Central Banks

Climate change impacts central banks’ core mandates of financial stability

Department/ policymaker

 

101 ideas for a sustainable finance policy package

 

Provide clarity on green 

Tilt investment to green opportunities

Build green investment pipelines

private finance

public finance

blended finance

Central bank

 

39. Stress testing

40. Disclosure requirements 

41. ESG risk management standards 

42. Capital & reserve requirements 

43. Tilt credit operations 

44. Green foreign exchange reserves

45. Adjust Collateral frameworks

46. Green credit guidance 

47. Green finance research and analysis

 

The role of central banks (CB) in addressing climate change is increasing in prominence. Where once central banks were thought of as far removed from these considerations, the growing consensus that climate change poses a systemic risk to financial stability brings it firmly within central bank remits. The growth of the Network for Greening the Financial System (NGFS) to 116 members, as of 14th June 2022, is proof of this. In addition, the threats of biodiversity loss to financial stability are such that the NGFS has declared that these fall within the CB mandate.[i]

Central banks’ reluctance to address climate change partly stemmed from concerns of distorting financial markets and impacting price stability, the main focus of CB mandates). This particularly limits green monetary policy, as asset purchase follows market distribution/structure – also known as market neutrality. However, the COVID-19 pandemic saw several central banks including Bank of Japan,[ii] Bank of England[iii] and Bank of Nigeria[iv] adjust monetary policy to support SMEs. Central banks’ COVID-19 response measures provide important examples for how central banks can address climate-related risks.[v]

Central banks are increasingly recognising that ‘market neutral’ approaches under-price climate risk and can overly favour high carbon assets due to their dominance of financial markets.[vi] Adjusting monetary operations away from the market neutrality principle andtowards climate neutrality can help ensure financial stability and resilience to climate-related risks.

Central banks can adapt almost all elements of their policymaking to reduce financial stability risks from climate change. While monetary and prudential instruments are presented separately here, there is a need for coordination of these policies, to address climate-related risks which affect financial stability. In addition to the below policies, the central bank can play an important influential role in growing sustainable finance, through research and development, for example, the research produced by the NGFS. [vii] They can also play an instrumental role in green Taxonomy development; ASEAN central banks led the development of the regional taxonomy and several national taxonomies. Through promotion of this research, and introduction of some of the policies outlined below, central banks can signal importance of climate change issues to market participants and encourage further action, beyond that incentivised by specific policies.[viii]

 

Address climate risk in prudential policy

Prudential regulation is primarily guided by the Basel Committee on Banking Supervision (BCBS). Basel III is its global framework for regulation, covering minimum capital requirements, supervisory review and market discipline. A review of its core principles and supervisory review process concluded these were sufficiently broad to accommodate supervisory response to climate change, however while they accommodate response to climate change, they do not explicitly account for climate risk. Until the Basel Framework explicitly integrates climate-related risk, and given the long timelines to update the framework, individual CBs will need to take steps to address climate-related risk exposure. 

BCBS recently issued 18 principles for the effective management and supervision of climate-related financial risks, to provide additional guidance on addressing climate-related financial risks.[ix] Central banks can use these principles to inform FIs about their expectations for the management and disclosure of climate and environmental risks.[x] For example, the BCBS principles suggest compensation policies could be altered to include climate risk.  

Within prudential regulation, central banks can take action to ensure financial institutions adequately integrate climate risk. Climate stress testing (carried out top-down by the CB or bottom-up by individual FIs) is an important tool to reveal sources of climate risk vulnerability within the economy. This can also prompt FIs to take action to improve climate resilience and can inform monetary and prudential policy operations.

