Don’t rely on central banks to fight climate change

At the end of August, five members of the United States House of Representatives issued a declaration urging President Joe Biden not to re-elect Jerome Powell, Chairman of the Federal Reserve, when his term expires in February 2022. The group, which included Alexandria Ocasio-Cortez (Democrat of New York), cited two concerns about Powell’s leadership: the Fed easing banking regulations and its lack of action “to mitigate the risk that climate change poses to our financial system.”

Ocasio-Cortez and his fellow congressmen are not the first to suggest that central banks – whose policies have traditionally focused on goals such as price stability and low unemployment – have a role to play in the fight against climate change. The UK Parliament’s Environmental Audit Committee (EAC) has encouraged the Bank of England to make bond purchases with borrowers’ carbon emissions in mind. Many central banks themselves have also accepted some responsibility in the fight against climate change: the European Central Bank says it is “committed to taking into account the impact of climate change in our monetary policy framework”.

But Chicago Booth’s Lars Peter Hansen warns that monetary policy is a weak substitute for fiscal policy, which is much better suited to tackle climate change through tools like carbon taxation and investing in green technologies. . Asking central bankers to intervene where budget makers cannot or do not want to expose central banks to reputational damage and loss of political independence, he argues.

Many observers inside and outside central banks have noted that climate change is a risk to the financial system, and some suggest that central banks are therefore responsible for assessing this risk and issuing regulations. to mitigate it. However, Hansen argues that our understanding of the economy’s exposure to climate change is still in its relatively early stages. While there are short-term concerns about the impact of climate change, the most significant consequences will play out over decades rather than years. These longer time horizons, combined with limited historical experience and wide speculation about possible policy responses, make quantitative assessments of potential consequences difficult. This, in turn, makes it difficult for central bankers to develop transparent policies that are socially productive.

While there is ample evidence that humans have a deleterious effect on the environment, he writes, there is considerable dispersion among quantitative geoscience models as to what a given level of emissions or carbon in l atmosphere will mean for the climate in the future. and perhaps even more disagreement between business models over what these climate impacts will mean for the economy.

This uncertainty about how climate change will evolve and how economies will respond to it should not discourage climatologists and economists, including those employed by central banks, from attempting to model and measure the relationship between change. climate and the financial system. But central banks need to be cautious about crafting monetary policy around these models until some of the gaps in our scientific knowledge are filled, Hansen warns.

“Including climate change as part of a direct or indirect financial stability mandate leaves a bit of guesswork for prudent decision-making,” he writes, adding, “Any undue reliance on our understanding could backfire on us. longer term and damage credibility. by false promises of success.

Central banks are also not currently well equipped to use their authority to monitor individual institutions with respect to their exposure to climate-related uncertainties. Banks and other financial institutions face the consequences of climate change if the assets they hold or the borrowers in their loan portfolios suffer. But assessing their vulnerabilities involves removing uncertainties about not only the evolution of climate change and the resulting economic effects, but also the response of policymakers and technology to those effects. “Regulators and the regulated are exploring new territory in terms of quantifying uncertainty,” writes Hansen.

In his view, a productive role central bankers could play in this area would be to collaborate – with the risk assessment departments of financial institutions as well as with academic economists – to help design ways of measuring and reporting. deal with these uncertainties. Private banks are motivated to understand their own exposures, but because their incentives are not fully aligned with the systemic concerns of regulators, the modeling task cannot be entirely given to them. Working together to understand how unknown variables will affect outcomes predicted by climate and economic models would be an important step in any effort to assess the dangers climate change poses to the financial system, says Hansen.

Likewise, efforts to incorporate climate uncertainty into the stress tests of financial institutions could be helpful, he says, but they require a careful and creative approach. Many central banks use stress tests to assess whether major banks are prepared for times of economic difficulty. But the envisaged financial market disruptions occur on a relatively short time scale compared to climate change. Some central banks, including the Bank of England, have started testing 30-year climate scenarios. Currently, according to Hansen, climate-based stress tests are of limited use because these long-term scenarios are not evaluated for their likelihood of materializing and do not allow for dynamic responses to new information or changes in weather. political, because climate uncertainty becomes at least partially resolved. For example, a predefined C02 Emissions scenario that seems plausible today could be much less plausible once we have more information in the future on the environmental and economic consequences of climate change.

Instead, central bankers could encourage private banks to establish a decision-making framework that prepares them for a wide range of contingencies, rather than focusing on statically specified 30-year scenarios.

As for central banks shifting the large portfolios they manage – and the asset purchases they make through programs like quantitative easing – toward green businesses and investments, as the EAC urged the Bank of England to do so, Hansen is skeptical. Not only do central banks lack the expertise to make such investments or to assess companies on their environmental credentials, but by becoming what Hansen calls “green venture capitalists,” they also run the risk of losing their focus. distance from the political arena, where some political decision-makers will surely have prejudices about which investments to support which are separate from their economic and social merit.

For now, writes Hansen, monetary and regulatory policies are not well suited to tackle climate change directly. But central bankers who feel obligated – or are obligated by others – to act should better focus their energies on helping financial institutions and budget makers to quantify and manage the uncertainty surrounding the intersection of science. climate and the economy.

About Virginia Ahn

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