Spanish governor favours green monetary policy

Central banks should explore the adoption of climate principles in their monetary policy operations, said Bank of Spain governor Pablo Hernández de Cos.

He added these goals should be addressed within the European Central Bank’s price stability mandate.

“The mandate of the European Central Bank is price stability. So we will have to take into account climate-related risk to strengthen that, so they allow us to fulfill our mandate,” said Hernández de Cos in Central Banking’s Summer Meetings today (June 14).

“I don’t think we need to go into the secondary objective of the treaty [wider support for European Union economic objectives]. I think we have to focus on the monetary policy mandate, price stability.”

The Spanish official argued there was room for manoeuvre in the ECB’s current policy framework. “[Don’t be] mistaken by this relatively narrow scope, there is plenty of room for climate action within this remit.”

Hernández de Cos pointed out climate change impacts the financial sector, inflation and the natural interest rate. As such, the phenomenon requires central banks to better understand the interactions of current policy tools with these new risks in both financial and price stability, he said. In order to accomplish this goal, models need to be developed and institutions should boost their research efforts in this field.

Balance sheet risks

Heightened climate risks can materialise not only in the balance sheets of private banks, but also for central banks.

This is one of the indirect effects of the unconventional monetary policy tools central banks have acquired since the global financial crisis. These include massive asset purchase programmes, though which these institutions support loose financing conditions for sovereigns and corporates.

However, sovereign bonds, and especially corporate bonds, may become increasingly challenging to manage in the coming years. Currently, the ECB holds almost €278 billion ($336.7 billion) euros in corporate debt through the Asset Purchase Programme (APP), and over €31 billion more through the Pandemic Emergency Purchase Programme (PEPP).

The ECB has carried out these operations according to the market neutrality principle. So, if a company issues more bonds, the central bank will hold more of that company’s bonds. Due to the high capital intensity of CO₂ polluting industries, companies from these sectors tend to benefit more from ECB purchases.

In order to avoid contributing to the mispricing of climate risks, some ECB officials, including president Christine Lagarde, have called for abandoning market neutrality in the institution’s corporate purchases.

Hernández de Cos agrees the ECB “should take due consideration to the appropriate assessment of climate risks in the overall risk management of our stock of assets and also on the specific criteria for new purchases in asset purchase programmes”.

As Deutsche Bundesbank president Jens Weidmann proposed earlier this month, the Spanish governor suggested introducing climate-related disclosure requirements in order for an issue or issuer to be eligible for ECB purchases. “Another one would be to expand the use of ratings that adequately include in their methodologies the impact of climate risks in the financial profile of issuers or specific issues,” added Hernández de Cos.

Climate change and inflation

Hernández de Cos stressed climate change and policies to tackle it can have substantial effects on inflation.

For instance, “policies aimed at promoting the transition towards a carbon-neutral economy – such as carbon taxes – are likely to affect the volatility of headline inflation, which includes energy prices”, he said.

However, climate change is also likely to affect non-energy prices, and core inflation dynamics. In fact, ECB researchers have recently pointed out that over the last decade, core inflation in the eurozone has been showing a much stronger correlation with energy prices.

“To the extent that carbon-intense producers of non-energy goods and services pass the costs of rising carbon taxes and other interventions on to their consumers, we could also see sizeable upward pressure in core inflation,” added Hernández de Cos.

“All in all, persistent upward pressure on, or substantial volatility in, headline inflation stemming from sustained climate policies could lead us to rethink how we formulate our policies in pursuit of price stability over the medium-term horizon.”

He said climate change is also likely to affect the natural rate of interest. The rate has already been falling for several decades, which has “shrunk the space” for interest rate policy, said Hernández de Cos. 

Yet, it is not obvious in which way climate change will affect the natural rate of interest. “On the one hand, it could further depress natural rates through negative effects on productivity, such as the impact of higher temperatures on labour supply and the destruction of capital stemming from natural disasters,” he said.

Additionally, higher economic uncertainty derived come climate risks could further boost precautionary savings. This would add downward pressure on natural rates.

“On the other hand, the transition towards a more sustainable economy will require substantial investment in green technologies, which may push equilibrium interest rates up,” added the Bank of Spain governor. “And if such investment succeeds in raising trend productivity growth, it could partially undo or even reverse the decline in natural interest rates.”