Central banks can make use of the NGFS scenarios for national scenario development and stress testing. These six scenarios provide supervisors with various 30-year forward projections of climate mitigation policies and physical climate risks.[xi]

One of the most comprehensive climate stress tests has been carried out by the European Central Bank (ECB). This assessed the physical and transition risks facing 2,000 banks and 4 million companies worldwide over a 30-year period. This showed the heterogeneity of physical and transition risk exposure across regions, sectors and financial institutions, and significant risk concentration. This stress test also explored complexities posed by amplification of natural hazards, such as protection gaps (non-insured losses).[xii] The 2022 supervisory stress tests focus on climate-related risks, carried out as a learning exercise to identify vulnerabilities, best practices and challenges without directly impacting capital requirements.[xiii] The results of the test found climate risks to be relevant for the majority of supervised institutions, with a high reliance on interest income from high-emitting sectors but a lack of long-term strategies to transition credit allocation.[xiv]

Some central banks, particularly in EM, may not have the capacity to carry out economy-wide stress testing. However, they could test a specific risk to which it is particularly exposed. For example, De Nederlandsche Bank (DNB) stress tested physical flood risks, finding that floods with a probability of 1/200 to 1/1000 years could lead to losses of EUR20-60bn.[xv] The National Bank of Belgium’s 2020 Financial Stability Report included an article on real estate transition risk exposures in the Belgian financial sector and recommended that “financial institutions analyse the extent to which the energy inefficiency of their real estate exposures could have an impact on current and future credit risks, and to take measures to manage and limit this transition risk”.[xvi]

A major barrier to stress testing, and introduction of climate criteria in monetary policy, is a lack of data.[xvii]   The lack of Scope 1,2 and 3 emissions, and the use of proxies by financial institutions for emissions data can be addressed by mandatory climate disclosure requirements.[xviii] These are increasingly being introduced by central banks and can also inform policy and prompt FI action. Disclosure requirements can follow the framework set out by the Taskforce on Climate-related Financial Disclosures (TCFD).[xix]

Several central banks now make their own climate disclosures. This provides an example and strong signal to the market. Assessment of climate risks and opportunities will also inform climate-related policymaking.

Similar to disclosure requirements, mandatory ESG risk management standards require financial institutions to incorporate E&S risk factors into their governance frameworks. These may include rules for lending, such as obliging banks to include an assessment of E&S risks as a criterion for loan origination. This reduces the flow of finance to polluting firms. [xx]

Central banks can adjust risk weightings for capital and reserve requirements to include climate risk. These risk weightings normally rely on historical data, and so central banks can add a green-supporting or brown-penalising factor. For example, Hungary’s Magyar Nemzeti Bank introduced preferential capital requirements for green mortgages, by discounting capital requirements against lenders’ balance sheet exposure to green mortgages. This was based on the lower risk of default on green mortgages.[xxi] [xxii]  

Eligibility of these loans for preferential reserve requirements could be verified by a climate science agency, which could assess whether the underlying investments would contribute to greening the energy sector and declare the bank loans that finance them eligible.

People’s Bank of China (PBOC) has included green credit in its macroprudential assessment, with a higher level of green assets improving a bank’s score.[xxiii]

Risk weighting adjustments are a powerful tool for the central bank to increase green lending, without incurring additional expenditure. They can also be made by central banks with even very narrow mandates as they address financial stability risks, rather than promote sustainable development or other such secondary objectives.

Similarly, central banks could introduce normative green capital requirements – in addition to Basel capital requirements. This is only possible in markets with a large enough pool of green debt. 

Some CBs require financial institutions to hold a counter-cyclical capital buffer, with which to absorb potential losses. This is increased when risks build in the financial system. CBs could introduce a carbon capital buffer, whereby financial institutions are required to hold a certain volume of capital proportionate to the emissions intensity of their portfolio. A carbon capital buffer could simultaneously provide resilience to transition shocks and ‘carbon bubble’ risks and create economy-wide incentives to allocate finance away from high-carbon sectors and technologies.[xxiv] No central bank has yet implemented a carbon capital buffer.

