Christine Lagarde: Climate change and central banking
Keynote speech by Ms Christine Lagarde, President of the European Central Bank, at the ILF
conference on Green Banking and Green Central Banking, Frankfurt am Main, 25 January 2021.
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In the famous fable "Belling the Cat", a group of mice gather to discuss how to deal with a cat
that is eating them one by one. They hatch a plan to put a bell on the cat so they can hear it
coming and escape before being caught. When it comes to who will actually do it, however, each
mouse finds a reason why they are not the right mouse for the job, and why another mouse
should do it instead. The cat never does receive a bell - and the story ends poorly for the mice.
In many ways, that fable describes mankind's reaction to the threats posed by climate change.
Already in 1986, the front cover of Der Spiegel showed Cologne cathedral half-submerged by
water and the headline declared a "Climate Catastrophe". This is just one example, among
many, that demonstrates that people were aware of the risks posed by climate change a
generation ago. Yet, while many people agreed on the seriousness of the issue, and that
something had to be done, concrete action has been much less prevalent.
It is with this history in mind that I want to talk about the role of central banks in addressing
climate change. Clearly, central banks are not the main actors when it comes to preventing
global heating. Central banks are not responsible for climate policy and the most important tools
that are needed lie outside of our mandate. But the fact that we are not in the driving seat does
not mean that we can simply ignore climate change, or that we do not play a role in combating it.
Just as with the mice in the fable, inaction has negative consequences, and the implications of
not tackling climate change are already visible. Globally, the past six years are the warmest six
on record, and 2020 was the warmest in Europe.. The number of disasters caused by natural
hazards is also rising, resulting in $210 billion of damages in 2020. An analysis of over 300
peerreviewed studies of disasters found that almost 70% of the events analysed were made more
likely, or more severe, by human-caused climate change.
That said, there are now signs that policy action to fight climate change is accelerating,
especially in Europe. We are seeing a new political willingness among regulators and fiscal
authorities to speed up the transition to a carbon neutral economy, on the back of substantial
technological advances in the private sector.
This increased action is often considered as a source of transition risk, which we need to take
into account and reflect in our policy framework. This is not "mission creep", it is simply
acknowledging reality. Yet the transition to carbon neutral is not so much a risk as an opportunity
for the world to avoid the far more disruptive outcome that would eventually result from
governmental and societal inaction. Scenarios show that the economic and financial risks of an
orderly transition can be contained. Even a disorderly scenario, where the economic and
financial impacts are potentially substantial, represents a much better overall outcome in the long
run than the disastrous impact of the transition not occurring at all.
It now seems likely that faster progress will be made along three interlocking dimensions. Each
of them lies outside the remit of central banks, but will have important implications for central
bank balance sheets and policy objectives.
Including, informing and innovating
The first dimension along which we expect rapid progress is including the true social and
environmental cost of carbon into the prices paid by all sectors of the economy.
Appropriate pricing can come via direct carbon taxes or through comprehensive cap and trade
schemes. Both are used to some extent in the EU. It is likely, though, that the next steps in
Europe will come mainly via the EU's Emissions Trading System (ETS), a cap and trade
scheme. The ETS is an essential infrastructure, although it has not always been successful in
the past at delivering a predictable price of carbon. Moreover, it currently covers only around half
of EU greenhouse gas emissions and a significant amount of allowances continue to be given for
free.
The effective price of carbon is expected to rise if the EU's targets for reducing emissions are to
be reached. Modelling by the OECD and the European Commission suggests that an effective
carbon price between €40-60 is currently needed, depending on how stringent other regulations
are. The introduction of the ETS Market Stability Reserve and the review of the ETS scheduled
for this year should provide the opportunity to deliver a clear path towards adequate carbon
pricing.
The second dimension where we expect to see progress is greater information on the exposure
of individual companies. At present, information on the sustainability of financial products - when
available - is inconsistent, largely incomparable and at times unreliable. That means that climate
risks are not adequately priced, and there is a substantial risk of sharp future corrections. Yet for
an open market economy to allocate resources efficiently, the pricing mechanism needs to work
correctly.
