November 29, 2022
This article was originally posted on the Green Central Banking Scorecard website.
Since the release of the first Green Central Banking Scorecard two years ago, green central banking appears to have gone mainstream. The vast majority of the world’s major economies recognise climate change as a threat to financial stability and are conducting research into the risks posed to the global economy.
Yet analysis produced in the latest edition of the scorecard shows there is still a long way to go to transform the financial system and turn research into policy that will avoid the worst effects of environmental breakdown.
Green central banking has gone mainstream
The COP27 cover decision has recognised that achieving the global transition to a low-carbon economy will require a “transformation of the financial system and its structures and processes” to mobilise investments of at least USD$4-6tn a year, and this will need to be supported by central banks. Over the last two years, the scorecard has aimed to heighten transparency about which central banks are leading the way in this green transformation and which ones are falling behind.
Since the first edition, central banks and prudential authorities have increasingly accepted that climate change falls within their core mandates. All central banks assessed in the scorecard, except for Saudi Arabia, are now members of the Network for Greening the Financial System. This compares to 16 in March 2021, reflecting almost unanimous acknowledgement of the relevance of environmental issues for these institutions.
Progress in recognising the significance of environmental breakdown has coincided with a tumultuous international context. From economic downturns during Covid-19 and the physical impacts of climate change materialising with increasing frequency and severity to the current energy price crises, it is clear that central banks do not operate within a vacuum. Scorecard leaders have recognised that monetary and financial stability cannot be separated from the risks presented by environmental breakdown.
Banque de France and the People’s Bank of China (PBoC) have both produced research explaining how the financial system is implicated in the causes, not just the consequences, of environmental degradation. Civil society groups have been at the forefront of pushing this message of double materiality, which is slowly entering the mainstream of central banking.
Expanding monetary policy toolkits
The changing macroeconomic context over the past two years has brought into sharper focus the inadequacy of central banks’ tools for dealing with crises. Currently, raising interest rates in an attempt to curb inflation may threaten capital intensive green investments, locking in longer term inflationary risks from climate breakdown. In this context, central banks have begun to innovate in their green monetary policies.
The European Central Bank (ECB) has taken a leading role in greening its market operations by tilting its corporate asset purchases programmes towards companies with a better climate performance. It has also committed to penalising the most carbon-intensive assets in its collateral frameworks. Green lending schemes have been adopted in China’s carbon emission reduction facility, and Japan’s climate response financing operations. These schemes provide lower interest rates for lending to green projects, enabling capital to continue flowing towards the green transition in a time of higher interest rates.
Despite progress on directing finance towards the renewable energy of our future, the failure to constrict fossil fuel financing has continued to halt real progress. Over the three scorecard editions to date, the PBoC has fallen from first to third place, and now to sixth due to its credit guidance towards the “green and efficient use of coal”.
China has provided RMB300bn of special central bank lending to coal, labelling it as a sustainable asset in its green industry taxonomy. Collateral frameworks and asset purchase programmes have also remained carbon intensive, none of which is consistent with the goals of limiting warming to 1.5ºC outlined in the Paris Agreement.
As central banks remain committed to the idea of “market neutrality”, they continue to disproportionately support carbon-intensive sectors, relative to these sectors’ contribution to the overall economy.
Analysis prioritised over action in financial regulation
Vocal concerns coming from central banks and financial regulators about environmental risks rings hollow as they continuously fail to adequately account for such material risks in their policymaking. Over the past two years, 14 out of the 20 central banks and regulators included in the scorecard have conducted, or committed to conducting, climate scenario analyses which aim to explore and quantify the risks posed to financial sectors by climate change.
Scenario analyses are inherently limited, as the models underpinning them are unable to accurately predict the impacts of environmental disasters or economic transformations that have no historical precedent. Yet even by their own measures, central banks have found regulated financial institutions are exposed to severe environmental risks. The ECB’s climate risk stress test earlier this year found that the combined credit and market risks of losses without an orderly transition to net zero would amount to a minimum of €70bn.
Despite clear evidence of the need to address environmental risks in order to avoid financial crises, no G20 central bank, financial supervisor or regulator has accurately reflected the risks associated with the financing of fossil fuel assets within its policies. Central banks and regulators should be adjusting capital requirements to account for the risk of new and existing fossil fuel exposures, limiting lending to the most environmentally destructive activities, and actively supervising credible transition plans to net zero. Instead, they continue to assume disclosures will sufficiently reallocate capital away from risky assets.
It’s clear this strategy hasn’t worked so far. Since the Paris Agreement, fossil fuel financing from the world’s 60 largest banks has reached USD$4.6tn.
The winner of this year’s scorecard, Banque de France, has set itself above its Eurosystem counterparts by committing to align its non-monetary portfolios with 1.5ºC, with stringent fossil fuel exclusion criteria. But across the G20, central banks continue to hold portfolios that fail to match their national environmental commitments, and most do not have any environmental policies for investment in their non-monetary portfolios.
Transformations don’t happen by themselves
Despite limited progress in green central banking so far, there is still hope. Since the inception of the Green Central Banking Scorecard in 2021, G20 central banks have almost unanimously rejected the previously-held assumption that climate action falls outside of their mandates. Recognition that financial sector activity causes real risks to the planet is promising, alongside positive steps forward in greening monetary policy and regulating climate-related financial risk.
With continued pressure, next year we hope to report that central banks and prudential regulators have taken action on transforming the financial system to the extent required to secure a healthy and thriving planet.