Central Banks and Climate Change: Is It a Problem of Fit, Opportunity, Suitability, or All of the Above?

Climate change is humanity’s defining challenge for the 21st century, but central banks have for a long time been absent from the picture. No longer. The Network for the Greening of the Financial System (NGFS), which includes among its members the central banks and monetary authorities of all the major financial centers, has been churning out papers with precise recommendations on how these authorities should shift their views on climate-related risks as regards supervision, disclosure, or monetary policy. Individual central banks and regulators have followed suit. Yet there have also been critics, such as Jens Weidmann, or John H Cochrane. For both advocates and critics, arguments about central banks’ mandate often get mixed with arguments about central banks’ ability to tackle the problem, and arguments on the desirability of greater climate focus get mixed with those about its legitimacy.

In a recent paper, we propose a methodology to clarify the debate and address the objections analytically and sequentially. We distinguish between arguments of ‘fit’, which consider whether climate change has a place in central banks’ mandate; arguments of ‘opportunity’, which analyze when central banks may, or should, act; and arguments of ‘suitability’, that analyze how central banks may (or may not) intervene. We propose a second-level distinction between the way these arguments may be analyzed by central banks themselves and the way they may be analyzed by courts when evaluating the lawfulness of that shift.

The first part of our paper analyzes whether climate change ‘fits’ within central banks’ mandate, or, rather, whether central banks can take into account the predicted effects of climate change to fulfil their mandates. Central banks’ mandates are diverse. If we take price stability as the ‘core’ denominator of those mandates, a historical perspective shows that central banks’ understanding of their mandate has evolved during the years. From this point of view, climate change impacts price stability, and affects a multiplicity of elements of the transmission mechanism. Considering factors that had a decisive impact on the transmission mechanism as out of central banks’ mandate because their effect on price stability was deferred and uncertain has led to poor decisions in the past (eg the leverage-driven bubble leading to the financial crisis). Climate change’s effects can be more drastic. Furthermore, climate change results in an aggravated version of the problem of time inconsistency, which is what justifies the existence of independent central banks in the first place.

These arguments may not only be considered by central banks in order to justify a more active role in climate change. They may also be argued in front of the courts, if a plaintiff claims that a central bank action goes against its mandate under the law. Though, on this point, central banks operate on safer ground since courts tend be deferential to central bank decisions, as it is the case in the US or the EU. Even the most reluctant courts acknowledge that central banks have discretion, if a proportionality analysis is conducted. This is key, as it requires looking at the side effects of the policy, but central banks should also do the opposite exercise, and analyze the costs of inaction.

This brings us to our second point, about arguments of ‘opportunity’, ie why central banks should intervene ‘now’, although the more drastic effects of carbon accumulation will be felt in the future. This problem is embodied in the idea of the (tragic) time horizon of monetary policy. However, one should not confuse ‘when’ central banks should act, with ‘how’ they should do that. One time horizon may be needed for policy rates and a different one for other tools and instruments. The analysis of ‘when’ should be informed by an assessment of the relative costs of action and inaction, ie the analysis should be symmetrical. Once this is factored in, an increasingly thick pile of evidence suggests that the cost of action is much lower than the cost of inaction. Furthermore, the typical analysis logically focuses on the direct shocks of climate change, but tends to underestimate a key factor, namely the interconnectedness of the financial system. The financial system has a network structure. Thus, the problem is not only that central banks may be facing greater costs in case of inaction, but also that the shocks resulting from climate change may precipitate contagion effects that central banks and regulators may then be powerless to deal with. This brings further echoes of the financial crisis, where sources of financial fragility and interconnectedness were ignored, precipitating a crisis. It also amplifies the case for early action.

In fact, if the risks of action and inaction are weighed, the proper question is not ‘why now?’, but ‘why not earlier?’. In our paper we provide an explanation for the long-standing passivity of central banks, based on the slow evolution of social norms. Central banks are not primarily bound by the formal legal texts that delineate their mandates, but by their shared understanding of those mandates, and conceptions about ‘time horizon’ or ‘financial risk’. Models show that, for the purposes of norm-transmission in networks, the role of Leaders and their proximity to each other is key, which lends support to the idea of establishing a ‘Network’ for the Greening of the Financial System where the most influential central banks can find a forum where they can influence each other and other players too. Furthermore, in another empirical study we use a value-at-risk (VaR) model to show that, while the perception that climate change is an important aspect has been present in the scientific community (measured by references in top scientific journals) and has also gained ground within political circles, specifically in the European Parliament, it has not been present in mainstream economics, with negligible references in the main journals. Central banks are even more recent newcomers to climate awareness, showing preliminary evidence of the slow evolution of social norms.

