Board member - Dr Sabine Mauderer

Central bank instruments and the climate Guest contribution in Börsenzeitung

24.06.2020 | Sabine Mauderer | Sarah Breeden DE

Climate change – like the COVID-19 pandemic – will have a profound effect on the global economy. It will be a key influence on the work of central bankers and supervisors everywhere not only with regard to our core objective of price stability, but also with regard to our objective of financial stability.

The nature and the extent of the potential economic and financial shock depends on our collective actions. Everyone has a part to play. If we take decisive action today, there is a good chance that global warming stays below 2.0˚C as set out in the Paris Agreement. If we ignore the risks, then the costs to the economy and the financial sector could be catastrophic for generations to come.

Central bankers and both micro- and macroprudential supervisors need to prepare for those different future pathways, or scenarios. We need to better understand and disclose the impact of climate change and the actions taken in response to it, if we are to ensure that we can achieve our objectives as risks from climate change materialise. To help us do that, climate-models will need to become an integral part of our analytical toolkit.

A new set of reference scenarios by the Network for Greening the Financial System­ (NGFS) – a global alliance of 66 central banks and supervisors set up to contribute to the development of climate risk management in the financial sector – provides an excellent starting point. The NGFS scenarios illustrate how climate change can affect key economic variables, including those that drive monetary policy deliberations. The NGFS also published a guide on how to use the scenarios, and a report on the impacts of climate change on monetary policy. Taken together, this provides us with concrete tools to prepare for the risks created by climate change.

The report on monetary policy shows that extreme weather events and higher temperatures could prompt short-term or even permanent disruptions to supply chains. Furthermore, workers could be dislocated as a direct consequence of more frequent disasters or as a permanent result of sea-level rise. On a regional level, the output of key sectors such as agriculture could be impacted, leading to employment losses.

In terms of inflation - the key yardstick for most central banks – climate change could prompt more frequent revisions to short-term expectations. Moreover, increasing price volatility could challenge the ability of central bankers to achieve their monetary policy objective. These developments require central banks to augment their toolkits – the Bundesbank, for example, is making the NGFS scenarios part of its economic models and analyses.

The NGFS scenarios will help expose vulnerabilities in the financial system to climate-related risks, and will serve as a key input for stress tests, including the Bank of England’s biennial climate stress test for banks and insurers. As an example, the scenarios show how delayed policy action would require a sharp rise in the price of carbon to meet binding climate targets. In addition, large financial investment flows would need to be redirected towards renewable energy and negative emission technologies (which remove CO2 from the atmosphere). In turn, this would trigger write-downs in the values of many real and financial assets, spikes in credit risks and perhaps even a climate-driven credit crunch.

As climate modelling is technical and complex, central bankers and supervisors will need to enhance the way they communicate their financial and economic analyses to households, governments and the financial community. That will foster a greater and broader understanding of the economic and financial risks associated with climate change.

We are living in an important time, as our actions today will crucially determine the future that is to come. We will play our part – and with today’s NGFS publications we now have some concrete tools to do so. But it’s not just for us; everyone should think about how future scenarios could affect them, if they are to weather the storms to of the future.