NY Fed calls for more realistic carbon tax assumptions by central banks

It comes as BoE's Sarah Breeden says UK companies should use carbon prices consistent with net-zero pathways to understand the impact of the green transition.

Central banks should study the feasibility of implementing a significant carbon tax before using the measure to underpin their forward-looking climate scenario analyses, the Federal Reserve Bank of New York has warned.

These exercises have become a mainstay of the central banking toolkit and aim to quantify the impact of climate hazards on economic indicators such as GDP, unemployment and inflation. Carbon prices, a key variable within the scenarios, are used as an indicator of policy intensity as governments attempt to slash emissions through taxation, emissions restrictions, regulation or other policies.

Most of the climate scenarios in use today have been developed or heavily influenced through the work of global central banking group the Network for Greening the Financial System (NGFS).

However, more work is needed to assess whether “an extreme carbon tax that would dramatically raise energy prices and bankrupt high emissions industries is ever likely to arise”, the NY Fed said in a staff research paper published recently.

Such research would be “helpful”, the supervisor said, noting that policymakers would need to weigh up the political implications of such a policy.

“In this light, it is somewhat implausible that policymakers would, for example, ever implement a carbon tax of a magnitude that would jeopardise the short-run debt-servicing abilities of high-emissions firms or dramatically reduce economic activity.”

In addition, the NY Fed said that political inclination to address climate change could vary over the electoral cycle, across jurisdictions, and would be impacted by developments in sectors such as renewables.

It separately called for more research into the formation of investor climate beliefs and expectations due to their links with asset prices. Climate risks will only be priced into current prices if investors are convinced of their inevitability, which needs to be reflected across different climate scenarios, said the NY Fed.

The supervisor also flagged research priorities related to “compound risks” – which describe the interaction between climate, economic, financial, political, and other risks, and potential feedback loops within the financial system that could cause, for example, contagion to spread between banks, or spreading from governments to financial institutions due to perceived sovereign risk.

Irene Monasterolo, a climate finance professor at the EDHEC Risk Climate Impact Institute., told Responsible Investor: “The authors are right to highlight the need to assess the implications of policy uncertainty and investor expectations and how to embed these dimensions in economic models in a meaningful way. This is in addition to the compounding of climate risks with other sources of risks, such as pandemics and banking crises.

“However, it is important to realise that climate risk is not comparable to other types of financial-related risks because it is forward looking and endogenous, thus requiring to work with scenarios.”

According to Monasterolo, existing research has already made some progress on some of the points raised by the NY Fed staff relating to the financial sector response to sharp increases in carbon prices and climate economy feedback loops.

But more work at financial supervisors is needed to integrate these dimensions into current NGFS scenarios, she said.

As of 2021, the European Central Bank, Banque de France (BDF), the Dutch central bank, Bank of England, Bank of Japan and 26 other central banks had either completed or were in various stages of carrying out climate scenario analyses, based on a survey by the NGFS.

The US Fed, which has notably lagged behind other NGFS peers, announced its own pilot exercise earlier this year.

Separately, the Bank of England’s executive director for financial stability, Sarah Breeden, has asked UK companies to use carbon prices consistent with net-zero pathways to understand the impact of the green transition on their operations.

Breeden said recent climate scenario analysis conducted by the BoE revealed “gaps in real economy firms’ understanding of what climate transition means for them” in a speech given yesterday.

The BoE’s inaugural climate scenario analysis, named the Climate Biennial Exploratory Scenario (CBES), was conducted in 2021 and involved the UK’s largest banks and insurers.