Occasional paper series : To be or not to be “green”: how can monetary policy react to climate change?

Climate change is the greatest challenge humankind is facing this century, and its impact is becoming increasingly evident. The Paris Agreement of 2015 represented a significant milestone in the international response to it. The signatories agreed to limit global warming to well below 2°C above pre-industrial levels. Climate models predict this requires cutting net carbon emissions to zero by around the middle of the 21st century, which makes significant structural transformation of the global economy unavoidable

Governments and parliaments have the primary responsibility and tools for addressing climate change. But within their mandates, central banks also need to tackle climate change, both to safeguard their ability to conduct policy smoothly and deliver on their mandates, and to ensure that they remain resilient to emerging climate-related financial risks. Depending on their policy remits, central banks could also consider going beyond a pure risk management perspective and seek to ensure that their operations do not undermine the transition to a low-carbon economy or actively support it.

While several central banks have recognised the implications of unchecked climate change for financial stability and supervision, the implications for monetary policy have received less attention until recently. Our paper aims to fill this gap by considering various reasons why climate change is an important influencing factor for monetary policy and reviewing the emerging literature on how climate change considerations can be incorporated into the conduct of monetary policy and central banks’ operational frameworks.

We start by reviewing the direct and indirect links between climate change and central banks’ policies and objectives and survey a wide range of actions that are currently being debated in the literature. These actions range from passive responses deployed to protect central banks’ balance sheets from emerging climaterelated financial risks, to more proactive policies aimed at supporting the transition to a low-carbon economy. The distinction between alternative approaches is not always clear cut, as it depends, not least, on how the measures are calibrated

Differing approaches may also entail potential conflicting aims. For example, a tension may arise between their effectiveness in pursuing the central bank’s mandate and supporting the transition, their feasibility and operational complexity, and the risk implications for the balance sheet. Any action will require policymakers to carefully weigh and balance the different trade-offs. These are also analysed, together with the constraints faced by central banks in taking action to deal with climate risks.

Some measures are controversial, since they can be seen as extending central banks’ mandate beyond traditional boundaries, encroaching in some cases upon economic policies and raising issues of legitimacy and risks for central bank independence. The exact form central banks’ reactions take will depend on their mandates, the prevailing institutional setting, legal and technical considerations, societal preferences and how various trade-offs pan out in each individual case.

The final part of the paper focuses on the specific challenges faced by inflation-targeting central banks. We consider how climate change could affect certain design features of this monetary policy regime and how it might evolve as climate risks unfold.

Climate disruptions will pose specific challenges for inflation-targeting central banks. These may require policymakers to re-examine the relative merits of some design features of the framework, in particular the definition of the inflation target, the type of inflation measure used in central bank communications and how to appropriately calibrate the “medium-term” horizon of monetary policy. However, the slow-moving, long-term nature of climate change and our still limited knowledge of its possible consequences for the economy and financial system suggest that more precise indications of the impact on inflation-targeting central banks will only emerge over time.