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Network for Greening the Financial System Technical document Adapting central bank operations to a hotter world Reviewing some options March 2021NGFS Technical document MARCH 2021 This report has been coordinated by the NGFS Secretariat/Banque de France. For more details, go to www.ngfs.net and to the NGFS Twitter account @NGFS_ , or contact the NGFS Secretariat sec.ngfs@banque-france.fr NGFS SecretariatNGFS REPORT 2 T he pandemic and its fallout have fast-forwarded us into a new dimension of central bank support to our economies. Central banks across the globe have shown unprecedented levels of resolve, responding swiftly and flexibly using a wide array of monetary instruments. At the same time, climate change remains an urgent and fundamental threat to our prosperity and collective well-being. Unlike for the pandemic, however, in the climate crisis we cannot see light at the end of the tunnel. The urgency to act is greater than ever: climate risks no longer lie beyond the horizon, they are already materializing. The time to take action is now. The NGFS started 2021 with undiminished energy and vigor. Our members are more determined than ever to get active, pressing ahead with concrete proposals on how to better account for climate-related risks in central banking and banking supervision. We strongly believe that now is the time for central banks to seriously consider how the progress made in reflecting climate-related risk in supervisory and macro- prudential methods can be matched by similar steps in monetary policy operations. The report “Adapting central bank operations to a hotter world” examines the implications of climate change for central banks’ operational frameworks and for the implementation of monetary policy in practical terms. Building on a common understanding among NGFS members that climate change has implications for the conduct of monetary policy, this report offers the most comprehensive analysis to date. Practitioners from the central bank community reviewed collateral and counterparty policies, asset purchases and credit operations with a view to offering a menu of options for climate-related adjustments in more concrete terms. This report does not prescribe a particular course of action. Regardless of their specific roles and mandates, central banks ought to be aware of climate risks that could threaten the integrity of their balance sheets. However, each central bank needs to decide for itself the best way to reflect climate risks in its operational framework. We are sure that this report will offer invaluable guidance for central banks in making these strategic choices with regard to their monetary policy operations. Of course, this is only the beginning. More work is needed to overcome obstacles and to fully integrate climate-related considerations into monetary policy. These issues will rank high among NGFS priorities going forward. Central banks clearly need to play their part in the joint global efforts to curb climate change as an urgent and universal challenge. While we cannot take on the tasks of governments, we also cannot be mere bystanders in the transition to a net zero economy. It is our responsibility to take on the challenge we are facing as publicly accountable institutions, serving our societies. We are grateful to all NGFS members and observers for contributing to our common cause in a truly challenging environment. Our network is thriving thanks to your determination and ideas and we urge you to stay committed. Our special thanks go to the lead authors of this report and its contributors, as well as the NGFS secretariat. Their tireless efforts have made it possible for us to mark this important milestone for the NGFS. Joint foreword by Frank Elderson and Dr Sabine Mauderer Dr Sabine Mauderer Chair of the workstream “Scaling up Green Finance” Frank Elderson Chair of the NGFSNGFS REPORT 3 Table of Contents Executive summary 4 1. Introduction 9 2. The state of play 12 2.1. Climate change brings new financial risks for central banks 12 2.2. Adapting traditional central bank models to climate change? 13 2.3. Potential courses of action 14 3. Principles for assessing potential climate-related adjustments to monetary policy operational frameworks 16 3.1. Consequences for monetary policy effectiveness 16 3.2. Contributions to mitigating climate change 16 3.3. Effectiveness as risk protection measures 16 3.4. Oper a tional f easibilit y 16 4. Reviewing potential options 18 4.1. Identifying the options 18 4.2. Summar y assessmen t 19 4.3. Open questions 21 5. Disclosure 22 5.1. Is disclosure a prerequisite for other potential adjustments? 22 5.2. Requiring disclosure from eligible collateral issuers and/or monetary policy counterparties 25 5.3. Disclosing the central bank’s own exposures to climate-related risks 25 6. Strategic choices when dealing with climate change 27 6.1. Risk tolerance and assessment 27 6.2. M etr ics 28 6.3. Da ta 29 6.4. Balancing tr ade - off s 30 7. Annexes 31 Annex 1. Detailed review of options 31 Annex 2. Climate-related metrics 46 Annex 3. Coordinating climate-related adjustments to operational frameworks 48 Annex 4. Bibliography and overview of recent proposals 50 8. Acknowledgements 54NGFS REPORT 4 The context calls for concrete action Under all possible scenarios, climate-related risks will have consequences for the economic outlook, for the financial system in which central banks operate and, thus, for the conduct of monetary policy. The timing and severity of these consequences depend on how swift and effective transition policies are. Moreover, climate change poses new financial risks to central banks’ monetary policy operations. Climate-related financial risks could impact directly on both central bank counterparties and the financial assets used in monetary policy operations (as collateral for credit operations or for outright purchases). As a result, climate-related shocks could generate financial losses for central bank balance sheets and, in extreme cases, they could affect the smooth implementation of monetary policy by exposing various monetary policy transmission channels to the impacts of physical and transition risks. Central banks can adapt their monetary policy operational frameworks to reflect climate-related risks Governments have a much broader and more effective range of tools and policies available to prevent and mitigate climate-related risks than central banks, and they are the actors responsible for designing and conducting national and international climate policies. However, contingent on their mandate, central banks have a responsibility to review their operational frameworks to ensure they remain resilient to emerging climate-related risks and to safeguard the continued smooth conduct of monetary policy, i.e. to consider the effect of climate- related risks on their operations as well as the effects of their actions on exposures of other entities, including the financial sector, to climate-related risks. There is a broad consensus among members of the Network for Greening the Financial System (NGFS) that, at the very least, central banks should carefully assess, and where appropriate adopt, additional risk management measures to protect their balance sheets against the financial risks brought about by climate change. However – and reflecting the diversity of existing central bank operational frameworks – there is as of yet no consensus