SPEECH
Monetary policy tightening and the green
transition
Speech by Isabel Schnabel, Member of the Executive Board of the
ECB, at the International Symposium on Central Bank Independence,
Sveriges Riksbank, Stockholm
Stockholm, 10 January 2023
1 ]
The green transition will fundamentally transform our societies.[ Protecting our planet requires
unprecedented large-scale investments in technical innovations and renewable energies to bring our
economies on a path towards net zero greenhouse gas emissions.
As our experience over the past two decades demonstrates, the relatively large upfront costs incurred in
these capital-intensive expenditures are particularly susceptible to changes in the cost of credit. Low and
declining interest rates have measurably contributed to the fall in the "levelised cost of electricity", or
2 ]
LCOE, of renewable energies.[ As a result, the cost of electricity from renewable sources is now
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comparable to, or lower than, that of conventional power plants.[
These developments now risk being reversed by the marked rise in global interest rates over the past
year. Since fossil fuel-based power plants have comparably low upfront costs, a persistent rise in the cost
of capital may discourage efforts to decarbonise our economies rapidly.
4 ]
Put simply, renewable energies are more competitive when interest rates are low.[ While simulations
suggest that the LCOE of a gas-fired power plant would change only marginally if discount rates were to
5 ]
double, that of offshore wind could rise by nearly 45% (Slide 2).[ Widening credit spreads may
exacerbate these effects in many developing and emerging economies.
The insight that the effects of interest rate changes are not symmetric across economic sectors is not new
6 ]
and it is empirically well-documented.[ The exceptionally high stakes involved in the green transition,
however, have sparked a controversial public debate about whether the current monetary policy tightening
may ultimately slow down the pace of decarbonisation.
Some argue that such tightening may even be inconsistent with the objective of price stability: unless
greenhouse gas emissions are cut rapidly, our economies will remain exposed to the risks of
"climateflation" and "fossilflation" - that is, persistent inflationary pressures associated with more frequent
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natural disasters and a continued dependency on gas, oil and coal.[
These concerns must be taken seriously. As they expose a potential dilemma directly relating to central
banks' primary mandate of price stability, we cannot ignore them on legal grounds.
It is therefore no surprise that climate change features prominently in a symposium on central bank
independence. Independence grants central banks significant leeway in their actions. But it also requires
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central banks to be held accountable - a point that Stefan Ingves highlighted in a speech last year.[ We
need to justify the course of action that we consider as most appropriate in achieving our mandate.
This is what I intend to do in my remarks today. I will argue that failing to arrest high inflation in a timely
manner would jeopardise the green transition more fundamentally, and that a restrictive monetary policy
stance today will benefit society over the medium to long run by restoring price stability.
I will also stress that fiscal policy needs to remain in the driving seat and accelerate the green transition,
and that the decline in the ECB's balance sheet as part of our monetary policy tightening requires us to
make additional efforts to align our actions with the objectives of the Paris Agreement.
Green transition can only thrive with price stability
Over the past year, we have moved forcefully to contain inflation by first stopping net asset purchases and
then by raising our key policy rates by a cumulative two and a half percentage points. We have also
announced that the Eurosystem will no longer reinvest all of the principal payments from maturing
securities in the asset purchase programme (APP).
We judge that interest rates will still have to rise significantly at a steady pace to reach levels that are
sufficiently restrictive to ensure a timely return of inflation to our 2% medium-term target.
As interest rates rise, financing investments in green technologies will become more expensive,
generating the risk that higher costs of capital may slow down the pace of decarbonisation. There are,
however, three interrelated reasons why tighter financing conditions are the appropriate response to the
challenges we are facing today.
First, current high inflation is a tax on investment. In many countries, it raises the user cost of capital by
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raising the effective tax rate on business investment.[ High inflation also increases uncertainty and
distorts relative price signals relevant for investment decisions. And it may slow down productivity growth,
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as occurred in the United States in the 1970s.[
Therefore, the green transition would not thrive in a high inflation environment. Price stability is a
precondition for the sustainable transformation of our economy.
Second, inflation will not subside by itself.
What started as a relative price shock has gradually morphed into a broad-based increase in the general
price level. Preliminary inflation data for December point to a persistent build-up of underlying price
pressures even as energy price inflation has started to subside from uncomfortably high levels.
To resolve today's inflation problem, financing conditions will need to become restrictive. Tighter financing
conditions will slow growth in aggregate demand, which is needed to reduce the upward pressure on
prices that has resulted from the long-lasting damage to the euro area's production capacity inflicted by
the energy crisis.
