How can we decarbonise international finance to deliver net-zero central banking? Nick Robins, Simon Dikau and Ulrich Volz present a roadmap for greening global finance.

“It’s 2050, and financial markets and the real economy have aligned with a sustainable and resilient net zero future, ensuring that global temperature rises are limited to 1.5°C Celsius.” This is not some fantasy, but the hard-nosed vision for finance that the United Nations has laid out to realise the goals of the Paris Agreement over the coming 30 years. Backed up by over 100 pages of detailed actions that need to be taken across the world’s $400 trillion financial system, the UN’s Climate Action Pathway projects the transformation that needs to take place in the way that banks, investors, capital markets and insurers  operate in the future.

As guardians of the financial system, financial authorities will play a pivotal part in delivering this vision, what we call net-zero central banking.

Making financial flows consistent with climate security

Accelerating the shift to the 1.5°C net-zero economy by mid-century is now the North Star for climate action and finance is critical to achieving this transition. Indeed, Article 2.i.c of the 2015 Paris Agreement set out the goal of “making finance flows consistent with a pathway towards low greenhouse gas emissions and climate-resilient development”.

Across the financial system, a growing number of banks and investors have made net-zero pledges. But “the financial system as a whole is funding temperature increases of over three degrees centigrade”, according to Mark Carney, the UN Special Envoy on Climate Action and Finance, who points to a “a striking gap between what society wants and what the market values”. In April 2021, Carney launched the Glasgow Financial Alliance for Net Zero (GFANZ), bringing together over 160 financial firms with assets in excess of $70 trillion who committed to make the transition to net-zero emissions by 2050.

Market momentum symbolised by GFANZ is clearly a powerful driver of positive change. But it will need to be complemented by structural reforms to the ‘rules of the game’ across the global economy and financial system. By May 2021, 131 countries, covering 73% of global greenhouse gas emissions, had adopted or were considering net-zero targets. To be effective, these targets have to be translated into credible policies that incentivise the shift in capital away from high-carbon business models and towards net-zero assets, assets which are also resilient to the mounting physical impacts of a disrupted climate. Alongside this, the management of climate risks needs to become central to the ways in which financial institutions and financial systems are overseen.

Over the past five years, a growing number of central banks and supervisors have been exploring their role in confronting the threats that the climate crisis poses to the functioning and stability of global finance. Membership of the Network for Greening the Financial System (NGFS) has grown more than tenfold from the eight institutions at its launch in December 2017, including every major institution from the US Federal Reserve to the European Central Bank and the Bank of England and on to the People’s Bank of China and the central banks of Brazil and India and many more. Over the past year, leading central banks have started to outline the role that they could play in delivering net-zero across the financial system. This now needs to become systematic.

The dual rationale for net-zero central banking

Working to build a net-zero financial system makes strategic sense for central banks and supervisors for two interlocking reasons: first, net-zero is the best way of minimising the risks that climate change poses to the stability of the financial system and the macroeconomy; and second, central banks and supervisors need to ensure that their activities are coherent with net-zero government policy.

Central banks and supervisors have a wide array of mandates, but delivering financial and monetary stability lies at the core. As the European Central Bank has concluded, “climate change makes monetary policy more difficult” and can “affect the stability of our financial and banking systems”. Rather than being regarded as one option among many, the net-zero economy needs to be seen as the outcome that will best enable central banks and supervisors to deliver their prudential and price stability goals over the long term.

The fact that achieving net zero in ways that are aligned with 1.5°C of warming is the best outcome for the stability of the financial system does not make it the most likely – far from it. Doing all they can to ensure that the financial system becomes aligned with 1.5°C therefore becomes a way for central banks and supervisors to achieve their monetary and financial stability targets. Setting a clear strategy for net zero would greatly enhance the chance of realising an orderly transition, one that minimises the amount of stranded assets and the degree of market turbulence.

Alongside this core stability argument for net-zero central banking is the obvious need to ensure that their actions are consistent with government policies. With most major economies now introducing net-zero policies, central banks need to make sure at a minimum that their activities do not undermine government policies and, more positively, complement government efforts in the real economy. A number of central banks have a statutory mandate to support government policy and this is now extending to climate action. In the UK, for example, the Chancellor of the Exchequer has updated the remit for the country’s prudential, financial stability, monetary policy and financial conduct authorities so that they now take account of the Government’s goal to “transition to an environmentally sustainable and resilient net-zero economy”.

Anchoring the climate policies of the world’s central banks around the goal of net-zero has a number of systemic advantages.

It helps to provide clarity and predictability in the marketplace, signalling to financial institutions the long-term goal the central bank is moving towards. Markets respond to signals from central banks, and the seriousness with which they consider net-zero targets will have a profound bearing on the allocation of capital.

It also helps to bring rigour to central bank actions by recognising the impact their own operations can have on climate risk. For example, the purchase of corporate and other assets by central banks has historically been ‘climate blind’: this not only builds up carbon risk on central bank balance sheets, but also deepens risk in the wider financial system that could then reverberate back in the future.

