1 Introduction

Ladies and gentlemen,

I would have been only too happy to meet you all in person. Even more so, as from my office it would only have been a short walk to the campus of the Goethe University.

And allow me the following side remark: There can hardly be a better person to name a university after than Johann Wolfgang von Goethe. Goethe combined many disciplines and subjects, and not just as a poet, dramatist, novelist and critic. He also conducted research in various natural sciences, studying minerals, plants, human anatomy and meteorology, to name a few. And let’s not forget that he reflected on the nature of money, even serving as finance minister in the Duchy of Saxe-Weimar-Eisenach, a small, former state in what is now Thuringia. Goethe seems to be a true all-rounder, able to turn his hand to any number of things.

Some would like to see central banks in a similar role. In their view, not only are we supposed to ensure price stability, help with supervising banks and safeguarding financial stability, foster growth or promote employment. Some also expect central banks to act as a rapid response unit for every economic crisis, keep sovereign financing costs low or provide savers with adequate interest rates. Recently, another item has been added to the wish list: we are being called upon to assume an active role in climate policy.

One thing is clear: climate change presents a challenge for all of humanity. The Swiss playwright Friedrich Dürrenmatt wrote in an appendix to his play The Physicists: “What concerns everybody can only be solved by everybody.” Therefore, every institution is right to ask itself what contribution it can make to mitigating climate change within the remit of its mandate.

2 Dealing with climate-related risks

The mandates of central banks and financial supervisors vary, but they typically include price stability, financial stability and the soundness of financial institutions. Climate change and climate policies can affect all of these mandates, as they may have an impact on macroeconomic and financial variables such as output, inflation, interest rates and asset prices, while altering the underlying structure of our economies. It is therefore essential for central banks to gain a full understanding of these repercussions for the functioning of the economy and the financial system.[1] We need to embed climate-related developments and risks in our analyses and update our analytical and forecasting toolkits accordingly.

Regarding the impact on the financial system and the economy, climate change entails both physical and transition risks.[2] First, physical risks result from persistent changes in climate and more frequent extreme weather events. Goethe himself experienced first-hand the enormous impact extreme weather can have. In his day, this was caused by a volcanic eruption far away on an Indonesian island. The year 1816 went down in history as the “Year Without a Summer”. People suffered from the cold and from persistent rain; crops failed and famine broke out.[3] Second, transition risks relate to the process of adjustment towards a lower-carbon economy.

Both the physical impact of climate change and the transition to a less carbon-intensive economy can be a source of financial risk.[4] For example, the ECB found in a sample of euro area banks that the exposures to the twenty largest emitters of carbon account for 20% of total large exposures.[5]

Clearly, it is in every market participant’s interest to properly protect themselves against climate-related financial risks by adjusting their risk management accordingly. Thus, first and foremost, it’s up to the financial sector to recognise and take into account such risks. Whether and how this is done has a bearing on several of our tasks as a central bank.

In banking supervision, we do not regard climate-related financial risks as a new risk category, but as a driver of classic categories such as credit risk and market risk.[6] We already expect banks to incorporate such risks into their risk management framework appropriately and to back them with adequate capital.

However, climate-related risks have certain characteristics that hamper their inclusion in ratings and internal risk models. First, historical data do not capture them adequately. Second, physical risks are potentially non-linear and expected to primarily materialise in the medium to long term. And third, the future pathway of climate change and climate action is highly uncertain, not least because it heavily depends on political decisions.

In this context, scenario analysis is a particularly useful tool.[7] Furthermore, it is important that banks take a forward-looking approach and consider a longer than usual time horizon. The ECB Guide on climate-related and environmental risks outlines the supervisory expectations and sets an ambitious goal: to fully integrate all relevant climate-related risks into banks’ risk management, business strategy and internal organisation.[8]

Every new beginning is difficult. But, to echo the king in Lewis Carroll’s “Alice in Wonderland”, we have to “Begin at the beginning.” According to a survey conducted by the ECB and the EBA, only a small number of institutions have fully incorporated climate-related risks into their risk management framework already.[9] In 2019, the stress test conducted by the Bundesbank and BaFin for small and medium-sized banks (less significant institutions, LSIs) yielded a similar result: only one third of the German credit institutions had incorporated climate-related risks into their risk management at least to some degree. Two-thirds did not take them into account at all.[10]

Clearly, an ambitious goal cannot be reached overnight. However, supervisors do expect continuous progress to be made. Therefore, addressing climate-related risks will continue gaining in importance in banking supervision. This year, we will use the supervisory dialogue to discuss the banks’ self-assessments and plans to meet the supervisory expectations. And next year, the ECB will conduct its supervisory stress test on climate-related risks.

Obviously, central banks are not commercial banks. But our financial assets can be just as exposed to financial risk as those of commercial banks. In this regard, central banks should practise what they preach. Hence, I believe that central banks should factor climate-related financial risks into their risk management. That should also apply to financial risks arising from monetary policy operations.

