How does ambitious climate policy affect optimal central bank collateral policy? This paper proposes a novel DSGE model with environmental and financial frictions, in which the quality and quantity of corporate debt affect welfare and optimal central bank policy, because banks can use corporate debt as collateral for central bank loans. By increasing default risk (collateral quality) and decreasing debt issuance (collateral quantity), higher emission taxes affect the optimal collateral policy trade-off in non-trivial ways. The model is calibrated to euro area data and offers a quantitative perspective on how this trade-off is resolved optimally.

A Central bank’s collateral policy specifies which assets banks can use as collateral to obtain funding from the central bank. Central banks set their collateral policy wide enough to ensure that the available quantity of collateral allows banks to borrow from the central bank when necessary, and narrow enough to make sure they are not overly exposed to low quality collateral, which might result in losses if a bank defaults on its central bank loans. This paper examines the implications of ambitious climate policy for optimal central bank collateral policy. High emission taxes reduce aggregate productivity, which negatively affects the sustainability of corporate debt: a collateral quality effect. At the same time, the reduction in productivity also depresses investment and loan demand: a collateral quantity effect. Which effect dominates is not obvious a priori and ultimately a quantitative question.

A quantitative DSGE model with environmental and financial frictions

The model features two environmental frictions that shape optimal climate policy. Firms generate emissions during the production process that inflict losses on the wider economy (Nordhaus, 2008). To address this externality, the public sector levies emission taxes, but firms can only reduce their emissions at a cost, for example by engaging in costly abatement activities (Heutel, 2012) or by switching to less productive technologies (Acemoglu et al., 2012). Optimal emission taxes trade off these costs with the benefits of emission reduction (lower emission damage). Additionally, there are three financial frictions which give rise to a collateral policy trade-off. Firms face a choice between equity and debt financing but can default on their debt. Banks can use corporate debt as collateral for central bank borrowing, which arises due to liquidity shocks. The central bank sets minimum rating requirements and valuation haircuts to protect itself against potential losses in case a bank defaults on its central bank loans. Optimal collateral policy balances the availability of collateral against the risk of the central bank being exposed to losses from accepting risky corporate debt as collateral. The model is calibrated to match important features of the corporate debt market, such as firms’ leverage ratio, their default frequency, and the collateral premium on corporate debt.

Implications for optimal collateral policy

Emission taxes reduce aggregate productivity, which impairs both the quality and quantity of collateral and hence affects both dimensions of optimal collateral policy. Quantitatively, it turns out that the collateral quality effect dominates for emission tax shocks with an empirically plausible persistence. In this case, firms reduce their investment and debt issuance only temporarily and it is optimal to tighten collateral policy. This can be achieved either by increasing valuation haircuts, or by raising minimum rating requirements, or through a combination of both. If emission taxes are highly persistent or even permanent, the collateral quantity channel dominates, as investment and loan demand remain depressed. By contrast, the riskiness of corporate debt reverts to its old level once firms can adjust their leverage ratio. The reason behind the short-lived collateral quality effect is that emission taxes do not affect firms’ incentives to use debt or equity financing. Taken together, our results suggest that it is a key challenge for central banks to distinguish between transitory and highly persistent (or even permanent) climate policy changes, as this distinction is a crucial determinant of the optimal collateral policy response.

References

Acemoglu, Daron, Philippe Aghion, Leonardo Bursztyn, and David Hemous (2012). “The Environment and Directed Technical Change.” American Economic Review 102(1), 131–166.

Heutel, Garth (2012). “How Should Environmental Policy Respond to Business Cycles? Optimal Policy under Persistent Productivity Shocks.” Review of Economic Dynamics 15(2), 244–264.

Nordhaus, William (2008). A Question of Balance: Weighing the Options on Global Warming Policies. Yale University Press.