Unlike advanced economies where central bank mandates are focused on ensuring price stability, developing economies tend to have a wider remit, including supporting the government’s economic policy agenda and its development efforts. So, they have more leeway to address climate change as it directly affects and interferes with their development efforts.
As part of 2021 World Environment Day, the governor of the Central Bank of Nigeria, Mr. Godwin Emefiele, talked about the need to protect Nigeria’s ecosystem and how as part of their efforts to protect Nigeria’s ecosystem, banks will now consider sustainable banking principles when lending money to corporate entities and individuals. The threat of climate change is arguably one of the biggest problems of our time. Rising sea levels, melting polar ice caps and desertification threaten the lives of millions ― especially the poorest who are disproportionately affected by climate change as they tend to be most dependent on agriculture, which is vulnerable to a changing climate. With agriculture employing 35 per cent of the population in 2020, and over 50 per cent of Nigerians estimated to be living in poverty, the central bank’s asking of banks to consider sustainable banking principles is a step in the right direction. But is consideration alone enough?
As with anything new, there have been conversations about the role of central banks in the fight against climate change. On the conservative side, people are of the opinion that central banks should stick to managing the currency and monetary policy of a state or monetary union and overseeing commercial banking systems. On the other side of the coin are those who believe central banks should play an active role in combating climate change because, like it or not, climate change does not just threaten the lives of people, it also endangers macroeconomic stability by causing economic shocks ― which can either be demand-side or supply-side. On the demand side, climate change risks can negatively affect elements of aggregate demand by affecting household (private) or government (public) consumption/investment and disrupting international trade. On the supply-side, climate risks can disrupt labour supply and productivity, technology, and physical capital. As temperatures continue to reach record highs, and climate events occur at an increasing rate, it is undeniable that these weather effects will have more significant impacts on global economic performance.
Unlike advanced economies where central bank mandates are focused on ensuring price stability, developing economies tend to have a wider remit, including supporting the government’s economic policy agenda and its development efforts. So, they have more leeway to address climate change as it directly affects and interferes with their development efforts. A far from exhaustive list of what central banks can do to intervene in addressing climate change and promote green finance are: being central to green prudential and macroprudential instruments that protect financial stability, the development of green finance guidelines and/or green bond markets, and the use of green credit allocation instruments to ensure the assignment of a predetermined amount of credit to green sectors.
Although green quantitative easing does not have the traditional quantitative easing aim of inducing economic growth, it could still do this by potentially boosting the green sector, stimulating employment, and having a ripple effect through the economy.
While there is no consensus with regards the objective(s) of macroprudential policies, the dominant theme is to mitigate risks to the financial system. In terms of macroprudential tools geared towards the environment, these include a green supporting factor involving central banks’ lowering of capital requirements for “green” loans and bonds in a bid to incentivise lending to green sectors and thus promote green investments; differentiated reserve requirements which influence credit allocation by allowing banks with higher green lending to maintain lower reserve requirements and counter-cyclical buffers. In India, the implementation of these ideas have seen the extension of loans to renewable energy companies incorporated in the Reserve Bank of India’s (RBI) Priority Sector Loans scheme, under which 40 per cent of net commercial bank credit must support priority sectors. And as early as 2010, the central bank of Lebanon reduced its requirements for green lending. In Bangladesh, commercial banks and non-bank financial institutions are required to allocate 5 per cent of their total loan portfolios to green sectors ― and the list goes on.
The impact of all this is clear. In Bangladesh, it is estimated that 10 per cent of the population is supported through a green-financing project which provides them solar powered homes. In India, lending to projects related to renewable energy grew at a higher rate than overall credit growth between 2009 and 2014. There has even been talk about directly using monetary policy to combat climate change. Traditionally used to achieve macroeconomic objectives like inflation targeting, growth and liquidity, there is a growing conversation about using monetary policy to mitigate the effects of climate change. A preferred policy option is the use of quantitative easing. As a monetary policy tool, quantitative easing is a rather unconventional device. First used in Japan in the early 2000s to fight deflation and subsequently by the Bank of England since 2009, it allows central banks to boost domestic spending and investment by injecting money directly into the economy through large scale purchases of government bonds. Because the yield on government bonds affect other interest rates across the economy, this intervention lowers the interest rates offered on business loans.
It essentially works by making it cheaper for businesses and households to access credit. Green quantitative easing, unlike regular quantitative easing, would involve central banks buying bonds issued by firms or governments, which are invested in environmentally friendly projects. Green quantitative easing stands to reduce the cost of green projects. It also has the potential to incentivise firms and governments to decarbonise their operations and shift towards greener technologies. Although green quantitative easing does not have the traditional quantitative easing aim of inducing economic growth, it could still do this by potentially boosting the green sector, stimulating employment, and having a ripple effect through the economy.
While central bank policies are not sufficient nor a substitute for government-led policies, they cannot be removed from the table as the risk that climate change poses is far too big for any institution with the power to help to do nothing.
There certainly are arguments against the implementation of certain greening tools. There are concerns about businesses undergoing green washing. About the lack of a clear cut definition of what a “green” asset class is. What different capital charges will apply to this? And the fact that a reduction of capital requirements will make green loans appear less risky, when they may not necessarily be. Conversely, the blurring of risk and policy considerations can create distrust within the banking sector. Thus, it has been argued that green quantitative easing is essentially designed to stimulate the economy, while boosting climate change mitigation. The extent of its deployment in any economy will depend on the relative levels of unemployment, as well as inflation. This leaves it somewhat inferior to a traditional carbon tax, as the incentive to be green will vary depending on the economic cycle. This makes it a rather unstable tool for mitigating climate change, considering that work in support of it suggests it will only work with a long-term commitment.
While central bank policies are not sufficient nor a substitute for government-led policies, they cannot be removed from the table as the risk that climate change poses is far too big for any institution with the power to help to do nothing. While it is great that banks will now consider sustainable practices in their lending process, there still is more that can be done.
Ehireme Uddin is an Economics graduate with a penchant for writing.
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