This requires a step change in the disclosure of climate-related data using standardised and
commonly agreed definitions. While TCFD-based disclosures have underpinned public/private
efforts to better inform, disclosure needs to be at a far more granular level of detail than is
currently available. In Europe. climate disclosures are governed by the Non-Financial Reporting
Directive (NFRD), which is currently under review. The Eurosystem has advocated for
mandatory disclosures of climate-related risks from a far greater number of companies,
including non-listed entities. Moreover, disclosures should be complemented by forward-looking
measures that assess the extent to which both financial and non-financial firms are aligned with
climate goals and net zero commitments.
The European Taxonomy Regulation that entered into force last year is also an important
milestone along this path. But it still needs to be fleshed out with concrete technical criteria and
complemented by an equivalent taxonomy for carbon-intensive activities. A further essential step
is the consistent and transparent inclusion of climate risks in credit ratings. Here, again, we have
high hopes that progress will now speed up.
While adequate carbon prices and greater information on exposures will help provide incentives
to decarbonise, that economic transformation cannot take place without the third dimension:
substantial green innovation and investment. Both, however, require a complex ecosystem of
which finance is a key element, so we expect to see increasing availability of green finance.
Green bond issuance by euro area residents has grown sevenfold since 2015, reaching €75
billion in 2020 - this represents roughly 4% of the total corporate bond issuance.
We need to see funding for green innovation increasing from other market segments as well,
especially as recent analyses point to the beneficial role of equity investors in supporting the
green transition. Assets under management by investment funds with environmental, social and
governance mandates have roughly tripled since 2015, and a little more than half of these funds
are domiciled in the euro area. Completing the capital markets union should provide a further
push to support equity-based green finance by fostering deep and liquid capital markets across
Europe.
Simultaneous progress along each of these three dimensions increases the likelihood of
substantial economic change in the near term. That is so because movement along each
dimension reinforces progress along the others and magnifies the effectiveness of climate
policy.
For example, the economic impact of higher carbon prices depends on the availability of
alternative green technologies. In the past, a sudden and substantial increase in carbon taxes
could have resulted in an economic downturn, substantial stranded assets and threats to
financial stability. Today, however, solar power is not only consistently cheaper than new coal or
gas-fired plants in most countries, but it also offers some of the lowest cost electricity ever
seen. Green finance and innovation are also developing rapidly. Introducing well-signalled carbon
pricing therefore becomes more feasible and could further sharpen incentives both to develop
new technologies and to carry out the substantial investment required for the widespread
adoption of the green technologies that already exist.
Climate change and central banks
Today, then, central banks face two trends - more visible impacts of climate change and an
acceleration of policy transition. Both trends have macroeconomic and financial implications and
have consequences for our primary objective of price stability, for our other areas of competence
including financial stability and banking supervision, as well as for the Eurosystem's own balance
sheet. Central banks are both aware of those consequences, and determined to mitigate them.
Much has already been accomplished and more is under way:
The founding of the Network for Greening the Financial System (NGFS), with membership
including all major central banks, is testament to that collective engagement with climate change.
At the ECB, we are now launching a new climate change centre to bring together more efficiently
the different expertise and strands of work on climate across the Bank. Climate change affects
all of our policy areas. The climate change centre provides the structure we need to tackle the
issue with the urgency and determination that it deserves.
In the area of financial stability and banking supervision, the ECB has taken concrete steps
towards expanding the financial system's understanding of climate risks and its ability to manage
them. We have issued a guide on our supervisory expectations relating to the management and
disclosure of climate-related and environmental risks. A recent survey of the climate-related
disclosures of 125 banks suggests there is still a way to go. It evaluated climate disclosures
across several basic information categories. Only 3% of banks made disclosures in every
category, and 16% made no disclosure in any category. ECB Banking Supervision has
requested that banks conduct a climate risk self-assessment and draw up action plans, which
we will begin assessing this year. We will conduct a bank-level climate stress test in 2022.
The ECB is also currently carrying out a climate risk stress test exercise to assess the impact
on the European banking sector over a 30-year horizon. Preliminary results from mapping
climate patterns to the address-level location of firms' physical assets show that in the absence
of a transition, physical risks in Europe are concentrated unevenly across countries and sectors
of the economy.
