The European Central Bank announced the outcome of the monetary policy strategy review launched in January 2020. You can read the full statement here.

The e-book "Perspectives on the ECB's monetary policy strategy review" published in late June 2021 by the Banco de Portugal laid down most of the arguments underlying this comprehensive review. Our Alumnus, Nuno Lourenço, contributed with a co-created Section on climate change (see below).

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The objectives of the Union include a high level of protection and improvement of the quality of the environment.

The 2015 Paris Agreement set the stage for the international response to climate change and as such the EU has established a target for the reduction of greenhouse gases (GHG) emissions: carbon neutrality by 2050. Climate change is triggered by a high concentration of carbon dioxide and other GHG in the atmosphere. It affects ecosystems throughout the world, by causing global warming, more frequent extreme weather events and rising sea levels. The economic effects of climate change are complex, long-lasting and heterogeneous across geographies.

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Climate change is a global negative externality and in the presence of externalities markets fail to provide an efficient allocation of resources.

Economic agents engage in activities that involve GHG emissions but do not take into account the negative effects of their actions on others. As a result, emissions are higher than they should be. One of the economic solutions to this problem has been known since the writings of Pigou (1920). It lies in the implementation of a tax on GHG emissions at the source that must be equal to the total marginal damage the polluter is not paying for. This provides incentives to producers to make their operations less carbon-intensive. Another policy prescription for climate change, drawing on the work of Coase (1960), is the implementation of tradable carbon rights, e.g. EU emissions trading schemes.

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Since the damage caused by the burning of fossil fuels is identical regardless of where pollution occurs, the tax on emissions should be set globally. The global nature of the externality calls for a coordinated response across governments around the world, which have the suitable instruments to take corrective actions.

Hassler, Krusell, Olovsson and Reiter (2020) estimate that cost inefficiencies from not setting a uniform carbon tax are sizeable. For instance, a carbon tax in the EU alone would not attenuate the global mean temperature increase. However, countries have incentives to free ride on policies aimed at curbing emissions, as they can refrain from their own climate change mitigation measures and still benefit from a lower concentration of GHG in the atmosphere. To enforce global cooperation, Nordhaus (2015) suggested the creation of a “Climate Club”, in which members agree to tax carbon and impose trade sanctions on carbon-intensive goods from non-member countries.

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Climate change is surrounded by uncertainties in several dimensions, including the mechanism through which GHG emissions affect the natural climate system, the economic impact of a given change in climate, and governments’ actions.

For example, the extent to which climate change triggers a tipping point, i.e. a point of no return in the climate system, remains uncertain, and its economic impact is even more undetermined. Actions to address climate change can take two forms: (i) mitigation, i.e. actions that lower emissions of GHG into the atmosphere and (ii) adaptation, which refers to actions that reduce the damages (or increase the benefits in some regions). Regarding mitigation policies, the main uncertainties concern the timing of implementation of more severe constraints or regulations and how these will materialise. As for adaptation, the different options that will become available (e.g. developing drought-resistant crops) and their costs are key sources of uncertainty. The time horizon underlying climate change phenomena is typically very long, far longer than economists are used to, placing the burden on future generations. Under these conditions, uncertainty is inevitably large, and the degree of risk aversion as well as how future losses are valued today are key factors for policy evaluations.

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The extent of governments’ intervention will shape the transition to a carbon-neutral economy.

A timely adaptation and the prosecution of a mitigation strategy will be less costly in the long run, as opposed to postponing the adoption of climate policies. Climate risks will be more pervasive and higher in magnitude and frequency under a disorderly transition. These risks spread to the real economy via supply shocks and to the financial system through asset stranding, whereby an unanticipated change in future policy can make carbon-based assets lose their value today.

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Climate change poses constraints on the conduct of monetary policy, especially under a disorderly transition where risks are more prevalent.

