The legal mandates of central banks (CB) typically include responsibility for price stability, financial stability and the safety and soundness of financial institutions (e.g. our banks and insurers). So they’re effectively tasked with scanning the horizon to identify and understand those structural issues that could impact our financial systems …. and the economy. Importantly, they are also generally autonomous from our political systems.
Climate change is a market failure; carbon isn’t assigned its necessary economic cost. Which means CB’s, led by the Bank of England Governor Mark Carney, are increasingly discussing the financial stability implications of climate change and the required appropriate response. Many are concerned that without further mitigation, cumulative emissions pose significant risk of economic disruption. CB’s views on what constitutes an appropriate time horizon for considering risks seem to be changing.
For instance, historically, weather related ‘shocks’ to the financial system have been short-term, the impact on output or inflation has been temporary and policy-makers have been able to ‘look through’ them. However, some are now beginning to think that the increased frequency and amplitude of adverse weather shocks can no-longer be ignored if we are to avoid more extreme outcomes, the financial impacts of which would be difficult for central banks to manage. Separately, the impact of climate related employment shifts on wage inflation or energy price shocks as we shift to renewable energy are other considerations which could make CB inflation targeting more difficult in the future.
In their regulatory role, CB’s perspectives are also changing. Insurers have long been on the front line of dealing with the weather related impacts of climate change. They have adapted their modelling and pricing accordingly. This is less the case for banks. Late last year, the ECB indicated to the Euro-zone banks it regulates, that it had identified climate-related risks as being among the key risk drivers affecting the euro banking system. Similar messaging has come out of the Bank of England.
What are these risks? Both the banks and their regulator are still exploring this. But basically they are either physical risks e.g. mortgages of homes at risk of flooding or consumer loans on diesels cars etc., or transition risks i.e. those relating to the shift to a low-carbon economy. Responses to a Bank of England survey last year suggested that relatively few of the UK banks are managing these risks in a strategic fashion, principally because their business planning horizon only stretches to a few years out.
Time horizon is the common link between a lot of these considerations for CB’s and the financial institutions they regulate. Think short-term and there is little incentive to address climate change. Do too little, too late and you might not be able to manage the impact. But do anything too radical in the short-term and you risk materially damaging your business or the systems financial stability. This is the balance that our national and central banks must find. However, they are now undoubtedly giving more consideration to using the tools they have to address climate change.