Green economic stimulus: Priority actions for central banks

By Adrian Fenton and Helena Wright

With the Covid-19 pandemic bringing global healthcare systems to near collapse, the trauma, ongoing loss of life and wider economic and social impacts could affect an entire generation. Governments will need to halt the spread of the virus and then rebuild our economy. The world is now facing multiple crises at the same time — the pandemic and an ongoing nature and climate emergency.

The Covid-19 pandemic has already led to economic stimulus packages being proposed or developed across the world. Central banks and financial regulators have a key role in stimulus packages which are executed by governments through the financial system. Ensuring that economic stimulus packages are green is vital as limited financial resources exist. The climate and nature crisis needs to be addressed concurrently, otherwise as Laurence Tubiana has pointed out, “it will likely be harder to fund climate policy after the crisis”.

The stimulus and recovery packages being developed should be seen as an opportunity to transform our economies to tackle the nature and climate emergency. Increased investment in low-carbon industries and sustainable infrastructure can create jobs, improve health and quality of life. For example, the Asian Development Bank has found that Asian cities suffer the worst air pollution in the world. Using economic stimulus packages to increase investment in sustainable transport can support both health and economic growth.

This global pandemic must accelerate and not lead to any roll-back of existing climate disclosure requirements for banks. It has been reported that banks are now using Covid-19 as an excuse to push-back against rules such as disclosure of climate-related financial risks and climate stress tests. The Network for Greening the Financial System (NGFS) has stated that climate change presents significant financial risks. The Covid-19 pandemic should not be used as an excuse to hide these known systemic risks growing in the economy. We should not try to use economic stimulus packages to help revive economies affected by Covid-19 by investing in high-carbon sectors, only to result in another economic crisis caused by the physical impacts of climate change. The solution to one crisis must not add fuel to the next crisis.

How we rebuild our economies matters to building resilience against future zoonotic diseases. Zoonotic diseases like Covid19 are made more likely due to drivers such as deforestation and the illegal wildlife trade. Unprecedented road-building, deforestation, land clearing and agricultural development make us more susceptible to mass epidemics. It is insensitive to use this moment to relax regulation on environmental issues which would make zoonotic disease transmission worse.

What are the priority actions which central banks can consider to ensure economic stimulus packages are likely to lead to green outcomes? Firstly, it is important to ensure against economic stimulus packages creating latent systemic risks by channeling finance to activities which lock-in emissions. As there is an ongoing climate emergency, businesses should commit to a transition pathway to achieve the Paris climate goals, as a condition for receiving support.

Immediately improving E&S risk management practices in financial institutions is vital considering the likelihood that these institutions will be the ones handling or receiving the economic stimulus packages. For example, China’s central bank, the People’s Bank of China (PBOC) has set out mandatory disclosures for banks to categorise what is ‘green’ in their portfolios. In Indonesia, guidelines issued by the financial supervisor OJK require sustainable finance principles to become part of risk management processes for banks. These measures will be all the more important for the upcoming economic stimulus.

The EU with the Green Deal has set out how a transition towards a low carbon economy could be taken forward. “The long-term work on the Green Deal continues in parallel…and continues to be one of the priorities as well,” according to Vivian Loonela, the EU Commission spokesperson for the European Green Deal.

For central banks, embedding environmental risk into their own portfolios could be as simple as having a minimum or explicit goal or holding more green corporate or sovereign bonds as part of portfolio management, instead of neutrally-orientated bonds. The Bank for International Settlements, for example, recently found that ‘green’ bonds can be eligible as a central bank reserve asset. This is important because bond purchases will very likely form a key component of economic stimulus packages. The European Central Bank (ECB), for example, recently announced plans to buy up to 750 billion euros in government and corporate bonds as part of the Coronavirus stimulus.

Central banks could utilise existing micro-prudential approaches such as ‘leverage ratio by sector caps’, ‘loan-to-value’ and ‘loan-to-income caps’, as well as ‘sectoral exposure restrictions’. These tools restrict the likelihood that economic stimulus packages will result in finance flowing to asset classes and sectors which embed systemic risk into the economy. These approaches require continued progress on mandatory disclosure of climate-related financial risk and taxonomies. Work on this must continue to be prioritised to help address systemic risk.

Credit allocation instruments might also be useful. For instance, targeted refinancing covering for the most ambitious components of Nationally Determined Commitments (NDCs) under the Paris Agreement could be created. Obvious examples are financing for renewable energy and building energy efficiency which together account for much of the electricity usage in urban areas. Bangladesh’s central bank, for example, has required commercial banks to allocate 5% of their total loan portfolio to green sectors, though arguably this proportion should be much higher to effectively target green growth. Additionally, central banks could use this opportunity to assist national development banks with mandates aligned with the decarbonisation agenda. Many development banks already have a commitment to align themselves with the Paris Agreement.

Given that Governments are due to submit tougher climate plans before the COP26 UN Climate Conference, the time is right for Central Banks and financial regulators to coordinate with government ministries on national policy planning processes. Central banks and financial regulators could work with finance ministries to develop comprehensive plans to finance the Nationally Determined Commitments (NDCs) under the Paris Climate Agreement as part of a green economic stimulus. In that way, the stimulus package could be geared towards making these Paris commitments more ambitious and enabling greater climate ambition so that systemic risks from climate change are reduced.

This is also an important time for Central Banks to demonstrate thought leadership on climate risk and the green economic stimulus. At this time, when a recession is imminent, Central Banks could offer thought leadership on green product development, such as development of green products such as positive incentive loans, credit facilities, contingency funds, and bonds. Using the tools at their disposal, Central Banks could also support ex-ante policy evaluation of green stimulus packages by screening them to ensure they do not embed more climate risk in the economy.

Green stimulus as a percentage of total stimulus in 2009. Source: International Labour Organisation, 2011

There is already a historical precedent for green stimulus measures in the last financial crisis. In 2009, 16% of all fiscal measures were allocated to “green stimulus” with the largest proportion going toward sustainable infrastructure spending such as high-speed rail networks. In 2020, the world has now agreed to the Paris Climate Agreement and the risks of climate change are still increasing. The proportion of ‘green’ stimulus therefore needs to be much higher in all national stimulus packages. The European Investment Bank recently committed to spend 50% of its annual lending volume for climate and environment-friendly projects, and the ‘InvestEU’ de-risking tool to leverage private finance has the same target for its infrastructure window: this is the new benchmark to gauge the consistency of stimulus plans with the Paris Agreement in all countries. Anything below will cost us more in the future through climate damages.

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