With the international community moving towards a “Net-Zero” economy, financial regulators and central banks have started showing significant interest in averting climate-related risks and promoting a green economic transition. Since 2015, when a report published by the Bank of England put forward that climate change could pose a risk to financial stability and economic development, there has been a shift in central banks’ mindset and they now participate in the Network of Central Banks and Supervisors for Greening the Financial System (NGFS). In 2020 and 2021, the European Central Bank and People’s Bank of China explicitly proposed to use monetary policy to enable the low-carbon transition. The EU is also pushing green investments via its financial taxonomy.
However, the traditional mandate of a central bank is to maintain the stability of price levels and the financial system. Some worry that by engaging in the climate change agenda central banks would not only deviate from their original mandate, but also violate their market neutrality principle and overburden their policy tools (violating the Tinbergen Rule, which argues that one policy tool should only solve one economic problem). Over 50% of surveyed experts do not support changing the European Central Bank’s mandate to incorporate the EU’s target of carbon neutrality.
This debate will intensify as the climate crisis worsens and the public policy response expands. In a recent paper, we provide theoretical evidence on the role of a central bank in combatting the climate crisis by addressing three specific questions: (1) Should central banks take existing climate policy into account when designing monetary policy? (2) If climate policy is taken into account, can the original monetary policy be aligned? and (3) Should central banks explicitly introduce climate-related objectives into monetary policy?
Should monetary policy take climate policy into account?
To answer this question, we mixed monetary policy with different climate policies and compared these combinations in a novel E-DSGE model. The results show that the effectiveness of monetary policy on price level can be influenced by the type and stringency of existing climate policy. This is because different climate policies have different implications for the price system: under a cap-and-trade type climate policy, the carbon price has the flexibility to vary, which can, to some extent, offset price fluctuations arising from exogenous shocks to the economy. In contrast, under the carbon tax type climate policy, the carbon price is fixed and cannot offset any price fluctuations following shocks. In addition, differences in the stringency of climate policy can lead to different carbon prices and hence different price levels. Therefore, the monetary policymaking process should take into account the type and stringency of existing climate policy.
If climate policy is taken into account can monetary policy be aligned?
We then explored if and how monetary policy can be improved when climate policy is considered. This is to try optimising the reaction coefficients in the Taylor rule of monetary policy in different policy mixes. The results show that if the existing climate policy is considered in the framework of monetary policy-making, the reaction coefficients of inflation and output in the traditional Taylor rule of monetary policy can be adjusted so as to improve the effect of monetary policy on price volatility and the level of social welfare. We also found that the values of the optimized coefficients can be changed when the type or the stringency of climate policy is different.
Should central banks explicitly introduce climate-related objectives into monetary policy?
We also tried to improve the policy mix by introducing a radical “climate-augmented” monetary policy rule, which can help determine whether it is good for a central bank to use the narrow monetary policy rule (interest rate rule) to proactively address climate change. The results show that explicitly introducing a climate-related target into monetary policy rule and setting the reaction coefficient of the new target in a reasonable interval can improve monetary policy in response to price volatility and can improve social welfare. However, under certain exogenous shocks, such a radical monetary policy may not be able to simultaneously achieve the goals of improving social welfare and addressing climate change (reducing greenhouse gas emissions), creating a dilemma for policy makers. While we would argue that yes, central banks should engage in the climate change issue, this finding suggests that central banks should still refrain from explicitly incorporating climate objectives into their narrow monetary policy rule until there is more evidence to support such action.
Original paper: Chen, C., Pan, D., Huang, Z., & Bleischwitz, R. (2021). Engaging central banks in climate change? The mix of monetary and climate policy. Energy Economics. https://www.sciencedirect.com/science/article/pii/S0140988321004096
 Environment-augmented Dynamic Stochastic General Equilibrium model (E-DSGE)
Photo: People’s Bank of China, one of the most active central banks in the green and climate agenda. Courtesy of the authors.