A carbon capital buffer, or a brown penalising factor on risk weighting would need to be carefully evaluated in order to ensure that it does not reduce the capital available to transition high-carbon corporates. 

Large exposure restrictions (by counterparty, sector, or geographic area) are employed to limit the exposure of financial institutions to assets entailing high risks or high carbon intensity. This can protect financial institutions against a carbon bubble but could also be employed for the fine-tuning of lending restrictions and credit allocation. Loan-to-value and loan-to-income caps could also be used to limit the extension of credit to certain industries and limit the flow of resources to carbon-intensive sectors or companies.[xxv]

Central banks will also need to evaluate prudential regulation to ensure that it does not unintentionally adversely impact green investment. For example, Basel III stipulates a higher capital requirement for long-term credit because long-term loans are considered riskier. This disproportionately impacts sustainable finance projects as infrastructure projects are, by nature, long-term.[xxvi]

Tilt monetary policy to incorporate climate considerations 

Central banks can adjust credit operations to reflect climate risk. This can be done by adjusting the interest rate of lending facilities to reflect counterparties’ climate-related lending, or according to carbon-intensity pledged collateral. 

For example, the Bank of Japan offers a zero-interest rate to FIs that finance climate mitigation projects in Japan, exempting these loans from negative interest rates paid on central bank deposits. The announced programme replaces an earlier, growth-oriented lending facility, which provided 0.1% subsidy to banks that financed projects deemed to contribute to economic growth.[xxvii] Availability of lending can also be made conditional on climate-related disclosure or proportion of green investments. For example, during the COVID-19 pandemic, Canada introduced a Large Employer Emergency Financing Facility (LEEFF), access to which required TCFD disclosure among other constraints.[xxviii] However, uptake was limited (total seven loans approved) since finance was also available to firms through the Bank of Canada’s asset purchasing programme on less onerous terms. [xxix] This demonstrates the need for consistency across financing facilities provided by the CB and government.

Central banks exert large influence over the market through asset purchases, a tool widely used since the 2007/8 global financial crisis. The size of asset purchase schemes has grown significantly since the GFC, particularly in DM, through quantitative easing programmes. While most CBs carry out asset purchase in accordance with market neutrality, which sets the objective to replicate the relative market capitalization in the central banks’ balance sheet, others have introduced measures to align asset purchase with climate goals. 

Since 2018, the Banque de France has aligned the equity portion of its EUR23bn asset portfolios with a below 2°C trajectory and is now working to align it with a 1.5°C trajectory. This is done by filtering out those companies least compatible with 2°C  and preferencing companies aligned with the target. It also purchased EUR1.6bn of its EUR1.9bn transition financing target by the end of 2021.[xxx]Sweden’s Riksbank made inclusion in its corporate bond QE conditional on compliance with sustainability standards.[xxxi]

As of October 2022, the ECB tilts all corporate bond purchase using an issuer-specific climate score, based on past emissions, ambition of climate targets and disclosure quality.[xxxii] This composite score also enables transition of emissions-intensive companies as the score is not solely based on emissions.

The importance of asset purchase also varies widely, while QE saw growth during the COVID-19 pandemic in order to boost market liquidity, market constraints arising from the energy crisis and Russian invasion of Ukraine saw these programmes limited given concerns over inflation – monetary tightening. 

Similar to asset purchase, foreign exchange reserves can be adjusted to take climate risk into account. For example, Sweden’s Riksbank applied climate risk weightings to a portion of its SEK500bn foreign exchange reserves and excluded bonds from the highly fossil fuel-dependent provinces of Alberta, Canada and Western Australia and Queensland, Australia.[xxxiii]  Hungary’s MNB created a dedicated green bond portfolio within its foreign exchange reserves in 2019.[xxxiv] However, such adjustments must be made carefully in order to avoid restricting the ability of highly polluting states to decarbonise. With growing concern over the impact of transition risk on cost of capital for emerging markets, such policies could include sensitivity to transition plans. 

