The central bankers’ identity crisis:

Financial regulators are joining the climate fight – but is it clear what they are meant to be doing?

By James Vaccaro, February 2022

Removed from the flood of attention-grabbing pledges at COP26, the world’s guardians of finance quietly rolled out a set of new climate policies and positions. While the Network for Greening the Financial System – now a hundred members strong – portrays unity and coordination across these powerful institutions, a rift may be forming in its ranks.

Financial regulators are split on the nature of their role in the transition to a sustainable economy. Central banks and supervisors in the Global North remain wedded to the myth of market neutrality, adopting a purely risk-based approach that seeks to restore the smooth and efficient functioning of markets. Many of their counterparts in the Global South, on the other hand, are increasingly seeing themselves as active agents in the struggle for 1.5 degrees Celsius.

The People’s Bank of China has long been engaged in direct credit guidance and recently announced a green targeted lending scheme, as did both the Bank of Japan and Bank of Korea. The central bank of Brazil, a top performer in the world’s first green ranking of monetary and prudential authorities, first implemented restrictions on certain types of environmentally harmful financing in 2008, and it is now strengthening a range of its green policies. Indonesia’s regulators have introduced incentives for the financing of green automotives and housing, alongside a raft of sustainable finance guidelines.

Meanwhile, US regulators are only just getting to grips with the reality of climate change as a systemic risk, and Australian and Canadian regulators are gearing up for climate scenario analysis exercises. While the European Central Bank is leaps ahead, having expressed support for ambitious measures like climate capital rules and portfolio restrictions, accounting for climate risk remains its guiding principle.

The Bank of England presents a particularly peculiar case, as the rift between a risk-based and impact-based approach is increasingly apparent across its very own operations. The Old Lady will use its corporate bond purchases to actively support the net-zero transition, but intends to leave financial policy on the sidelines. The Bank claims it may use climate-related capital requirements to address the consequences of climate change, but not its causes.

The Prudential Regulation Authority, the branch of the Bank responsible for capital rules, believes its role in the transition is to “ensure that firms are effectively managing the climate-related financial risks they face”. Governor Andrew Bailey reinforced this message at COP26, asserting that “[a]ddressing the causes [of climate change] – driving the transition - is for climate policy and is rightly the responsibility of governments.” But why, then, is the Bank of England seeking to address the causes of climate change through its monetary policy operations? 

The contradiction is glaring, and the remits of the Bank’s key policymaking committees provide no satisfactory answer - quite the contrary. Although the precise wording differs slightly across the committees responsible for monetary, financial, and prudential policy, all of their updated remits include an active role for tackling climate change, not only managing its consequences.

Even if the Bank insists on exonerating itself of any responsibility beyond traditional risk management, it must recognise that climate risk will be unmanageable unless we address the ways in which finance is driving the climate crisis.

Another key feature of economic and climate models used by central banks is that they assume the neutrality of the financial sector. This could be a dangerous and misleading assumption as we witnessed in the role that parts of the financial sector played in causing and amplifying the global financial crisis. It has been further demonstrated in recent research that the difference between an enabling and hampering financial sector has massive impact on climate outcomes in addition to government action:

Mind the gap

When looking at the potential scenarios for temperature or for the emissions from fossil fuels there is a pull in different directions: either towards greater transition risks or physical risks.

>>> More Physical Risks

Transition risks, if they happen, are likely to come from the curtailment of activities. Their financial impact would be significant, direct and immediate. Whoever is holding the stranded asset at the time will either need to be bailed out or suffer severe financial consequences. Physical risks, on the other hand, are likely to have an impact in the longer term; therefore, financial models will discount their effect (the ‘tragedy of the horizon’). And the impacts are likely to be externalised: physical risks don’t attach neatly to the assets that caused them (or who financed them). So, just like the Global Financial Crisis, there is a risk that by not addressing the causes, the consequences build up for everyone leading to a financial and environmental meltdown. Unlike the Global Financial Crisis, a Climate Financial Crash could not be bailed out. The irrecoverable carbon cannot be put back and the climate; feedback loops will not be reversed by quantitative easing. 

A consensus has emerged among sustainable finance experts across sectors that climate-related capital requirements would be a highly impactful and technically feasible tool to enhance financial stability and support the net-zero transition. This is something that should be considered in the consultation run by the Basel Committee on Banking Supervision (the ultimate convening of central bank rulemakers) on climate risk. However, they appear to go to some lengths to avoid mentioning the possibility that the financial sector could have an impact on the environment - only the other way around. 

In an open letter to financial regulators, leading academics and civil society organisations have called for the ‘one-for-one’ rule, requiring every unit of investment in new fossil fuel projects to be backed by an equivalent amount of capital. This would protect against future losses and accelerate a shift towards cleaner investments. If regulators are truly in on the climate fight, they must rapidly adopt bold measures of this kind and apply it to other significantly harmful activities areas such as deforestation. 

And surprisingly, it isn’t just climate campaigners and NGOs who think that these measures should be introduced. A number of senior bankers and investors have acknowledged that there’s a need for regulatory changes to ‘level up’ the market. For as long as some financial institutions are allowed to profit from harmful activity, it will be a disincentive for any to move at the pace required. Changing the capital pricing for fossil fuels and deforestation will pivot strategies and attention towards sustainable solutions. That’s not a view that always gets through to the bank lobbyists and associations who have deep muscle memory to push back on anything that spells holding more capital, which makes it even more important for regulators to remember what their role should be. 

It’s clear that many financial regulators are very concerned about the risks of climate change. There’s likely to be a growing feeling that analysing the data of the past will be of little value in the face of unfamiliar future consequences. And there may be growing unease that an approach narrowly applied to the consequences to individual institutions could be woefully inadequate at capturing the broad systemic consequences for the planetary and economic crisis that may lie ahead. It is time to recognise that part of their duty includes proactively protecting the environment (and the societies and economies that it supports) from the impacts of finance. Doing so will save more than just financial stability.

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