Why central banks have to be climate change activists
As the ECB touches gloves with the Bundesbank over climate, Nick Silver argues central banks have a duty to steer the markets towards green
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Two heavyweight central bank Presidents are squaring up for a fight over climate change. The disagreement is whether the European Central Bank (ECB) asset purchase programmes should be biased towards ‘green’ or should be market neutral.
In the green corner, we have Christine Lagarde, President of ECB, who says that “in the face of what I call the market failures”, we have to ask “whether market neutrality should be the actual principle that drives our monetary-policy portfolio management”.
Lagarde goes on to say that central bankers “will have to ask themselves the question as to whether or not we’re not taking excessive risk by simply trusting mechanisms that have not priced in the massive risk that is out there”.
She is tentatively suggesting that the market is wrong – it is mis-pricing climate risk and the ECB could therefore compensate by preferencing green.
The whole purpose of intervening in the market and purchasing assets is to alter the market - an asset purchase is inherently non-market neutral
In the ‘brown’, or more accurately the ‘light green’ corner, we have Jens Weidman, President of Deutsche Bundesbank, the German central bank, who writes in the Financial Times: “It is not up to us to correct market distortions and political actions or emissions”. Governments have the tools to address climate change, such as taxes and cap-and-trade, and have the political mandate to do so.
Weidman argues that central banks do have a role to play with respect to climate change, but it should be limited to ensuring transparency and proper consideration of climate risk.
So who is correct?
Weidman is correct that governments should set a carbon price, and that central banks cannot “wave a magic wand” to solve climate change, but his argument rests on the assertion that it’s a central bank’s job to ensure price stability and that “market neutrality” best ensures this outcome. However, the whole purpose of intervening in the market and purchasing assets is to alter the market - an asset purchase is inherently non-market neutral.
Weidman might respond that if you buy assets that are ‘neutral’ between sectors, you may be changing the liquidity of the overall market without affecting the balance between sectors.
We have to remember, though, that the ECB is not planning to buy one or two bonds; it is embarking on a €3.5trn asset purchase campaign. This will cause a massive distortion in the market – it is impossible to invest this amount of money in a market neutral way.
The landscape of assets that the ECB could purchase does not map neatly onto the economy landscape as a whole; it is necessarily highly skewed. The owners of these securities are not representative of the population as a whole and the interest rates affect different sectors of the economy in different ways. Therefore, when a central bank engages in an asset purchasing programme, it prejudices certain groups.
There could be a variety of reasons why some corporations are disproportionately represented by the debt instruments the ECB will purchase. Some require more capital than others, or have chosen to fund themselves in the debt market. Larger entities have access to the financial markets, whereas smaller ones do not. When a central bank purchases debt instruments, the cost of capital of some sectors will be reduced compared to others; specifically large corporations with lots of debt and high capital requirements.
Generally, the wealthier you are, the more financial assets you own. Buying assets pushes up their prices, making wealthier people wealthier, and increasing inequality. Leaving aside whether this is fair or not, wealthier people spend money differently to poorer people, so certain sectors of the economy will benefit at the expense of other sectors.
Finally, changing interest rates away from ‘market’ value necessarily favours some groups over others, in a highly complex way. Take pension funds as an example – lowering interest rates means the cost of purchasing a pension increases, leaving people retiring worse off.
In summary, the asset purchase programme of the ECB will not be market neutral, so Herr Weidman has to be disqualified from this fight for basing his argument on a theoretical ideal that is so far from reality it can be of no instrumental value.
But I have not addressed the question of whether central banks should bias their purchase to ‘green’. There is perhaps a stronger argument against this: that the ECB does not have a democratic mandate to enact climate change policies - it is up to governments to do this.
The EU’s headline policy on climate change is 55% GHG reductions by 2030 (below 1990 levels) and climate neutrality by 2050. This effectively means that all unabated fossil fuel usage will have to cease within 30 years, and all carbon-intensive industries will have to transform themselves. In such an environment, some carbon-intensive companies may survive if they take drastic action, but realistically the energy and high-emissions industries will be dominated by new entrants (for example, Tesla has a competitive advantage over, say, Ford, when it comes to electric cars).
Capital markets are biased towards the past. Carbon heavy industries are generally capital intensive and have been around for a long time, which means that they have received large amounts of funding already, and represent a disproportionately large proportion of capital markets. The rapidity of transformation implied by the EU’s policy means that the ‘brown’ economy will have to quickly disappear and be replaced by a green one. The green sector is currently smaller than it must become and is therefore under-represented by debt instruments. Hence, by pursuing a “market neutral” strategy, the ECB would be reducing the cost of capital for fossil-based companies, effectively propping up declining industries.
Furthermore, this will enable carbon intensive companies to invest in new capital stock (which will become stranded), employ more people, pay taxes and lobby; weakening government resolve to implement the policies that Herr Weidman advocates to achieve a rapid transition to a low-carbon economy.
To follow the democratically mandated EU climate change policy, the ECB has no choice but to preference green asset purchases over ‘brown’. By pursuing a “market neutral” approach, it would be actively defying this policy.
Nick Silver is the co-founder of the Climate Bonds Initiative and a Director at Callund Consulting, which advises developing countries on social insurance. He is on the Council of the UK’s Institute and Faculty of Actuaries, and has roles at the Grantham Institute, Cass Business School and Anglia Ruskin University.