their products and services the risks associated with climate
change and, thus, helping to drive the process. As in any process of structural change, it is
not sufficient to identify the investments that are going to have to be made, but also the
opportunities that will doubtless arise.
Here, it is worth highlighting that the exposure of Spanish banks to the activities
potentially most affected by climate transition risks represents around 20% of their
total exposure to productive activity. Following the international financial crisis, these
exposures saw a smaller increase in default rates than the rest of the economy, even when
those activities at the epicentre of the crisis - construction and real estate activity - are
excluded. Moreover, these default rates have now returned to their pre-crisis levels, while
in other activities they have not.13
However, our analysis suggests the lower realised risk of those activities more exposed to
transition risks is, above all, a consequence of the fact that these activities are more
profitable than those of the economy as a whole. However, in a scenario of internalised
such costs, this profitability advantage and, therefore, the risk differential would
practically disappear. This needs to be taken into account by financial institutions when
they take their decisions.
Moreover, as in the case of any structural change, the past may not be a useful guide to the
future, so that different climate transition scenarios should be considered and their
implications analysed, irrespective of the behaviour of borrowers in the past. This is
precisely the main contribution of one of the macroprudential tools made available to
financial sector supervisors since the international financial crisis: stress tests. The
Banco de España, like other international supervisors, is developing the necessary
methodologies to perform this type of exercise for climate risks.
Developing these methodologies, however, is not without difficulty. First, there are
significant information gaps that need to be covered as soon as possible. On one hand,
only large firms have estimated their carbon footprints and practically none of these estimate
their footprint when the inputs incorporated into their productive process are included. On
the other hand, there is no centralised register of energy ratings of homes, the heating and
cooling of which accounts for around 25% of total emissions, these being the main collateral
for credit transactions through the creation of mortgages. These examples are just some of
the most notable difficulties involved in evaluating such risks. On balance, I consider that
supervisors can play an important role in this area by identifying and disseminating the
information necessary to assess the associated risks.
Second, the problem needs to be addressed at sector level, or even for each individual
borrower. Specifically, our risk assessment models must incorporate this sectoral
dimension and consider the potential reallocation of resources between activities,
sectors and businesses that will inevitably occur.14 The methodological difficulties
involved in incorporating these dimensions are significant.
Third, the time horizon of climate risks goes far beyond the two or three year one that
is traditionally the most relevant for monetary policy and financial stability. On this
issue, it is again important that we succeed in overcoming the "tragedy of the horizon." And
that we anticipate the materialisation of such risks.
In addition to this task of raising awareness and encouraging financial institutions to
incorporate climate risks into their analysis, the question sometimes arises as to whether
financial regulators should also study the possibility of introducing reforms to speed up the
process. In my opinion, financial regulation cannot and should not take the lead in this
process, and even less stand in for the possible inaction of other actors; its role must
be limited to accompanying the decisions taken by other authorities, which, as already
mentioned, have much more appropriate instruments for these purposes. Our
mandate, as financial regulators, is to safeguard the economy's financial stability and this
must be the fundamental objective.
In fact, if the - basically fiscal - measures implemented by governments are sufficiently
successful the role of regulators and supervisors should largely be to ensure that
financial institutions properly incorporate the impact of such measures into their risk
analysis. That said, many of the models used by institutions to evaluate risks are based on
historical data, which, by their very nature, will take a long time to incorporate the changes
that occur. Stress tests may be very helpful here and supervisors could develop action
guidelines as a reference for institutions.
The role of central banks and monetary policy
The general public currently have rather high expectations regarding the role that central
banks can play. An example of this is the press conference held following the meeting of
the Governing Council of the European Central Bank in March. In her answers to journalists
questions, President Lagarde mentioned "climate change" up to ten times. In fact, one in
three of the questions asked related to this issue.15 In my opinion central banks should
contribute to this common purpose, insofar as this does not interfere with the Eurosystem's
primary objective, which is price stability.
Indeed, in the Eurosystem we have embarked upon a strategic revision of our monetary
policy. As part of this we intend to reflect on the way in which we can incorporate
climate risks and promote the sustainability of the economy.
For this purpose, we need, first, to improve our understanding of the implications of
climate change and economic policies designed to mitigate this phenomenon for the
economy as a whole and, in particular, for price stability. The overriding aim should be to
incorporate these implications into the economic analysis and forecasting tools on which
the decision-making process is based.16
In addition, climate risks (both physical and counterparty risks) may affect other elements
of monetary policy instruments and operations. In these areas, the main objective of
central banks should be to ensure, along with other public authorities, that markets
correctly address climate risk. Once this objective has been achieved, our monetary
policy collateral policies would immediately lead to an adjustment in the amounts that
counterparties can obtain.
These and other considerations must be analysed in the Eurosystem monetary policy
strategy review. However, while this review is carried out, we in the Governing Council of
the ECB are aware, to paraphrase President Lagarde that trickles become oceans if cared
for. In this respect, the Banco de España has already approved the incorporation of
sustainability and responsibility criteria into its investment policy for the reserve
portfolio it manages. As a result, and taking into account our mandate obligations, we are
progressively increasing our holdings of green bonds and, for example, we are one of the
founder members of the green investment fund set up by the Bank for International
Settlements.
Conclusions
In conclusion, the challenges associated with climate change require coordinated action,
both at international level and at the level of the various different economic policies. Allow
me to stress that it is governments who have the legitimacy and are best prepared to lead
the process of transformation to a more sustainable economy. Thus, fiscal policy should
play a leading role in this process, and also in the measures needed to mitigate the social
costs of the transition. In any event, the importance of the financial sector in channelling the
enormous funds needed to make the investments required by this transition and to identify
the opportunities that may arise in this process is unquestionable. We supervisors and
central banks must ensure that financial institutions properly incorporate climate change
risks and concentrate on creating the appropriate conditions conducive to the capital flows
needed for the transition to a sustainable economy.
Thank you very much for your attention.