“Climate change is macrocritical” – interview with Danae Kyriakopoulou

Environmental sustainability is no longer a long-run consideration that is beyond the time horizon of central banks and financial supervisors. The challenge facing central banks is not that of how to begin reconciling environmental sustainability with their present objectives. Rather, it is how to continue reconciling the lack of environmental sustainability with these objectives – said Danae Kyriakopoulou to Economania blog. She represents the view that central banks must go beyond climate risk lens and support transition which means focusing not just on how climate change affects the financial system but also, reflecting a double materiality principle, how the actions of actors in the financial system contribute to the acceleration of the climate crisis, or to its solution.

Kolozsi Pál Péter (KPP): Climate change has become really topical during the last couple of years – even among central bankers who are typically considered as the most conservative representatives of the field of economics. What can explain that change in your opinion?

Danae Kyriakopoulou (DK): Central banks’ interest in the climate agenda has intensified in the past two years but that has been the result of a gradual process. The shock of the 2008 Financial Crisis was particularly important in terms of enabling a sensitivity among central banks to monitor potentially significant future financial stability challenges.

With regards to climate change, a major turning point came with the signing of the Paris Agreement in 2015, which signalled that major policy changes will be needed for the commitments to be achieved. This set a clear political direction. Taking this as a given, central banks as independent and unelected bodies took up their responsibility to explore what this meant for the financial system and their mandates relating to price and financial stability. Central banks recognised that the transition would have important implications for the financial system, and so would be within their mandates to act. The Financial Stability Board’s setting up of the Taskforce for Climate-related Financial Disclosures (TCFD) in that same year is one example demonstrating this.

There were also specific turning points in individual countries. For example in the UK, the Adaptation Reporting Power (ARP) was created as part of the Climate Change Act of 2008. This enabled the Secretary of State to ask the Bank of England and other key organisations to report on what steps they are taking to prepare for climate change. The first such report was published by the Prudential Regulation Authority on climate impacts on the insurance sector in 2015 and two further rounds have been published since, the latest in 2021 on the role of capital requirements.

Perhaps the most important turning point for central banks globally was the creation of the Network for Greening the Financial System (NGFS) in December 2017. Even though it started as a small group, the body of work it has created has helped draw in more central banks into its framework and demonstrate the links between climate change and their policies and operations. In that regard, one cannot underestimate the critical role of leadership at the individual level, at least in the early phases of cementing the agenda. Central banks’ climate agendas would not be as advanced as they are today without the commitment of leaders such as Mark Carney, Frank Elderson, Luiz Pereira da Silva and others.

KPP: Central banks can support the fight against climate change but they cannot win that fight alone. How could you describe the potential cooperation between central banks, the government and the financial sector in that context? In your opinion, is international cooperation necessary between the different central banks in that fight?

DK: The climate challenge is too big for any one institution to solve alone. All agents including governments, central banks, supervisors, regulators and the private financial sector must work together in a coordinated and aligned manner.

Their work must be complementary; their mandates, functions and toolkits are different. The primary responsibility lies with elected representatives and governments to first and foremost set the direction of policy that can give non-elected bodies such as central banks a basis on which to act. The signing of the Paris Agreement mentioned previously is one such example.

Beyond providing the signals, governments also need to deploy their toolkit to address climate vulnerabilities in the financial system and direct capital to where the opportunities from the transition lie. With climate, we cannot afford another decade where monetary policy and central banks are ‘the only game in town’. This did not work in the case of generating a recovery in the previous decade and will certainly not be enough to address the scale of the climate challenge.

Beyond working together with governments and other actors, central banks also need to continue working together with each other, to exchange knowledge and share best practice in what is an emerging and uncharted territory of work for many. Cross-central bank collaboration has already been exemplary through the work of the NGFS.

KPP: How do you see the impact of climate change on financial stability and inflation, concerning the extent and the time horizon?

DK: There is no question that climate change is macrocritical. The economic shocks it induces are already impacting both financial stability and inflation. The scale of the impact is already big and growing further. While environmental risks are non-linear, complex, and subject to ‘radical uncertainty’ and ‘green swan’ tail events, the extent to which they materialise does at least partly depend on the action central banks but also other policy-makers take today.

The impacts on financial stability have been the ones most closely examined by central banks so far. They are felt through two broad channels: Physical risks capture disruption to economic activity and trade, or destruction of assets and loss of productivity from rising temperatures, extreme weather events and natural disasters. Physical risks also capture climate-change related loss of biodiversity that can affect sectors such as agriculture and, in turn, the financial institutions that are exposed to it.

The second broad category is that of transition risks, induced by shifts in policy, regulation, technology and consumer preferences. These shifts will incentivise a reallocation of resources from some sectors to others that will – at least in the short term – cause frictions and disruptions. The most relevant one for financial stability is the potential of a ‘climate Minsky moment’, causing a widespread repricing of risk.