By bringing aggregate supply and demand back into balance, we will accelerate the process by which
inflation will fall back to our 2% target and thereby ensure that longer-term inflation expectations remain
anchored.
Third, the experience of the 1970s shows that a policy that is falsely calibrated on the assumption that
inflation will decline by itself could ultimately put the green transition more fundamentally at risk.
In this case, monetary policy would need to raise interest rates even more forcefully to restore trust in the
economy's nominal anchor. In the 1970s, financing conditions tightened to an extent that made capital
accumulation prohibitively expensive.
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Our current policy is calibrated to avoid such very bad outcomes.[ A determined reaction to the risk that
inflation may become entrenched not only safeguards price stability but also provides the conditions under
which the green transition can thrive sustainably.
Indeed, while the cost of credit has become more expensive because of our actions, financing conditions
remain favourable from a historical perspective. Measures of real long-term interest rates, for example,
which matter most for green investments, remain low in historical comparison (Slide 3).
Accordingly, a large majority of leading climate economists polled last year see only a mild or very mild
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impact of rising borrowing costs on the transition to net zero emissions by 2050.[
So far, there is also no evidence of funding shortages for green investment projects. While conventional
bond and equity funds have experienced a sizeable decline in net inflows in 2022, the same was not true
for environmental, social and governance (ESG) funds (Slide 4, left-hand side). ESG equity funds have
even seen sustained inflows.
Such portfolio rebalancing has made green investments relatively more attractive from a funding
perspective. In the case of German government bonds, for example, the yield of a green bond compared
with that of a conventional bond with similar characteristics has declined, implying that the "greenium" has
reached record levels in absolute terms (Slide 4, right-hand side).
Recent research also warns firms not to delay the transition as nominal interest rates rise. ECB staff
document a positive relationship between the greenhouse gas emissions resulting from a firm's operations
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and credit risk estimates.[ That is, firms that do not actively reduce their carbon footprint will face higher
risk premia and hence higher borrowing costs at any level of risk-free interest rates.
All this means that it would be misleading to use tighter financing conditions as a scapegoat for further
delays in the green transition. By bringing inflation down in a timely manner, monetary policy restores the
conditions that are necessary for the green transition to thrive.
Fiscal policy needs to accelerate the green transition
In this environment, fiscal policy needs to remain in the driving seat when it comes to fighting climate
change. Regrettably, many governments failed to use the past years of low interest rates to accelerate
investments in greener and more sustainable energy carriers at a pace commensurate with the challenges
we are facing.
Hence, the largest impediment to a rapid decarbonisation is not the cost of capital, but rather the
considerable lack of progress by governments in implementing prior climate commitments.
The OECD, for example, estimates that global fiscal support for the production and consumption of coal,
oil and gas almost doubled in 2021. Russia's invasion of Ukraine has almost certainly led to a further
increase in inefficient fossil fuel subsidies to ensure short-term energy security.
Governments must end the reliance on fossil fuels as quickly as possible. They should step up their efforts
at a time when average interest costs - thanks to the long period of low interest rates and the extension in
bond maturities - are still projected to remain below growth rates for some time to come, thereby
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supporting their capacity to foster private and public investments.[
Viable support schemes for renewable energies and green technologies, such as first-loss guarantees,
interest rate subsidies and government-sponsored financing facilities, should be continued and expanded
where feasible.
Unlike untargeted, broad-based transfers and fossil fuel subsidies that distort incentives, such measures
are welcome from a monetary policy perspective: their positive impact on the economy's productive
capacity will help both restore price stability over the medium term and support debt sustainability by
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boosting potential growth.[
Several structural measures are equally important.
One is a comprehensive use of carbon prices to spur substitution away from fossil fuels. All else equal, a
higher LCOE of renewables requires a higher carbon price to preserve incentives for decarbonisation.
Removing red tape is another area where action is urgently needed. At present, administrative bottlenecks
prevent that the rollout of renewables happens at a pace that is consistent with reaching climate neutrality
by 2050 at the latest.
Finally, governments should reinforce their efforts to deepen capital markets and create a green Capital
Markets Union. ECB research has long shown that stock markets are more effective than banks in
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supporting the decarbonisation of the economy.[
Yet, EU equity markets remain fragmented and often illiquid. Reliance on bank lending at a time of rising
constraints on banks' balance sheets considerably reduces the set of options for firms to push ahead with
their green agenda.
