The pivotal role of central banks in the climate transition

Cedric Pacheco By Cedric Pacheco

Climate and environmental risks pose a risk to the stability of the financial system. As guardians of monetary policy and financial stability, central banks possess powerful tools that can reshape the financial system, the capital flows and incentives in ways that accelerate or hinder the transition to a net-zero, sustainable economy. 

At their core, central banks aim to maintain price stability and ensure the smooth functioning of the financial system. Climate change poses systemic risks that threaten both of these mandates through physical risks like natural disasters as well as transition risks like stranded carbon-intensive assets. Recognizing this, groups like the Network for Greening the Financial System (NGFS) have brought climate considerations to the forefront for central banks and regulators.

One of the most powerful levers central banks have is their management of the enormous portfolios of assets they purchase and accept as collateral. By limiting the share of assets issued by entities with a high carbon footprint that can be pledged as collateral by individual counterparties when borrowing from the central banks, they can directly reduce climate-related financial risks and impact the cost of capital. Partners such as Council on Economic Policies (CEP) and the Sustainable Finance Lab played a vital role in calling for the integration of climate considerations into corporate bond portfolios of central banks: the European Central Bank has started taking steps in this direction by tilting its corporate bond purchases away from polluters. But much more can be done across other asset classes and monetary policy tools.

In addition, financial regulators can ensure banks properly account for climate risks by adjusting capital requirements and stress testing parameters. Those exposed to significant transition or physical risks would then need to hold more capital, increasing their financing costs for carbon-intensive activities. While the ECB has started this process, most regulators have been slow to embed climate factors into supervisory practices.

The distributive impacts of these policies also deserve scrutiny. Favoring certain asset classes or sectors will have knock-on effects across different segments of society. Policymakers must carefully weigh these dynamics to ensure a just transition that doesn't exacerbate existing inequalities. Programmes like refinancing loans for rooftop solar or home retrofits could help democratize access to green investment opportunities.

Of course, monetary policy and regulation exist within a broader policy landscape. Coordination with fiscal policy levers like carbon pricing, green subsidies, and public investment will be crucial for catalyzing the required shifts in private capital flows at the pace and scale needed. Central banks don't operate in a vacuum - their actions must be complementary to and aligned with other climate policies.

While challenges abound, central banks are already taking their first steps to catalyze the system-wide reforms needed for sustainable prosperity. But much more ambition and bolder actions are still required from these influential public institutions. The path to sustainable financial policy may sometimes seem technical and complex. But make no mistake - how central banks deploy their tools will be pivotal in determining the success of the climate transition and the future health of the global economy.

About the author

Cedric Pacheco

By Cedric Pacheco

Cédric is a Senior Programme Manager at Laudes Foundation in London where is responsible for designing and delivering the Foundation’s financial policy and regulation programme by identifying, supporting and scaling policy interventions that address the threat of climate change and incorporate social equality. Prior to that, Cédric worked in the financial industry for more than eight years focusing on European financial regulations and public affairs at the Association for Financial Markets in Europe and in various positions in Equities Capital Markets at Bank of America Merrill Lynch, NYSE Euronext and Global Private Equity. Cédric is French and Portuguese and a father of a three-year old girl.

Finance and Capital Markets