How should central banks respond to the climate crisis?

Central banking has entered a new era – the era of the climate crisis.

This is exemplified by several recent developments. Central banks and supervisors around the world have established the Network for Greening the Financial System (NGFS), which promotes ideas and practices for the development of a climate-aligned financial system. Since 2016, the People’s Bank of China has actively promoted the greening of the Chinese financial system. Last year the European Central Bank launched a strategy review with a special emphasis on how climate change can affect monetary policy. This year the UK government added environmental sustainability to the mandate of the Bank of England.   

It is now uncontroversial that central banks should take climate change into account. But a big question remains: how should they do so? This is where an important battle of ideas and politics is under way.

The dominant view among central bankers in the Global North is that monetary authorities should respond to the climate crisis in a passive way. The supporters of this view consider climate change as a new source of risk for the financial system. They recognise that climate-related events – like floods, hurricanes and draughts – can affect the ability of people and companies to repay debt, making the banking sector vulnerable to climate change. They also recognise that abrupt changes in climate policies could create risks for those that have lent their money to carbon-intensive companies. And they argue that, as guardians of financial stability, central banks should take action to protect both private financial institutions and themselves from climate risks.

The supporters of this passive approach also emphasise that the incorporation of climate risks into central banking should respect the so-called ‘market neutrality principle’: the idea that central banks should not distort ‘free’ markets and should not favour specific sectors compared to others. Market neutrality has become a central tenet in central banking since the 1980s and conservative thinking does not want to abandon it in the name of the climate emergency.    

But a more radical approach about central banking and climate change is gradually gaining more popularity. This approach calls for an active participation of central banks in the fight against climate change. The starting point of this approach is that the financial system has a significant responsibility for the climate crisis that we are facing. This relies on an undeniable fact: private financial institutions actively support dirty activities and central banks’ operations suffer from a carbon bias.

For the supporters of the radical approach the key issue is not how central banks will protect the financial system from climate change. The main issue is how central banks will lead the decarbonisation of finance that is so much needed for tackling the climate crisis. The message of the active approach is clear: central banks should target carbon neutrality, not market neutrality.

This radical approach does not naively assume that central banks will save the planet by themselves. But it emphasises that central banks are powerful institutions that have a crucial role to play in the decarbonisation process – and their supposedly ‘market neutral’ actions should not undermine the actions of citizens and governments against climate change.

The passive and the active approach differ fundamentally in their policy recommendations. For the supporters of the passive approach no deep transformation is necessary. Central banks should simply measure climate risks – as they have done with other risks in the past – and should then incorporate these risks into their operations. They should also encourage financial institutions to do the same.

On the contrary, for those who endorse the active approach urgent radical changes are necessary. Central banks should, for example, stop providing financial support to fossil fuel companies through their quantitative easing programmes, should climate align the rules under which they lend money to commercial banks and they should actively incentivise and guide banks to provide more credit for environmentally friendly investments.  

The active approach is the only approach that is in line with the climate emergency. And the more central banks delay to endorse this approach, the more they undermine our collective efforts to avoid catastrophic climate change.

But even the endorsement of the active approach by central banks would not go far enough. The active approach still suffers from an important limitation: it has not put climate justice at the core of its analysis and policy recommendations.

The Global North has the primary responsibility for the climate crisis. This is crystal clear by just looking at the historical path of emissions across the world. And despite their lower responsibility, the countries in the Global South are already suffering more from the climate crisis.

This has two important implications. First, the pace of central banks’ decarbonising efforts should be much higher in the Global North compared to the Global South. Several large companies in the Global North have caused suffering in the Global South through their polluting activities over the last decades. Central banks in the Global North cannot postpone the introduction of penalties for these companies that continue to generate massive amounts of greenhouse gas emissions. In contrast, Global South central banks need to have a higher flexibility in designing their decarbonisation policies – a reflection of the lower historical responsibility of the Global South for the climate crisis.  

Second, central banks both in the Global North and the Global South should start to seriously consider how they can support climate adaptation investments in the Global South. Central banks in the Global North could, for instance, commit to use their printing power to buy the government bonds of climate vulnerable countries that have high needs for adaptation investment (e.g. in flood defences and water retention) or suffer from climate-induced sovereign debt crises. Such measures should accompany other broader initiatives, like climate reparations and debt relief programmes, that would give the space to the Global South to address the climate crisis in a way that serves the interests of the local communities, free of neo-colonial approaches.

We have no time to waste. The more quickly central banks stop relying on outdated economic ideas that serve the status quo, the better our chances for a globally just transition to a decarbonised economy.