Collateral frameworks can be adjusted to account for the climate risk of an asset. The collateral framework has a significant impact on price and allocation of capital. It determines what assets an FI can pledge to receive a loan from the CB. This Several central banks have widened the framework, for example the ECB’s includes sustainability-linked bonds. The PBOC includes AA-rated green bonds and credit, citing the lower non-performing loan ratio of green loans.[xxxv]

A haircut (reduction in value) is applied to pledged assets based on their riskiness. This is traditionally calculated based on historical data. Incorporating climate risk will allow better resilience to future systemic risk- as outlined regarding risk weightings for capital and reserve requirements above. Adjusting the haircut allows for a scaled approach to green monetary policy. 

Calculation of green supporting or brown penalising factors may require evidence from climate stress tests, and their strength may also depend on whether the CB feels it is within its remit to actively promote net zero transition. The NGFS suggests the most impactful haircut adjustment to be one that uses a sliding scale combining positive and negative screening, and that this would prevent constraints to liquidity by ensuring post-haircut collateral volume remains constant.

Channel lending to priority activities

Credit guidance is used by a limited number of central banks. This is when the CB mandates that a certain share of loans is issued to specific sectors or that firms in those sectors have access to credit at discounted interest rates. Green targeted refinancing lines enable financial institutions to lend at lower interest rates to sustainable projects by offering refinancing at preferential terms for specified green asset classes. This is most relevant in economies which lack market-based refinancing options for banks due to relatively underdeveloped secondary security markets. 

Asian central banks have used priority sector lending (PSL) to increase the supply or reduce the cost of credit for specific sectors, typically either those that are underserved by financial markets or that are strategically significant. A handful of central banks are experimenting with introducing climate-smart sectors into priority sector lending. The Reserve Bank of India (RBI) added renewable energy as a priority sector in 2015; in 2020, it introduced sub-categories of renewable energy and doubled the lending cap to INR 30 crore (USD3.8m). At the end of March 2020, the aggregate outstanding bank credit to the non-conventional energy sector constituted 7.9% of the outstanding bank credit to power generation compared with 5.4% in March 2015. Bangladesh Bank requires financial institutions to allocate 2% of all loans to green projects and for 15% of all loans to meet a wider definition of supporting ‘sustainable’ activities.

However, these mandatory credit quotas have the potential to create severe market distortions and should be carefully evaluated against other less distortive incentive measures such as preferential treatment of green lending. Rather than setting a hard quota, central banks could offer preferred interest rates for priority sectors; setting interest rates to promote sustainable and curb unsustainable lending. As with other forms of credit guidance, this is a highly interventionist policy and may not be suitable for many central banks.

 

[i] NGFS, 2022. Central banking and supervision in the biosphere: an agenda for action on biodiversity loss, financial risk and system stabilityhttps://www.ngfs.net/en/central-banking-and-supervision-biosphere-agenda-action-biodiversity-loss-financial-risk-and-system

[ii] Bank of Japan, n.d. Special Funds-Supplying Operations to Facilitate Financing in Response to the Novel Coronavirus (COVID-19) https://www.boj.or.jp/en/mopo/measures/mkt_op e/ope_v/index.htm/  

[iii] Bank of England, 2020. The Bank of England’s Term Funding Scheme with additional incentives for SMEs will open to drawings on 15 April 2020 https://www.bankofengland.co.uk/news/2020/apri l/the-tfsme-will-open-to-drawings-on-april-15-2020  

[iv] Central Bank of Nigeria, 2020. CBN Moves to Cushion the Impact of COVID-19 Crisis https://www.cbn.gov.ng/Out/2020/CCD/CBN%20UPDATE%208TH%20Edition%20-%20web.pdf

[v] Burge, L. et al., 2021. Embedding sustainability into the COVID recovery: A Primer for ASEAN Central Banks, Climate Bonds Initiative, https://www.climatebonds.net/resources/reports/embedding-sustainability-covid-recovery-primer-asean-central-banks