Central banks have devoted less attention to exploring the potential impacts on inflation and price stability, but these are now also emerging in the agenda. The concepts of physical and transition risk channels can be deployed here too. The increased intensity and frequency of natural disasters and the increased volatility in weather patterns can affect economic output and in turn, prices. This can increase price volatility and make inflation forecasting and decision-making in relation to monetary policy more difficult for central banks.

The transition itself, as a process of reallocation of resources from some sectors to others, is – at least in the short term – generating impacts on inflation. As argued by ECB Executive Board member Isabel Schnabel in a recent speech, the energy sector is one example where the transition phase may result in a protracted period of higher inflation. Increased demand for metals and minerals such as copper, aluminium and lithium that are needed as inputs to construct sustainable energy and transport infrastructure will also increase their prices, generating so-called ‘greenflation’.

KPP: Environmental sustainability and price or financial stability objectives can be conflicting in the short run. How would you reconcile these different objectives?

DK: Environmental sustainability is no longer a long-run consideration that is beyond the time horizon of central banks and financial supervisors. Price and financial stability objectives are already being affected. As an indication, global losses from natural disasters in 2020 came to US$210bn. Due to the increasing likelihood and severity of extreme weather events, physical risks are growing in frequency and intensity. The greater challenge facing central banks is not that of how to begin reconciling environmental sustainability with their present objectives. Rather, it is how to continue reconciling the lack of environmental sustainability with these objectives. The disconnect is becoming harder and harder to reconcile.

Looking at transition risks, it is clear that delivering the transition will generate short-term friction and costs as governments define their transition plans and the economy adjusts and reallocates resources from some sectors to others. But it is also clear that delivering the transition is absolutely necessary in the face of an existential crisis that is climate change. Since it is not possible to avoid the costs of it, the question becomes how to reduce them and make them manageable, and minimise implications for financial stability. Anticipating and managing these risks in a gradual way can reduce the level of the impact. ‘Too little, too late’ or a ‘disorderly transition’ should be avoided.

KPP: „Central banks must go beyond climate risk lens and support transition” – that is the title of one of your recent articles. What do you mean by that message?

DK: Central banks have so far engaged with the issue of climate change mostly through a risk lens, exploring how climate change affects the financial system through the physical and transition risk channels explored above. This is derived from the core mandates of many of these institutions that cover price and financial stability.

However, some central banks (such as in the Eurosystem) are also subject to secondary mandates to support the economic policies of the states in which they operate. In those cases, central banks could have a legal responsibility to go beyond the risk lens – without prejudice to their core objectives – and actively support the transition. This means focusing not just on how climate change affects the financial system but also, reflecting a double materiality principle, how the actions of actor in the financial system contribute to the acceleration of the climate crisis, or to its solution.

In practice, this involves as a first step developing new tools and using existing ones to correct market failures and internalise mispriced risk. For example, central banks could look to revisit the ‘market neutrality’ principle guiding asset purchases as it has been shown that this can lead to a carbon bias that stands in contrast to their government’s net-zero transition plans. Following this, central banks can direct capital by deploying a ‘tilting approach’ to asset purchases that penalises assets that contribute to the climate crisis and supports those that contribute to its solution. Other options, already employed by some central banks, include green targeted-lending programme or adjusting macroprudential tools such as capital requirements.

KPP: How do you see the role central banks actually play in the fight against climate change? Are these actions appropriate taking into considerations the legal mandates of central banks?

DK: Central banks have come a long way in recognising the role they can play in the biggest challenge that faces humanity today. This has happened in a gradual and cautious way, and has always been presented in relation to their mandates. This is partly explained by the circumstances in which the central banks’ climate agenda emerged.

The critical period spans across 2015 with Mark Carney’s ‘tragedy of the horizon’ speech, to 2017 with the creation of the NGFS, to 2019 when the NGFS reached ‘critical mass’ with its members covering the majority of the global economy and carbon emitters. That period, after the global financial and euro area crisis and before the Covid crisis, was also a time when central banks were at the spotlight for taking on too much in relation to their operations to generate a recovery, particularly asset purchases in developed economies.

This profoundly shaped the way they understood and publicly defined their role in the climate agenda, being very careful to link any action and argument to their mandates, and grounding the agenda on concepts of risk. The first progress report of the NGFS in October 2018 for example was careful to state that “Climate-related risks are a source of financial risk. It is therefore within the mandates of central banks and supervisors to ensure the financial system is resilient to these risks.”