And how could these arguments of ‘opportunity’ (or ‘when’ to act) play out in court? Generally speaking, a ‘precautionary’ approach on the face of uncertain, but potentially catastrophic, outcomes has been admitted in international instruments (like the Rio Declaration, principle 15), climate change treaties (UNFCCC, article 3.3.), supranational law (such as EU Treaties and  cases of the Court of Justice of the EU), or national laws (as is the case in Australia or the Philippines).

‘Precaution’ allows proportionate early action; and there is no shortage of estimates on climate change’s potential costs and risks to feed a cost-benefit analysis (CBA). The issue has to do with process. The precautionary principle penalizes (disproportionately) action, as opposed to inaction. CBA in administrative practice does assess costs and benefits within a specific administrative process that emphasizes discussion and consensus. CBA in case law is problematic because some courts have deployed the test requiring precise evidence of the costs of a measure over its benefits, including the costs of inaction. The result is an asymmetric treatment of costs/risks, and a preference for the status quo.

This last consideration brings us to our third point, which relates to ‘suitability’. Once we conclude that central banks can and should intervene, and that they should do so now, it is equally important to determine ‘how’ central banks may intervene, and how this may affect their role. It is conventional to object that a climate-friendly stance by central banks will introduce distortions in the market, and thus endanger market neutrality. Yet ‘market neutrality’ is not a binding principle, just an aspirational policy, and one that is as honored in the breach as in the observance. Yet, a more important argument is that market neutrality objections against climate-based central bank policies suffer from a lack of symmetry. If we consider the ‘unconventional’ measures (including massive asset purchases) after the 2007-2008 financial crisis, they were but a reaction to a crisis that was partly precipitated by central banks’ obliviousness towards asset bubbles, leverage or financial fragility. Thus, ignoring a phenomenon because its effects lie in the future is not ‘market neutral’ if that means more intrusive, less planned, intervention at a later stage.

The objection that climate-based policies will jeopardize central banks’ ‘independence’ suffers from a similar lack of symmetry, because it rests upon two simplifications. First, it assumes that a warmer future presents no threat to central bank independence. On the contrary, the pressure would mount to subsidize governments’ steep adjustment to the warmer climate. Second, it assumes that climate-focused policies mean a more subservient role for central banks vis-à-vis governments. On the contrary, evidence suggests that government policies are not up to the enormity of the task, which means that central banks need to rely on their own technical expertise and vast amounts of data to objectively gauge the path and the cost of adjustment, and evaluate the credibility of government policies to meet their targets. This does not place them outside their traditional remit, but at the heart of it.

Thus, central banks’ climate-related adjustment promises a renewed relationship with industry and, especially, political bodies. In principle, courts are not called to be major players in this shift, but they will surely be the ones monitoring that the agreement is honored. Court scrutiny will predictably focus on two pillars: transparency and accountability. The latter, in our view, requires less a reform of the framework than a reform of the practices, with more assiduous and granular exchange of views between central banks and political bodies.

In conclusion, a methodical, step-by-step analysis of the different arguments shows that central banks may, and should, integrate climate change considerations as part of their mandate, that they should be proactive, and that they should adjust their toolkit with precision. They should accompany this adjustment with a clear communication strategy to signal their precommitment, allowing market expectations to do their part. This shift will be contentious, and fraught with uncertainty and conflict, but this cannot deter institutions designed to be less time-inconsistent than elected leaders.

David Ramos Muñoz is an Associate Professor of Private Law at Universidad Carlos III de Madrid

Antonio Cabrales Goitia is a Full Professor of Economics at Universidad Carlos III de Madrid

Ángel Sánchez is a Full Professor of Applied Mathematics at Universidad Carlos III de Madrid