In addition, net-zero central banking is needed as there are specific challenges that can only be addressed at the system level, not least ensuring that the voluntary commitments from banks and investors are robust and comprehensive.

The road ahead: critical actions to deliver net-zero central banking

The first ‘green shoots’ of net-zero central banking are starting to emerge. These need to grow into a comprehensive approach covering all parts of the regulatory architecture. To do this, in March 2021 we recommended action by central banks and supervisors across seven priority areas. Since then, a growing number of financial authorities have taken steps in this direction, and a selection of the measures have been incorporated in the UN’s Climate Action Pathway (CAP) for Finance.

1. Strategy: The first step is for central banks and supervisors to develop a net-zero roadmap, a step that is included for central banks in the UN CAP for Finance for immediate action in 2021. This would set out how the financial institutions and systems they oversee will be aligned with net-zero by 2050. The roadmap could take a sequential approach outlining long-term expectations as well as near-term actions, including steps to achieve alignment of their own operations, and wider capital flows within the financial system. Importantly, the roadmap should include net-zero across the energy system and in land use, thus connecting climate action with the loss of biodiversity.

This will involve close liaison and cooperation with policymakers. Providing independent advice to governments on what the financial system needs to do to facilitate the transition will be a vitally important role in terms of real economy policies (e.g. carbon pricing), and also financial system measures (e.g. climate stress testing). Upgrading the housing sector is a case in point, where building regulations, energy labelling, public finance and the prudential supervision of mortgage portfolios need to be closely aligned.

2. Prudential regulation: Prudential supervisors need to make net zero a core element of their practice, at micro and macro levels, aligning supervisory expectations and prudential instruments with net zero. This would involve requiring all regulated financial institutions to develop and disclose net-zero transition plans. Central banks and supervisors can play a key role in helping to consolidate trusted and efficient tools, methodologies, data systems and taxonomies required for net zero, thereby bringing consistency and credibility across the financial system and avoiding the risk of ‘greenwashing’. Capital requirements should also be calibrated to reflect financial institutions exposure to climate risks.

3. Scenarios and stress-testing: Central banks and supervisors need to introduce annual climate stress tests, a step the UN CAP for Finance recommends for all institutions by 2025. A growing number of central banks are already embarking on this, and it is vital that these stress tests and the climate scenarios they use have to be consistent with a net-zero pathway geared to 1.5°C. They need to signal clearly that they are not indifferent to the outcome and complement long-term scenarios with short-term outlooks over the next five and 10 years, not least because of the need to increase net-zero investment between five and seven times during the 2020s.

4. Monetary policy: Central banks need to consistently integrate climate change into monetary frameworks and models to adequately account for the impacts of climate change on macroeconomic outcomes, a step included in the UN Finance CAP for immediate action in 2021. In addition, central bank monetary instruments and policy portfolios need to
become operationally aligned with net zero. For example, the Bank of Japan is introducing a new climate lending window that offers low-cost loans to banks for environmentally-friendly projects or companies, while the European Central Bank is including climate risks in its collateral framework and asset purchases.

5. Portfolio management: Central banks should also strengthen the sustainable and responsible investment practices for their portfolios. This means including a net-zero target and a “plan for operational alignment with net zero” for immediate action in 2021, according to the UN CAP for Finance. This would bring central banks into line with the actions of other large asset owners. Here, the Banque de France and the Swedish Riksbank have been in the vanguard.

6. Just transition: Central banks also need to consider the implications of net zero for jobs and livelihoods, a point picked up in the UN CAP for Finance for action in 2021, not least where the authority has a wider economic mandate (such as the Federal Reserve in terms of employment). One place to start would be in identifying sectoral and regional concentrations risks in the transition, which could then inform government policy. In developing countries, this means that actions to deliver net zero need to be closely linked with strategies for financial inclusion.

7. International cooperation: The goal of net zero needs to be incorporated into international financial and regulatory frameworks as well as the policies and operations of systemic bodies, such as the Bank for International Settlements, the Financial Stability Board, the International Monetary Fund, the Organisation for Economic Co-operation and Development and the International Association of Insurance Supervisors. There is also a great potential for cooperation and sharing of best practice on net zero, for example, through the new Central Banks’ and Supervisors’ Climate Training Alliance.

Net zero success requires a whole-system response. It needs governments to take the leading role in delivering real economy policies and public financing strategies. It needs banks, investors and other financial institutions to align their portfolios with net zero, responding to rising demand from clients and civil society. And it needs central banks and supervisors to complement and amplify net-zero policies by introducing the rules and the tools that ensure every financial decision takes climate change into account. The 2020s look set to be the decade of net-zero central banking.

Further reading: Read the authors’ publications Net-zero central banking: A new phase in greening the financial system and Climate-neutral central banking: How the European system of central banks can support the transition to net-zero.

This commentary is based on the article ‘Net-zero success demands a whole financial system response’, published in The Environment magazine in November 2021.

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