First, it will likely have a negative impact on r*, increasing the probability of the policy interest rate hitting the ELB. Second, climate change likely affects countries differently, which might increase the difficulty in maintaining price stability in the euro area with a single monetary policy. Third, it may change the monetary policy transmission mechanism by affecting banks and other financial market participants through additional uncertainty, thus inducing higher volatility in financial markets. Finally, supply shocks will become more recurrent due to an increased frequency of extreme weather events.

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Several measures can be devised to assess financial risks associated with climate change.

First, standardised disclosures of climate-related data sustained by the development of a clear taxonomy and reporting standards are crucial. Actions in this regard must be clear and verifiable, to avoid conflicts of interest. Second, fostering dialogue with rating agencies and other independent institutions is also key. Third, promoting research on climate change risks is also valuable. This is an area where central banks can contribute with their own internal models to study specific policies. Finally, central banks should avoid adding to policy uncertainty, i.e. the private sector and regulated financial institutions should not be left to speculate about unknown policy interventions. The ECB is already taking steps to address many of these topics.

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Taking a more active role in addressing climate change needs to be assessed carefully by the ECB given the inherent trade-offs with the fulfilment of the primary objective, besides the fact that monetary policy has very limited effects on climate change.

First, monetary policy instruments may be designed to take into account climate considerations (e.g. green bond purchases) but attaining the primary objective will always prevail. Therefore, the future normalisation of monetary policy and the consequent reduction of the central bank’s balance sheet could interfere with the maintenance of these green bonds. Second, claiming a prominent role in addressing climate change could be detrimental to the ECB’s reputation, in view of the inadequacy of monetary policy instruments for this purpose. These reputation costs could undermine the ECB’s ability to act in the future. Finally, enlarging the scope of the ECB’s actions may submit it to political pressure and undermine its independence, an essential factor to achieve its main objective. In fact, central banks are granted independence under the condition that they operate within a limited sphere of competence, and can be held accountable against clearly defined objectives.

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The ECB has applied the concept of market neutrality to help guide monetary policy implementation, in line with the requirement to act in accordance with the principle of an open market economy with free competition as stated in the TFEU.

In the absence of market failures, market neutrality guarantees that asset purchases have a minimal impact on relative prices and on the efficient allocation of resources. This means that the purchase of corporate bonds by the ECB is proportionate to the amount of bonds outstanding. Deviations from market neutrality, such as operational and risk management requirements for collateral and purchase eligibility, can be justified if deemed necessary to achieve price stability. Additionally, these deviations might be justified under a market failure such as climate change.

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The ECB’s purchases in the corporate bond market overweight polluting sectors, but modifying its holdings to be greener may not promote an efficient allocation of resources and would likely have limited effects on tackling climate change.

When the carbon tax is set appropriately, market efficiency is restored and a monetary policy with green bond purchases or Targeted Longer-Term Refinancing Operations (TLTRO) with green features would introduce a distortion in the economy. If it is set too low, then a monetary policy with green features could be welfare improving as it would contribute to reducing GHG emissions in the EU. Such measure could be justified if the associated costs were relatively small and the benefits of the reduction of emissions in the EU were substantial. However, recent work by Hassler et al. (2020) suggests that subsidies to green energy foster more use of energy in total but have limited effects on global temperature. Additionally, they advocate that the costs of setting an inappropriate carbon tax are highly asymmetric. Setting an overly high tax is not very detrimental to social welfare as opposed to setting an overly low tax. Finally, a more active role of central banks in addressing climate change may generate unjustified reliance on the abilities of monetary policy and incentivise governments to set low carbon taxes, as these are typically unpopular.

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Exercising prudence would be advisable given that acting with inadequate instruments to address climate-related objectives may have unintended consequences.

While there is scientific consensus that global temperatures are rising, it is almost unanimous that governments are at the root of the transition to a low-carbon economy. Monetary policy cannot serve as a substitute for policy action taken by governments. This does not mean inaction. In fact, as described above, much can be done by the ECB within the scope of its mandate.

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The e-book can be found here .