By Philippe Waechter, Chief Economist, Ostrum Asset Management
Christine Lagarde, president of the European Central Bank (ECB), has long asserted the need to adapt monetary policy to take climate change into account. Thus, during a conference organized by the Bank for International Settlements (BIS) in June 2021, she stood out from her American and Chinese colleagues. Most other policymakers, although well aware of the impacts of climate change, have indicated that this theme is not part of their objectives, that it is more generally a question for society and depends on the overall policies of the government.
But Christine Lagarde wants the ECB to align with the European Commission’s (EC’s) objectives. As part of the Fit for 55 plan, Europe’s objective is to reduce greenhouse-gas emissions by 55 percent by 2030 compared to 1990. The ultimate goal is carbon neutrality by 2050.
The ECB aims to stick with this objective, considering it has the necessary levers to influence behavior over time.
The monetary-policy framework is challenged
The form of monetary policy has changed significantly since the financial crisis of 2008-09. It will, frankly, be upset by the integration of climate change.
In the 1990s, the ideal behavior of central banks was formalized by John Taylor, a Stanford University economist. The interest rate set by the monetary authority was a function of the deviation of activity from its potential and the distance of the inflation rate from the target chosen for the evolution of prices. It worked well, but central banks were then overwhelmed by the financial crisis, which forced them to keep rates at zero for several years. The usual instrument was no longer operational. Asset purchases replaced the manipulation of interest rates. The consequence has been a dramatic increase in central banks’ balance sheets. Expressed as a percentage of gross domestic product (GDP), the balance sheets of the U.S. Federal Reserve (the Fed) and the ECB have increased almost sevenfold from what they were before the financial crisis.
The recent rise in inflation has forced central banks to take the opposite approach to what they did previously by becoming rapidly and strongly restrictive. Despite the changes, the determinants of the actions of the central banks are to be found in the evolutions of the economic cycle—countering the tensions here or relaxing the constraints there.
The impact of climate change
The Paris Climate Accords (Paris Agreement) define a temperature target for the end of the century and plot a way to get there. The target is 1.5 degrees Celsius (°C) above the pre-industrial average (1850-1900) by 2100; the instrument is carbon neutrality by 2050. It will, therefore, be necessary for society to no longer be able to emit net carbon into the atmosphere in 2050. Any carbon emitted must then be absorbed so that it does not accumulate further, thus limiting the warming effect. This is a necessary condition for the stabilization of the temperature.
This framework defines a trajectory that will converge toward carbon neutrality and ultimately toward the target temperature that will be viable over time.
This is the first interaction between monetary policy and climate change. The modeling of monetary policy will have to be made conditionally based on the convergence toward carbon neutrality. We cannot do without a complex formalization incorporating the path to follow dictated by climate change and the conditions of the economic cycle.
Beyond these elements of formalization, we must also question the dynamics of inflation in this context. Will the energy transition be inflationary? Will central banks be able to maintain their 2-percent target? It is still too early to talk about this new era since the goal of containing inflation has not yet been reached. The transformation of the economy will be such that we cannot shape tomorrow’s model on yesterday’s.
Three additional remarks
- Investing quickly to get on the right trajectory will allow for a smooth transition. The later this adaptation takes place, the more brutal and destabilizing the road ahead will be for the economy.
- If there is an optimal trajectory of convergence toward carbon neutrality, it is not the one taken by governments. As part of the Paris Agreement monitoring, each government must define its commitments in line with the signed agreement.
This exercise is renewed every five years. After the COP27 (2022 United Nations Climate Change Conference) in Sharm el-Sheikh, Egypt, in November 2022, the commitments made by the signatory governments of the Paris Agreement suggest that by the end of the century, the temperature will be 2.7°C above the pre-industrial average. That is way above the target. This implies that catch-up dynamics, which may sometimes be brutal, will be required to get back on the right track. This will destabilize economies and profoundly disrupt central banks’ decision-making.
- This divergence illustrates the difficulties central banks will face. The Network of Central Banks and Supervisors for Greening the Financial System (NGFS) defines three main scenarios: in the first, there is a form of coordination at the international level to deal with climate change; in the second, there is a disorderly situation without real coordination and with delays in investments; and in the third, the worst becomes possible. In their reflections on monetary policy, the central banks and, above all, the ECB will have to calibrate their strategies according to these three scenarios, which are not alike.
Dealing with climate change will not be easy for the world in general, but for central banks, the period will be more difficult to manage. The trend level of inflation is poorly understood. Could the target rate of 2 percent still be relevant in a world in which the economic model is upset? In addition, the deviations observed from the correct trajectory risk causing catch-up phases, generating volatility in macroeconomic dynamics and, therefore, in prices.