But there is more: climate change also impacts our primary mandate of price stability through
several channels. This is why climate change considerations form an integral part of our ongoing
review of our monetary policy strategy. Climate change can create short-term volatility in output
and inflation through extreme weather events, and if left unaddressed can have long-lasting
effects on growth and inflation. Transition policies and innovation can also have a significant
impact on growth and inflation. These factors could potentially cause a durable divergence
between headline and core measures of inflation and influence the inflation expectations of
households and businesses.
The transmission of monetary policy through to the interest rates faced by households and
businesses could also be impaired, to the extent that increased physical risks or the transition
generate stranded assets and losses by financial institutions. According to a recent estimate by
the European Systemic Risk Board, a disorderly transition could reduce lending to the private
sector by 5% in real terms.
And climate change can also have implications for our monetary policy instruments. First, the
Eurosystem's balance sheet itself is exposed to climate risks, through the securities purchased
in the asset purchase programmes and the collateral provided by counterparties as part of our
policy operations.
Furthermore, several factors associated with climate change may weigh on productivity and the
equilibrium interest rate, potentially reducing the space available for conventional policy. For
example, labour supply and productivity may diminish as a result of heat stress, temporary
incapability to work and higher rates of mortality and morbidity. Resources may be reallocated
away from productive use to support adaptation, while capital accumulation may be impaired by
rising destruction from natural hazards and weaker investment dynamics related to rising
uncertainty. And the increase in short-term volatility and accelerated structural change could
hamper central banks' ability to correctly identify the shocks that are relevant for the
mediumterm inflation outlook, making it more difficult to assess the appropriate monetary policy stance.
Our strategy review enables us to consider more deeply how we can continue to protect our
mandate in the face of these risks and, at the same time, strengthen the resilience of monetary
policy and our balance sheet to climate risks. That naturally involves evaluating the feasibility,
efficiency and effectiveness of available options, and ensuring they are consistent with our
mandate.
The ECB is also assessing carefully, without prejudice to the primary objective of price stability,
how it can contribute to supporting the EU's economic policies, as required by the treaty. Europe
has prioritised combating climate change and put in place targets, policies and regulations to
underpin the transition to a carbon-neutral economy. While the Eurosystem is not a policy maker
in these areas, it should assess its potential role in the transition.
We recognise that our active role in some markets can influence the development of certain
market segments. The ECB currently holds around a fifth of the outstanding volume of eligible
green bonds. Standardisation helps nascent markets gain liquidity and encourages growth. And
our eligibility criteria can provide, in this context, a useful coordination device. For example, since
the start of this year, bonds with coupon structures linked to certain sustainability performance
targets have been eligible as collateral for Eurosystem credit operations and for outright
purchases for monetary policy purposes.
We have also taken action with regards to our non-monetary policy portfolio, namely our own
funds and pension fund. The ECB raised the share of green bonds in its own funds portfolio to
3.5% last year and is planning on raising it further as this market is expected to grow in the
coming years. Investing parts of the own funds portfolio in the green bond fund of the Bank for
International Settlements marks another step in this direction. A shift of all conventional equity
benchmark indices tracked by the staff pension fund to low-carbon equivalents last year
significantly reduced the carbon footprint of the equity funds. Other central banks are also
aligning decisively their investment decisions with sustainability criteria.
Conclusion
Let me conclude.
Climate change is one of the greatest challenges faced by mankind this century, and there is
now broad agreement that we should act. But that agreement needs to be translated more
urgently into concrete measures. The ECB will contribute to this effort within its mandate, acting
in tandem with those responsible for climate policy.
Unlike the mice in the fable, not only do we have to recognise that we cannot keep waiting for
someone else to act, we also must recognise that the burden cannot fall on one party alone.
There is no single panacea for climate change, and combating it requires rapid progress along
several dimensions. Relying on just one solution, or on one party, will not be enough to avoid a
climate catastrophe. And here we can actually learn something from mice. As the Roman
playwright Plautus wrote, "How wise a beast is the little mouse, who never entrusts its safety to
only one hole."