The European Commission's recent package of legislative measures, including the proposed
harmonisation of key aspects of corporate insolvency law and the removal of red tape for companies to list
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and raise capital on public exchanges, is an important step in the right direction.[
But further decisive steps are needed to fast-track the establishment of a European green capital markets
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union.[
The ECB needs to intensify its efforts to support the green transition
While governments need to accelerate their efforts to put the economy on a path towards net zero
emissions, the drastic change in the macroeconomic and financial environment over the past year also
requires central banks to review the scale and scope of their own contribution to the green transition.
Without prejudice to the ECB's primary mandate of price stability, we are obliged to support the EU's
general economic policies in line with our secondary objective. We must therefore ensure that all of the
ECB's policies are aligned with the objectives of the Paris Agreement to limit global warming to well below
2 degrees Celsius.
Climate actions are still falling short of the Paris objectives
Over the past few years, we have embarked on a demanding journey to make our monetary policy
framework climate change-proof. In 2021, we decided on a comprehensive and ambitious set of measures
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as part of our first climate change action plan and we have begun to deliver on those commitments.[
We have started to integrate climate change considerations into our macroeconomic models. We will soon
publish new experimental statistical indicators related to climate change. And we will increasingly address
climate risks in our risk control and collateral frameworks, including by eventually making climate-related
corporate disclosures compulsory for bonds to remain eligible as collateral in our refinancing operations.
The Eurosystem itself will start to disclose the climate change-related exposures of parts of its own
balance sheet around the end of the first quarter of this year.
Moreover, we are now tilting our corporate bond portfolio towards issuers with better climate scores, with a
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view to removing the existing bias towards emission-intensive firms.[
Although our current actions in relation to climate change are ambitious, they are still falling short of the
Paris objectives as they are not sufficient to ensure a decarbonisation trajectory that is consistent with
carbon neutrality of our operations by 2050.
Three areas, in particular, require additional efforts.
Greening the stock of corporate bond holdings
First, the ongoing decline in our balance sheet will visibly diminish the effect of some of our actions going
forward.
For example, for our corporate bond portfolio we are following a flow-based tilting approach where we
adjust our reinvestments of corporate bonds based on a climate score that reflects issuers' carbon
intensity, their decarbonisation plans and the quality of their climate-related disclosures.
Our main steering tool in this process is the tilting parameter - that is, the weight we put on the climate
score in our benchmark allocation for new purchases. However, the tilting parameter lost part of its punch
when we decided to stop net asset purchases (Slide 5). The forthcoming reduction in reinvestments will
further significantly constrain the ability of a flow-based approach to decarbonise our corporate bond
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portfolio at a pace that is consistent with our climate ambitions.[
The decarbonisation of our corporate bond portfolio depends not only on our tilting parameter but also
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considerably on the rate at which the firms in our portfolio decarbonise their businesses.[
For example, assuming full reinvestment, we would achieve only half of the total decarbonisation of our
corporate bond holdings by 2030 if firms were to stop taking steps to decarbonise their activities (Slide 6,
left-hand side). This effect depends to a significant extent on the actions of a few high-emitting companies
(Slide 6, right-hand side).
Together, this implies that by ending our reinvestments, the speed of decarbonisation of our portfolio would
slow down substantially and be largely out of our control.
A flow-based tilting approach is thus insufficient to achieve our goal. The Paris Agreement requires a
stable decarbonisation trajectory in our portfolio irrespective of our monetary policy stance or companies'
individual actions.
We therefore need to move from a flow-based to a stock-based tilting approach for our corporate bond
portfolio. This means that, absent any reinvestments, actively reshuffling the portfolio towards greener
issuers would need to be considered.
At the same time, we should not divest completely, at least not initially, from those companies whose
actions are particularly important in managing the green transition, but rather foster incentives for them to
reduce emissions further.
The stock-based approach would also have to apply to other private asset classes in our portfolio, namely
covered bonds and asset-backed securities. That requires a framework for assessing the climate impact of
such exposures.
Greening our public sector bond holdings
The second question is how to put our public sector bond holdings, which currently account for around half
of our balance sheet, on a Paris-aligned path.
Aligning our large public sector bond holdings with the objectives of the Paris Agreement is proving
challenging for a variety of reasons. First, purchases of sovereign bonds are guided by the capital key,
which limits the scope for tilting strategies based on countries' carbon intensities. Second, there is not yet
a reliable framework in place to assess the extent to which sovereign bond portfolios are aligned with the
Paris Agreement. And, finally, the amount of green sovereign bonds is still limited, in particular when
compared with the size of our current bond portfolio.
