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Climate change and central banks

Article by

Carlos García

On 11/06/18 Benoît Coeuré, member of the Executive Board of the European Central Bank (ECB), spoke about the impact of climate change on monetary policy, reflecting a shift in the perception of monetary authorities that should be taken into account.

Initially, he left the polemic aside on whether or not there is climate change – which settled the question of saying that climate change is not a theory, it is a fact – and we cannot continue to ignore its effects on our quality of life, nor the serious risks of economic interruption that it entails.

In short, central banks must also act, beyond the action of governments and the private sector. This reflection of the member of the ECB is inscribed in the one that preceded it in 2015 when Mark Carney, president of the Bank of England (BOE), coined the term The Tragedy on the Horizon in the framework of a discussion on the implications of climate change in terms of financial instability.

This warning from the BOE president was fruitful in the creation by the G20 of the Working Group of the Financial Stability Board on Financial Disclosures, to help design an orderly and clear transition of the financial impact of climate change in companies and the public sector. This group published its first state report a few weeks ago.

Likewise, in this framework, the Banking Supervision of the ECB informed the banks that risks related to the climate have been identified as one of the main risk factors affecting the banking system in the euro area.

Likewise, the Network of Supervisors and Central Banks for the Greening of the Financial System published its first progress report some weeks ago, reaffirming that climate-related risks are within the mandates of supervision and financial stability of central banks and the supervisors
Now, how does climate change fit into current monetary policy? Its reaction to the shocks generated by the supply side, and how it affects the implementation of monetary policy? It must be recognized that extreme weather events erode the conventional policy space of central banks more frequently, and raise the dilemma between price stability or production stability.

For example, the low carbon energy transition can change relative prices to a degree that will destabilize inflation in the medium term. Also, droughts and heat waves often cause shortages of crops, which increases the pressure on food prices. Hurricanes and floods destroy production capacity, which increase the prices of inputs and production. Also unusually cold winters can be seen as malignant productivity shocks, that is, they can raise the prices of inputs for the same level of production.

The effects of climate change can no longer be seen as temporary. When the inflation perspective is affected in the medium term, the behavior of monetary policy is affected, making it more misguided and erratic. This would be aggravated if catastrophic events generate irreversible consequences in the economy.

In an accelerated energy transition that prioritizes de-carbonization, the marginal cost of renewable energy production can become considerably lower and generate a lasting change in the energy matrix that persistently modifies relative prices. That would affect the monetary policy to affect aggregate inflation.

On the other hand, central banks should warn of the impact of the greater financial risks implicit in the doubts about the continuity of the investments that currently contribute to the energy matrix. In that sense, they must take care of the management of their financial reserves and procure actions that collaborate in the route towards an orderly energy transition.

The recent report of the United Nations Climate Panel makes even more relevant the alerts contained in the ECB member’s speech, since in a scenario that seeks to limit the increase in temperature to 2ºC, according to the International Energy Agency (AIE), at least 80% of the hydrocarbons should remain in the subsoil. If this scenario involves avoiding reaching a limit of 1.5 ° C, this percentage of hydrocarbons increases to 85 or 90%. This change in the energy matrix, for which there would be a space of twelve years, implies strong economic and political costs, which central banks, for example, cannot ignore.

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