Addressing climate change is thus primarily about enabling central banks to achieve these core price (financial and macro-) stability objectives. It is clear that addressing these objectives is no longer possible without understanding the implications of climate change for the financial system and preparing it for them. While the primary responsibility is of course with governments, the financial system that central banks oversee will have to fund the transitions. There should be no doubt that they will have to play a core role in ensuring risks are acknowledged and priced in – especially in the face of market failures. And, depending on mandates and their interpretations, some might be tasked to do even more.

To date, I would argue that there haven’t been instances where central banks have braved to take on actions that would be remotely questionable in relation to their mandates. This is not necessarily a positive thing – given the scale of the climate challenge central banks can afford to push further and be bolder in their actions. Looking back at the history of central banking, institutions have often been able to rapidly rethink their approaches in the face of emergencies so we know that this is possible.

KPP: The growing activity of central banks concerning environmental sustainability can put into question the independence of central banks which is considered crucial related to their price stability mandate. What is your opinion about that potential conflict?

DK: In many jurisdictions, central banks are often ranked among the most trusted public institutions. This level of trust is an important asset, but also bestows on them the responsibility to continue to protect it by continuing to be seen as independent institutions removed from the temptations to act without consideration for the long run that come with being subject to a political cycle.

Climate change entered most central banks’ agenda at a time when their independence was under attack over their unconventional monetary policies.  This generated scepticism among some in relation to the climate agenda, and an unwillingness to engage in an issue that may be interpreted as political. For example, in a speech on climate change and central banking in November 2018, Yves Mersch, executive board member at the ECB at the time, warned that ‘The bigger threat to price stability over the long run does not lie in relative price changes [caused by climate change], but rather in a loss of independence by central banks following a situation in which they have ventured far into a political agenda with distributional consequences.’

However, times are now changing. As more evidence becomes available about the scale of the climate challenge and its potential impacts on the economy and the financial system, the more relevant question today is not whether central banks are doing too much to the extent that it would damage their independence, but whether they are doing enough.

The rationale for central bank independence is rooted in the ability of central banks to deliver stable prices in the face of short-term temptations that politically elected institutions may face. As I have argued previously, this ability is preserved by pursuing the right policy options and delivering good results, not by refraining from doing so to defend a reputation for independence for independence’s sake. If fear of losing independence ends up preventing central banks from pursuing the right policies and using the tools appropriate for the conditions they face, this can risk being the very reason why they end up losing their independence.

KPP: In the short run, what would be your most important advice to central banks? Some are focusing more on prudential regulation, some on integrating green aspects into monetary policy, and others on making reporting concerning climate impact mandatory. What is your position on that?

DK: Overall, all central banks that have not done so already will have to acknowledge the far-reaching implications of climate change, expand their analytical frameworks and assess the broader economic stability implications. In terms of responding by creating the financial architecture to address these realities, appropriate next steps will be different for different central banks and will depend on four broad factors.

First, their specific mandates. Central banks with a secondary mandate to support the transition can take bolder action than those with just a price stability or a price and financial stability mandate. In the case of the latter, central banks may focus on liaising with governments to explore ways in which their mandates can be updated to reflect new realities. For example, the Bank of England’s remit was updated in 2021 to explicitly include reference to its obligations in relation to the climate agenda. Central banks in emerging markets and developing economies also often have much broader mandates and are involved in their countries’ broader sustainable development policies.

Second, the climate circumstances in their jurisdictions. Some countries, particularly in the Global South, will be more exposed to natural disasters, or will struggle more with raising the funding and resources needed to address them. Appropriate action in those cases may involve scaling up sustainable capital markets with products such as catastrophe bonds, or strengthening the insurance market. Others may expect to be hit harder by gradual changes in temperatures, which may require directing capital towards renovating and building climate-resilient infrastructure.

Third, the economic circumstances. Oil-exporting economies, for example, will be more exposed to transition risks. Economies where the financial sector does not play a major role or where the informal economy is big, may face lower risks of financial instability but may still see their economies hurt by climate change. Focusing on the potential impacts on financial stability will in such cases not be the most appropriate course of action as it may distract from the bigger picture.

Fourth, at which point of their ‘climate journey’ they are. Central banks who started their journey later than others do not have the luxury to take the same steady, slow path. They must accelerate action now and catch up. Climate change is not going to wait.

Kolozsi Pál Péter

Danae Kyriakopoulou is Senior Policy Fellow at the Grantham Research Institute on Climate Change and the Environment at the LSE where she leads the policy work on climate and economic development. From 2016 to 2021, she was the Chief Economist and Director of Research of the Official Monetary and Financial Institution Forum (OMFIF). As part of this, she set up the Sustainable Policy Institute and served as its Managing Director and Chair of its Advisory Council, of which she is now a member. Previously she was Managing Economist at the Centre for Economics and Business Research. She holds a BA in Philosophy, Politics and Economics and an MSc in Economics for Development from the University of Oxford.