us just examine the effects that climate change would have on the economy, with some sectors more directly exposed than others. for example, agriculture and livestock will have to withstand more severe repercussions than services or manufacturing. the rising of global temperatures could render vast regions unsuitable for land cultivation, straining access to food and prompting mass migration. it will also affect industries like construction, which rely on outdoor work. lower income countries are particularly vulnerable to global warming, while coastal states are vulnerable to rising sea levels. these shocks to output cannot but have significant implications for prices. climate change will impact how the economy operates and will exert a substantial influence on price dynamics. indeed, given the eurosystem ’ s primary objective is price stability, it is important for monetary policy makers to be aware of these effects as they set the policy stance. monetary policy is going to be affected by climate change, as well by the measures taken by governments to address it. first, climate change will affect the structural parameters of the economy. one key parameter is the natural rate of interest. the natural rate of interest is fundamental notion of central banking. when interest rates lie below the natural rate, monetary policy is accommodative, and vice - versa. in turn, the monetary policy stance has an impact on the price level. there is uncertainty over the direction of the impact of climate change on the natural rate - our r star : climate factors could contribute to the secular decline of natural rates in line with prevailing structural trends such as demography. conversely, higher investment to combat emissions could lead to a rise in productivity which may push up r - star. second, climate change will alter the transmission mechanism of monetary policy. the value of assets posted as collateral by financial intermediaries could decline due to the higher frequency of extreme weather events. this could dent the capital and liquidity positions of banks and other financial intermediaries, thereby weakening their ability to channel funds to the real economy. if the financial system is weakened, the transmission of monetary policy is impaired, meaning that changes to the monetary policy stance will not be properly transmitted to the real economy. the third channel is via climate - related financial risks on the eurosystem balance sheet. rules regarding asset purchase programmes and the collateral framework will be revised to encourage counterparties to steer away from fossil fuels, speeding up the transition to net zero. the eurosystem, which consists of the ecb and all the national central banks of the euro area – including

they are compensated on the upside. this extends the boom. incentives incentives may be very important in determining whether we have a system that is dampening rather than amplifying. i think bad outcomes are not just about bad luck, they are also about bad incentives. the problem with incentives may be due to faulty compensation schemes, poor risk management or the fact that participants do not bear the full costs of their actions. one problem that we had in the u. s. banking system over the past year was a reluctance of banks to raise sufficient capital to be able to withstand bad states of nature. they didn ’ t want to do this because this might unnecessarily dilute their shareholders. as a result, many banks did not hold sufficient capital and market participants knew this. this led to tighter financial and credit conditions, which made the bad state of the world more likely. this is an example of both bad incentives and an amplifying mechanism. the supervisory capital assessment program ( scap ) exercise that we undertook in the united states leaned against this. by forcing all the banks to have sufficient capital to withstand a stress environment, we increased the likelihood that all the big banks would be able to survive a stress environment. this generated an improvement in confidence and a willingness of banks to engage with each other. this also made it easier for banks to be able to tap the capital markets. the scap exercise made a bad state of the world outcome less likely, helping to create a virtuous circle rather than a vicious one. the scap exercise was conducted on an ad hoc basis. it probably would be much better to figure out how to do these types of exercises on a systematic basis. such exercises may need to be hardwired into the oversight of the financial system. capital requirements are one area where i think we could adjust the rules in a way to improve incentives. for example, imagine that we mandated that banks had to hold more capital, but that the added capital could be in the form of a debt instrument that only converted into equity if the share price fell dramatically. what would this do? it would change management ’ s incentives. not only would management focus on generating higher stock prices, but they would also worry about risks that could cause share prices to fall sharply, resulting in dilution of their share holdings. debt convertible into equity on the downside would also be helpful in that it would be a dampening mechanism – equity capital would be automatically replenished, but