This most classic part of monetary policy is not the one on which the ECB has focused most speedily.
Financial stability is at the heart of the ECB’s action
In the ECB’s monetary strategy, there is also a dimension linked to financial stability—reflecting its role as the lender of last resort. This objective is not treated in the same way as inflation, but we can also clearly see the destabilizing nature that climate change could have on financial systems.
The issue here is more about the assets and their quality in the context of climate change. A clear element of the energy transition is the decarbonization of the economy. We must quickly and drastically reduce the use of fossil fuels to curb greenhouse-gas emissions. To respect the framework of the Paris Agreement, the IPCC (Intergovernmental Panel on Climate Change) recommends the emissions peak be reached in 2025. We must, therefore, act very quickly.
Decarbonizing the economy means both promoting renewable energies with small carbon footprints and forcing companies to adopt strategies in their production processes that are compatible with the energy transition. This also involves discussing the sectors with activities directly linked to fossil fuels.
A new framework to which we must adapt
The global economy must adapt to the new environment in all of these different aspects. A central bank’s objective is to intervene as quickly as possible to facilitate adaptation. This point is not insignificant because there is a techno-optimistic vision of the climate issue that suggests that in the not-so-distant future, one or more technologies will be found to allow excess carbon to be absorbed. This assumes that everything can always continue as it has before.
No reasonable person can subscribe to this idea, especially not leaders of central banks. Moreover, the BIS evoked in the conference mentioned in the introduction the possibility of a “Green Swan”—a reference to a black swan event, which is the eruption of a systemic shock on financial markets that cannot be anticipated. According to the BIS, a Green Swan would be more destabilizing because there would be physical impacts resulting from climatic events in addition to financial shocks. In other words, the financial shocks would be accompanied by lasting physical impacts resulting from rising oceans, heat domes or more widespread fires.
The ECB’s action
For now, the ECB has focused more on the necessary decarbonization of the economy and the issue of financial stability. It has considerable leverage for this since it has been buying assets for a long time and on a large scale. As a key market player, it has the power to set the conditions required for it to purchase these assets.
Since October 2022, the ECB has focused on the business market. For assets purchased as part of its unorthodox monetary-policy operations, the bank buys securities issued by states, agencies, covered bonds and many companies.
In 2022, the portfolio of corporate assets held by the ECB was 385 billion euros. It classified the issuers from zero to five according to three criteria: the first based on their past greenhouse-gas emissions policies, the second on their commitments made for the future and the third on the quality of the information published in the context of decarbonization. After analyzing its portfolio, the ECB indicated that one-third were rated four, one-quarter were rated three, and one-fifth were rated five, the highest rating. More than half of the portfolio, therefore, had a rating of four or five.
The ECB has been using these criteria when arbitrating its purchases of corporate assets since October 2022. Lagarde noted that the portfolio now has a larger proportion of assets with clearly defined goals of reducing emissions than the securities market. Its objective is to accentuate this strategy and make it sustainable. For assets that do not meet its criteria, the ECB can significantly reduce its purchases or shorten the duration of the assets purchased to avoid taking long-term risks.
Several questions remain unanswered
- The first concerns the expansion of the assets retained. For now, only business assets are concerned. In the near future, the entire portfolio must be associated with decarbonization. This will make it possible to influence states’ policies in particular. This move to a larger scale will be essential for the credibility of the ECB’s actions.
- The second involves the adequacy of this substitution of securities with a monetary policy of reducing the balance sheet in the short term. Until now, the ECB has continued to buy securities as part of its monetary policy so that it can make choices regarding its new purchases as well as the reinvestments of income from its portfolio. Its balance-sheet reduction will first be accomplished by less reinvestment and then by stopping reinvestment and asset purchases. The central bank will then have to arbitrate within its balance sheet. This will be a more complex operation to carry out.
- It may also intervene directly in refinancing operations to influence day-to-day behavior. Discounts may be applied to assets provided as collateral. Ultimately, the Eurosystem will accept as collateral only securities that comply with the Corporate Sustainability Reporting Directive (CSRD). This will apply in 2026.
The European Central Bank wants to take stock of the upheavals caused by climate change quickly. By being at the heart of the financing of the economy, it has considerable leverage and the ability to be effective.
Other central banks will end up copying it because climate change is transversal, and there is an urgent need to change the current situation to maintain the world’s population in a livable environment.