among central banks as to what climate-related adjustments would be optimal. Identifying the relevant measures and assessing the adequate level of protection against climate-related financial risks, and the quantification thereof, is a challenge for central banks at the current juncture. Where it falls within their policy remit, central banks could also consider going beyond the adjustment of their operational frameworks solely from a risk management perspective by seeking to ensure that their monetary policy operations do not undermine the transition to a low-carbon economy and/or by exploring ways in which they can actively support that transition. In practice, the frontier between these alternative approaches (mitigating balance sheet risk on the one hand, and actively supporting transition on the other) is blurred and may depend on the actual calibration of operational measures as well as the central bank’s mandate. According to current scientific evidence, taking no action is not viewed as a sustainable option given the systemic impacts of climate change on the real economy, on financial risk, on market prices and thus on the conduct of monetary policy and on monetary policy frameworks. At the same time, central banks need to be mindful about the potential risk involved in considering adjustments based on what is still a limited body of information, which may have an impact on their credibility. The menu of options available to central banks to factor climate-related risks into their operational framework is potentially large Adjustments could be considered across the main operational functions that central banks carry out for the purposes of implementing monetary policy. This report analyses possible changes to three of the most important policy fields: credit operations, collateral policies, and asset purchases. Executive summaryNGFS REPORT 5 The review concentrates on potential measures on the asset side of a central bank’s balance sheet. Hence, the stylised options listed in Table 1 all pertain to liquidity-providing instruments. Based on the available literature and expert analyses, the review by the NGFS group of experts focuses on nine stylised options across these three main policy fields (Table 1). They were chosen because they are relevant to multiple central banks and relate to existing tools. Some options represent a greater departure from standard central bank operational policies than others. Depending on their mandate, legal environment and individual assessment, certain central banks may not find some of the stylised options to be feasible. The review therefore contains neither recommendations, nor indications of members’ preferences. Table 1. Selected stylised options for adjusting operational frameworks to climate-related risks Credit operations a (1) Adjust pricing to reflect counterparties’ climate-related lending Make the interest rate for central bank lending facilities conditional on the extent to which a counterparty’s lending (relative to a relevant benchmark) is contributing to climate change mitigation and/or the extent to which they are decarbonising their business model. (2) Adjust pricing to reflect the composition of pledged collateral Charge a lower (or higher) interest rate to counterparties that pledge a higher proportion of low-carbon (or carbon-intensive) assets as collateral or set up a credit facility (potentially at concessional rates) accessible only against low-carbon assets. (3) Adjust counterparties’ eligibility Make access to (some) lending facilities conditional on a counterparty’s disclosure of climate-related information or on its carbon-intensive/low-carbon/green investments. Collateral b (4) Adjust haircuts c Adjust haircuts to better account for climate-related risks. Haircuts could also be calibrated such that they go beyond what might be required from a purely risk mitigation perspective in order to incentivise the market for sustainable assets. (5) Negative screening Exclude otherwise eligible collateral assets, based on their issuer-level climate-related risk profile for debt securities or on the analysis of the carbon performance of underlying assets for pledged pools of loans or securitised products. This could be done in different ways, including adjusting eligibility requirements, tightening risk tolerance, introducing tighter or specific mobilisation rules, etc. (6) Positive screening Accept sustainable collateral so as to incentivise banks to lend or capital markets to fund projects and assets that support environmentally-friendly activities (e.g. green bonds or sustainability linked assets). This could be done in different ways, including adjusting eligibility requirements, increasing risk tolerance on a limited scale, relaxing some mobilisation rules, etc. (7) Align collateral pools with a climate-related objective Require counterparties to pledge collateral such that it complies with a climate-related metric at an aggregate pool level. Asset purchases d (8) Tilt purchases Skew asset purchases according to climate-related risks and/or criteria applied at the issuer or asset level. (9) Negative screening Exclude some assets or issuers from purchases if they fail to meet climate-related criteria. a Credit operations are widely used to provide aggregate liquidity and usually take the form of collateralised lending. b Collateral policy defines the range of assets that can be pledged to secure central bank credit operations, as well as the risk control measures that apply to them. c Annex 1 expands upon the different approaches for haircuts and valuation adjustments. d Central banks may buy a variety of assets from both public and private sectors, typically in an effort to exert greater influence on longer-term interest rate levels and spreads while improving market liquidity.NGFS REPORT 6 Four criteria can help review the menu of options available to central banks Assessing different climate-related adjustments to monetary policy operations is difficult because of the heterogeneity of central bank operational frameworks. Regardless of these differences, the potential adjustments to central bank operations can be assessed against four general principles (see Table 2). These are: (1) Consequences for monetary policy effectiveness; (2) Contributions to mitigating climate change; (3) Effectiveness as risk protection measures; and (4) Operational feasibility. Depending on their mandate and on the course of action chosen, central banks may assign different weights to these four principles. Consequences for monetary policy effectiveness. Assessing the implications for the effectiveness of monetary policy operations (including in terms of lending or purchasing capacity by the central bank, potential distortions, stigma, etc.) of any of the options is challenging since they very much depend on their exact design as well as the central bank’s specific circumstances. Still, options which materially reduce available monetary policy space, or which can jeopardise the efficacy of monetary policy, are unlikely to be considered desirable, in particular if their design and calibration cannot be used to minimise any unintended consequences. While further jurisdiction- specific work is needed, a few preliminary points can be made. Some options run the risk of curtailing, more or less significantly, central bank operations and the policy space. These options include (i) negative screening that would (a) exclude a significant number of counterp