Finding options for overcoming these constraints within our mandate is critical: any attempt to green the
stock of our bond holdings needs to include a solution for our sovereign bond portfolio, in particular in the
light of the review of the ECB's future operational framework, which is likely to imply a larger steady-state
balance sheet, potentially including a structural bond portfolio.
At present, there are two options to make our sovereign bond portfolio greener in a timely manner.
One is to increase the share of bonds issued by supranational institutions and agencies. A considerably
larger fraction of their outstanding bonds is already green (Slide 7).
Tilting our purchases towards green bonds issued by supranational institutions and agencies would be in
line with the objectives of the Paris Agreement and would not conflict with the requirement to be guided by
the capital key.
The second, complementary option is to steadily reshuffle our sovereign bond portfolio towards green
bonds as governments expand their supply of green bonds over time.
Greening our lending operations
Finally, we need to intensify efforts to green our lending operations, including the collateral framework. As
a first step we will limit the share of assets issued by entities with a high carbon footprint that can be
pledged as collateral by individual counterparties when they borrow from the Eurosystem. We will also
consider climate-related risks when determining haircuts for corporate bonds.
But these measures will have only a small impact on the overall collateral provided by our counterparties.
A systematic greening of the ECB's collateral framework is therefore an important tool to ensure that all of
our monetary policy actions are aligned with the Paris Agreement, especially in an environment in which
we have started shrinking our balance sheet, as this reduces the set of options available to support the
green transition during the current tightening cycle.
Green targeted lending operations, for example, could be an instrument worth considering in the future
when policy needs to become expansionary again, provided the underlying data gaps are resolved. But
they are not an option for the immediate future given the current need for a restrictive monetary policy.
Conclusion
Let me conclude.
Many central banks globally are responding to current high inflation by tightening financing conditions.
While a higher cost of credit will make the financing of renewable energies and green technologies more
expensive, it would be misleading to use higher interest rates as a scapegoat for a further delay in the
green transition, for two main reasons:
First, restoring price stability in a timely manner provides the conditions under which the green transition
can thrive sustainably. And second, the largest barrier to a rapid decarbonisation remains the lack of
progress by governments in implementing prior climate commitments.
Governments must remain in the lead in accelerating the green transition. By promoting green
technologies and renewable energies, they will enhance the productive capacity of the economy and
thereby help restore price stability over the medium term.
In line with our mandate, we stand ready to further intensify our efforts to support the fight against climate
change, building on the achievements of our climate change action plan.
Our long-term goal is to make sure that all our monetary policy actions are aligned with the objectives of
the Paris Agreement. This means greening our stock of bond holdings, including public sector bonds, as
well as our lending operations and collateral framework.
Greening monetary policy requires structural changes to our monetary policy framework rather than
adjustments to our reaction function.
Restoring price stability through an appropriate monetary policy today will benefit society over the longer
run and will facilitate the transition to a greener economy.
Thank you.
Annexes
10 January 2023
Slides
ENGLISH

1.
I would like to thank Benjamin Hartung for his contribution to this speech.
2.
See, for example, Egli, F. et al. (2018), "A dynamic analysis of financing conditions for renewable energy
technologies", Nature Energy, Vol. 3, pp. 1084-1092. The "levelised cost of electricity" is a measure of the
average net present cost of electricity generation for a generating plant over its lifetime.
3.
Fraunhofer Institute for Solar Energy Systems (2021), " Study: Levelized Cost of Electricity - Renewable
Energy Technologies ", June.
4.
Monnin (2015) finds that at interest rate levels above 2%, the average cost of producing electricity is
higher for green energy technologies. See Monnin, P. (2015), " The Impact of Interest Rates on Electricity
Production Costs ", CEP Discussion Note, 2015/3, June.
5.
International Energy Agency (2020), " Projected Costs of Generating Electricity 2020 ", December. See also
Schmidt, T.S. et al. (2019), "Adverse effects of rising interest rates on sustainable energy transitions",
Nature Sustainability, Vol. 2, pp. 879-885.
6.
See, for example, Durante, E. et al. (2022), "Monetary policy, investment and firm heterogeneity",
European Economic Review, Vol.148, 104251; and Auer, S. et al. (2021), "Corporate leverage and
monetary policy effectiveness in the euro area", European Economic Review, Vol. 140, No 103943,
November.
7.
See also Schnabel, I. (2022), " A new age of energy inflation: climateflation, fossilflation and greenflation ",
speech at The ECB and its Watchers XXII Conference, 17 March.
