Central Banks and the Just Energy Transition: A Realistic Path Forward

By Pietro Calice, Senior Financial Economist, World Bank, and Dimitri G. Demekas, Adjunct Professor of Macroprudential Policy, School of International and Public Affairs, Columbia University

The concept of a just energy transition, or just transition, has gained prominence in recent years as policymakers grapple with the social and economic implications of moving towards a low-carbon economy. Governments in different countries are implementing various public-policy initiatives to tackle this challenge. At the same time, in the private sector, voluntary initiatives are attempting to introduce just transition considerations into financial transactions by replicating approaches and instruments used in climate finance.

More recently, there have been calls on central banks and financial regulators to play more active roles in the just transition using the policy and regulatory tools at their disposal. Can just transition considerations be incorporated into the current risk-focused regulatory framework? Should central banks and financial regulators actively promote the just transition beyond risk considerations? What is a realistic and appropriate role for central banks and financial regulators in supporting the just transition?

The concept of a just transition

A just transition refers to the process of mitigating the negative impacts of the shift to a low-carbon economy on workers, communities and sectors that are heavily dependent on carbon-intensive industries.

The idea of a just transition was first articulated by the International Labour Organization (ILO) and has since been incorporated into international agreements such as the Paris Agreement.^1,2 It is based on social norms of fairness and justice, including procedural justice (ensuring transparent and inclusive decision-making), distributive justice (sharing costs and opportunities fairly) and restorative justice (rectifying negative impacts).³

The just transition concept recognizes that despite the environmental benefits and new economic opportunities created by the transition to a low-carbon economy, it will also cause localized job and income losses and broader economic and social disruptions. Making this a “just” transition means compensating for these losses and ensuring that the benefits of the energy transition are shared as widely as possible.

Challenges in defining and measuring the just transition

One of the fundamental challenges in implementing a just transition is defining its scope and measuring its progress. Unlike the climate transition, which has clear, science-based targets, the just transition reflects context-dependent social norms that can vary across countries and over time. This makes it difficult to establish objective criteria for success or to measure the contribution of various economic activities to the goal of a just transition.

A key challenge is reaching an agreement on the policy goal: Exactly “how much” just transition do we want? Since the just transition reflects social norms, defining and agreeing on a goal involves judgments on the balance of interests of different groups, the desirable degree of remediation for private damages incurred as a result of energy-transition policies and the appropriate time horizon for such remediation. There are no objective, science-based yardsticks for making these judgments.

Another challenge is measuring the contributions of various economic activities to the goal of a just transition. The broad and vague terms used to describe the just transition (“leaving no one behind,” “minimizing any challenges from the climate transition,” “creating decent work and quality jobs,” etc.) make it difficult to quantify progress. Moreover, the magnitude of an activity’s impact would depend on whether one chooses to focus on its effects on employment, income distribution or other environmental, developmental and broader social aspirations; on the time horizon over which these effects are expected to materialize; and on the scale (local, national or global) at which these effects are to be measured.

Current policy initiatives

Governments have begun implementing various public-policy initiatives to address the challenges of a just transition. These typically focus on specific sectors or regions affected by energy transitions, such as coal mining or fossil-fuel-based energy generation. The initiatives often involve fiscal measures such as public transfers, subsidies, infrastructure investments and worker-retraining programs.

Examples of such initiatives include Greece’s Fair Transition Fund, which collects 6 percent of the revenue from auctioning the allowances of the European Union’s (EU’s) Emissions Trading System (EU ETS) to support regions affected by coal phaseouts.⁴ Another example is the Latrobe Valley Authority in Australia, established to support workers who lost their jobs after the closure of the Hazelwood Power Station and promote economic diversification in the area.⁵

While these initiatives are primarily led and funded by governments, some also incorporate elements of public-private collaboration. However, most current just transition policies do not have a specific financial policy or regulatory component.

The role of private finance

The private financial sector is coming under increasing pressure to consider just transition issues in their business practices. This pressure stems from various sources, including political declarations, potential litigation risks and growing investor interest in environmental, social and governance (ESG) issues.

In response, some voluntary private-sector initiatives have emerged, attempting to introduce just transition considerations into financial transactions. These include innovative debt instruments and investment vehicles that screen assets based on their issuers’ just transition characteristics.

For example, the Just Transition for Climate fund, launched by Amundi in 2021, aims to maintain a carbon footprint that is 20 percent lower than its benchmark while also considering a “just transition rating” for its investments.⁶

However, these efforts have faced considerable conceptual and practical challenges, particularly in defining and measuring social impact.