[viii] Sachs, J.D. et al., 2019. Handbook of Green Finance: Energy Security and Sustainable Development, Asian Development Bank Institute, https://www.adb.org/publications/handbook-green-finance-energy-security-sustainable-development

[ix] Basel Committee on Banking Supervision, 2022. Principles for the effective management and supervision of climate-related financial riskshttps://www.bis.org/bcbs/publ/d532.htm

[xi] NGFS, n.d. Scenarios Portal, https://www.ngfs.net/ngfs-scenarios-portal/

[xii] ECB, 2021. Climate-related risk and financial stability. Frankfurt

[xiii] ECB, 2022. ECB Banking Supervision launches 2022 climate risk stress test https://www.bankingsupervision.europa.eu/press/pr/date/2022/html/ssm.pr220127~bd20df4d3a.en.html

[xv] DNB, 2017, Waterproof? An exploration of climate-related risks for the Dutch financial sector. https://www.dnb.nl/media/r40dgfap/waterproof-an-exploration-of-climate-related-risks-for-the-dutch-financial-sector.pdf

[xix] Taskforce on Climate-related Financial Disclosures, 2017. Recommendations of the Task Force on Climate-related Financial Disclosures https://www.fsb-tcfd.org/recommendations/

[xx] Sachs, J.D. et al., 2019. Handbook of Green Finance: Energy Security and Sustainable Development, Asian Development Bank Institute, https://www.adb.org/publications/handbook-green-finance-energy-security-sustainable-development

[xxi] Magyar Nemzeti Bank, 2021. Notice on the criteria for the Preferential Green Capital Requirement Treatment for housing loans https://www.mnb.hu/letoltes/notice-preferentialgreen-capital-requirement.pdf

[xxii] Magyar Nemzeti Bank, 2020. Facilitation, deadline-extension in the green capital requirement programme https://www.mnb.hu/en/pressroom/pressreleases/press-releases-2020/facilitation-deadlineextension-in-the-green-preferential-capitalrequirement-programme

[xxiii] Choi, J., Escalante, D. & Lund Larsen, M., 2020. Green Banking in China, A CPI Discussion Brief, https://www.climatepolicyinitiative.org/wp-content/uploads/2020/08/Green-Banking-in-ChinaEmerging-Trends-1.pdf

[xxiv] D͛Orazio, P. and Popoyan, L., 2019. ͚Fostering green investments and tackling climate-related financial risks: which role for macroprudential policies?͛ Ecological Economics

[xxv] Sachs, J.D. et al., 2019. Handbook of Green Finance: Energy Security and Sustainable Development, Asian Development Bank Institute, https://www.adb.org/publications/handbook-green-finance-energy-security-sustainable-development

[xxvi] Cardona & Berenguer, 2020. What role for financial regulation to help the low-carbon transition? https://www.i4ce.org/wp-core/wp-content/uploads/2020/06/RegulationBasCarbone_VA.pdf

[xxviii] CEEFC, 2020. Large Employer Emerging Financing Facility Factsheet https://www.cdev.gc.ca/leeff-factsheet/

[xxix] Osler, 2021. Long term recovery from COVID-19: A primer on LEEFF and its current impact on economic recovery https://www.osler.com/en/blogs/construction/march-2021/long-term-recovery-from-covid-19-aprimer-on-leeff-and-its-current-impact-oneconomic-recovery

[xxx] Banque de France, 2022. Responsible investment report 2021https://publications.banque-france.fr/en/responsible-investment-report-2021

[xxxiv] MNB, 2021. The positive environmental impact of the MNB's green bond portfolio increased significantlyhttps://www.mnb.hu/letoltes/eva-paulik-attila-tapaszti-the-positive-environmental-impact-of-the-mnb-s-green-bond-portfolio-increased-significantly.pdf