8.
Ingves, S. (2022), "Inflation targeting for nearly 30 years - a robust framework for all times?", speech
before the Swedish Economic Association, 31 May.
9.
See, for example, Cohen, D. et al. (1999), "Inflation and the User Cost of Capital: Does Inflation Still
Matter?", in Feldstein, M. (ed.), The Costs and Benefits of Price Stability, University of Chicago Press for
the NBER; and Andrés, J. and Hernando, I. (1997), "Does Inflation Harm Economic Growth? Evidence
from the OECD", NBER Working Paper, No 6062.
10.
See, for example, Clark, P. (1982), "Inflation and the Productivity Decline", American Economic Review,
Vol. 72(2), Papers and Proceedings of the Ninety-Fourth Annual Meeting of the American Economic
Association, pp. 149-154.
11.
Schnabel, I. (2022), " Monetary policy and the Great Volatility ", speech at the Jackson Hole Economic
Policy Symposium organised by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, 27
August.
12.
Poll conducted by Reuters among 68 climate economists between 1 July and 13 September 2022. 50 of
these 68 experts said rising borrowing costs would have a mild or very mild impact on reaching net zero
carbon emissions by 2050.
13.
Carbone, S. et al. (2021), " The low-carbon transition, climate commitments and firm credit risk ", Working
Paper Series, No 2631, ECB, December.
14.
Schnabel, I. (2022), " United in diversity - Challenges for monetary policy in a currency union ",
commencement speech to the graduates of the Master Program in Money, Banking, Finance and
Insurance of the Panthéon-Sorbonne University, Paris, 14 June; and Bouabdallah, O. et al. (2023), "Fiscal
policy: from free to affordable lunch", The ECB Blog, 4 January.
15.
Schnabel, I. (2022), " Finding the right mix: monetary-fiscal interaction at times of high inflation ", keynote
speech at the Bank of England Watchers' Conference, London, 24 November.
16.
De Haas, R. and Popov, A. (2019), " Finance and carbon emissions ", Working Paper Series, No 2318,
ECB, September.
17.
European Commission (2022), " Capital markets union: clearing, insolvency and listing package ", 7
December.
18.
See Lagarde, C. (2021), "Towards a green capital markets union for Europe", speech at the European
Commission's high-level conference on the proposal for a Corporate Sustainability Reporting Directive, 6
May.
19.
See ECB (2021), " ECB presents action plan to include climate change considerations in its monetary
policy strategy ", 8 July; and ECB (2022), " ECB takes further steps to incorporate climate change into its
monetary policy operations ", 4 July.
20.
Following its decision to decarbonise its corporate bond holdings on 4 July 2022, the ECB provided details
on the tilting mechanism that was subsequently implemented as of October 2022 (see press release of 19
September 2022). Already in February 2021, the Eurosystem agreed on a common stance for climate
change-related sustainable and responsible investment principles for its euro-denominated non-monetary
policy portfolios (see press release of 4 February 2021). Empirical evidence shows that the Eurosystem
holdings under the corporate sector purchase programme (CSPP) are biased towards more carbon-
intensive firms as these have larger investment needs and therefore represent a disproportionate share of
the investable universe. See also Schnabel, I. (2021), " From green neglect to green dominance? ", speech
at the "Greening Monetary Policy - Central Banking and Climate Change" online seminar, 3 March; and
Papoutsi, M., Piazzesi, M. and Schneider, M. (2021), " How unconventional is green monetary policy? ",
JEEA-FBBVA Lecture at ASSA, January..
21.
The carbon footprint of the stock of corporate bond holdings depends on the net flow of assets, which is
determined by not only the amounts of reinvestments following the tilted benchmark allocation, but also
the amount and composition of maturing assets in any given month. If there are many redemptions of
assets issued by carbon-intensive companies in any given month, this will reduce the overall carbon
footprint of the portfolio and vice versa. This may lead to additional fluctuations in the carbon footprint of
the portfolio from month to month.
22.
The decarbonisation is also affected by conjunctural factors as the drop in absolute emissions during the
pandemic has illustrated. At the same time, carbon intensities tend to increase in years with lower
economic activity as the numerator (greenhouse gas emissions) falls more sluggishly than the
denominator (e.g. revenues). A Paris-aligned decarbonisation trajectory would ideally ensure a robust
approach that looks through short-run fluctuations in carbon emissions and carbon intensities related to
purely conjunctural factors.