The debate on financial regulation

A recent World Bank paper examines the arguments for and against involving central banks and financial regulators in promoting a just transition.⁷

Proponents argue that regulatory intervention is necessary to ensure discipline in the field of ESG ratings, mitigate potential “social risks” to the financial system and promote important societal ambitions, such as the transition to a low-carbon economy and the United Nations’ Sustainable Development Goals (SDGs).⁸

However, there are several challenges in incorporating just transition considerations into the current risk-focused regulatory framework, including:

Difficulty in defining and measuring just transition-related financial risks. The social dynamics and outcomes of the political process are highly uncertain and context-dependent, making it challenging to quantify risks.
Lack of historical data and the long time horizons involved. This makes it difficult to use well-established risk-management tools, such as Value-at-Risk (VAR) models or stress tests, to assess just transition-related risks.
Potential conflicts with existing regulatory mandates. The current legal mandates of central banks and financial regulators do not generally include the promotion of “societal ambitions”, such as the just transition.

Therefore, using regulatory tools to promote the just transition could be ineffective and potentially counterproductive. For instance, attempts to use capital requirements to influence credit flows towards socially desirable objectives have shown limited effectiveness in practice. The EU’s “SME supporting factor“, introduced to encourage bank credit to small and medium-sized enterprises (SMEs), has had no material impacts on lending prices or volumes to SMEs.⁹

Moreover, there is a risk of compromising regulators’ independence and ability to achieve their core objectives.¹⁰ Taking on responsibilities for the just transition—a fundamentally political project—may expose central banks and financial regulators to criticism for mission creep, potentially compromising their independence and ability to achieve their policy goals.

A realistic agenda for financial regulation

With these caveats in mind, central banks and financial regulators can play supporting roles in the just transition within the parameters established by government policy. This could include:

Ensuring accurate data collection on the social impacts of climate-transition projects. Central banks and financial regulators can help ensure that granular, high-quality, auditable data on the social impacts of climate-transition projects are collected and used by financial firms.
Raising awareness among financial firms about the government’s just transition agenda. This includes ensuring that any disclosure and reporting requirements are consistently enforced across the financial sector.
Sensitizing financial firms to just transition-related risks, particularly the litigation risk. Ongoing work to strengthen operational-risk frameworks would help improve financial firms’ ability to assess and mitigate this risk.
Identifying and removing obstacles that prevent financial firms from incorporating social-impact considerations into their business decisions. This may involve assisting in the definitions and data compilations related to social impact, providing training to build skills in the financial industry, encouraging governance changes in financial firms and establishing regulatory sandboxes for innovative instruments in blended finance or de-risking.

For central banks and financial regulators to play this role effectively, a necessary precondition is a clear, overarching just transition strategy developed by the government. Collecting social-impact data, enforcing disclosures, raising awareness, encouraging innovation, building skills and disseminating best practices in the financial industry require a clearly defined objective and a sense of social priorities.

Moreover, central banks and financial regulators should remain mindful of the limitations of their toolkits and the risks and potential unintended consequences of their actions. The regulatory tools at their disposal are unlikely to be effective for promoting a just transition, and attempting to use them for this purpose would pose difficult operational tradeoffs.

The lack of policy coordination may compound these shortcomings: If the central bank and financial regulators move ahead on their own to support the just transition without a framework and a clear sense of priorities provided by the government, their efforts could not only prove fruitless but could also trigger a backlash, potentially compromising their ability to achieve their other policy goals.

Conclusion

The just transition is a valid and important public-policy objective. However, it is fundamentally a political task that should be mediated through the political process rather than delegated to technocratic agencies such as central banks and financial regulators.

While central banks and financial regulators can play a supporting role, they should remain mindful of the limitations of their toolkits and the potential unintended consequences of their actions. Ultimately, the just transition is a political project that requires a clear, overarching strategy from the government. Central banks and financial regulators can only play a supporting role once such a strategy is in place.

The just transition agenda for finance goes beyond regulation. Financial firms have social responsibilities that they can and should discharge without regulatory compulsion. The task of the government, supported by the central bank and financial regulators when appropriate, is not to displace these initiatives with regulation but to signal political priorities, align incentives and establish a broad framework that would help direct and amplify their impacts, as well as to complement them with judicious policy action where markets fail.

References

¹International Labour Organization (ILO): “Guidelines for a just transition towards environmentally sustainable economies and societies for all,” 2015, Geneva.

²United Nations/United Nations Framework Convention on Climate Change (UNFCCC): Paris Agreement, 2015.

³Energy Policy: “Just transition: Integrating climate, energy, and environmental justice,” Darren McCauley and Raphael Heffron, August 2018, Volume 119, Pages 1-7.

⁴Organisation for Economic Co-operation and Development (OECD): “Towards a just transition in Greece’s lignite-dependent regions,” October 6, 2021.