For this purpose, the Eurosystem has a legitimate interest in making climate-related financial risks more transparent: In my view, we should consider only purchasing bonds or accepting them as collateral for monetary policy purposes if their issuers meet certain climate-related reporting requirements. In addition, we could examine whether we should use only those ratings that appropriately include climate-related financial risks.

By taking such measures, the Eurosystem would help foster market transparency and standards at rating agencies and banks. In this way, we could act as a catalyst for change in the financial system and support climate policies in the EU without overstretching our mandate.

3 Central banks cannot substitute for stringent carbon pricing

But problems arise when monetary policy, financial supervision or banking regulation are pressed into service for other purposes. Each of these domains already has a clearly defined objective. This focus is also consistent with the Tinbergen rule, named after the first Nobel Laureate in economics, Jan Tinbergen. His rule stipulates that for each separate economic policy target, there must also be at least one separate instrument.[11]

If the instruments are overloaded with multiple targets, conflicts of objectives will emerge sooner or later. At worst, the existing core tasks could end up taking a back seat without the new targets being met. To quote Jean Tirole, who was also awarded the Nobel Memorial Prize: “We must resist this trend of governmental agencies becoming jacks of all trades and masters of none.”[12] Metaphorically speaking, the man who chases two rabbits catches neither. Using banking regulation to pursue climate policy objectives could represent a “chase for the second rabbit”.

For example, one might aim to make green investments more attractive for banks by offering a discount on the bank capital required for such exposures. However, a green supporting factor could distort the risk-based capital requirements and thus might undermine efforts to reinforce the stability of the banking sector.

Moreover, lowering capital charges may not be immediately effective, as the EU’s experience with a similar supporting factor for SME lending has shown. In its initial assessment of the available data, the EBA found no sufficient evidence that this move provided additional stimulus for lending to smaller firms relative to larger firms.[13] Banking regulation should retain its risk-oriented focus. It should not be used as an instrument to promote other policy objectives.

It would be just as wrong to use monetary policy as a means of pursuing climate policy, for example, by favouring “green” securities and excluding bonds issued by carbon-intensive enterprises. For one thing, the impact of such measures on emissions should not be overestimated, as I have already explained on previous occasions.[14] For another, the measures could come at a high price: here again, conflicts of interest may arise, this time with our primary objective of price stability. Asset purchase programmes are part of our expansionary monetary policy, and this is not meant for perpetual use. Indeed, it would be short-sighted to assume that inflation rates will hover at very low levels forever.[15]

When necessary in order to maintain price stability, the Eurosystem needs to apply the brakes and scale back its asset purchases or portfolio. But if the programmes were favouring green assets, that would also mean less support for the transition of the economy. Should the scale of climate action really depend on inflation developments? Certainly not! A clear and credible path of transition is essential for businesses, as they need reliable perspectives to make the necessary long-term investments.

In this context, we should remember that Robert Mundell, yet another Nobel Laureate, extended Tinbergen’s rule significantly, as “instruments (…) should be directed at those targets (...) on which they have the most direct influence.”[16] Climate action crucially depends on carbon emissions becoming more expensive. In order to raise carbon prices, both emissions trading systems and carbon taxes are effective and efficient tools. The decisions to use these tools are a matter for governments and parliaments. As elected representatives, they have the democratic legitimacy needed to make such wide-ranging decisions.

Many believe that not enough climate action is being taken at the political level. Some go further, claiming that central banks therefore need to “step in”. As tempting as this idea might sound, it is not up to independent central banks to correct or replace political decisions. We were not granted independence to make the decisions that politicians are unwilling to make. We were granted independence because independent central banks are best equipped to safeguard price stability. An active role in climate policy could undermine our independence and, eventually, jeopardise our ability to maintain price stability.

4 Central banks as a blueprint for independent carbon agencies?

Ladies and gentlemen,

I am very disappointed when I see half-hearted climate policies and a lack of commitment to a clear transition path. Why is it so difficult for politicians to take ambitious and credible climate action? One reason is what Mark Carney described as the “tragedy of the horizon”: “the catastrophic impacts of climate change will be felt beyond the traditional horizons of most actors – imposing a cost on future generations that the current generation has no direct incentive to fix.”[17]

In addition, the literature points to a time inconsistency problem, which may resemble the one facing monetary policy: after policymakers have set climate targets, they may have an incentive to put them on the back burner in order to boost employment in the short run or avoid unwelcome distributional effects.[18] Being aware of this incentive and the multitude or fuzziness of the government’s objectives, businesses could lack confidence in a long-term climate policy. In this case, they will not make the investments needed for the transition to a carbon-neutral economy.

Against this backdrop, there is an academic debate on how to enhance the credibility of climate policy and whether monetary policy provides a suitable blueprint. Indeed, central banks were granted independence in order to solve monetary policy’s time inconsistency problem.[19] From then on, they were able to safeguard price stability insulated from political influences. And it paid off.[20]

Some economists have suggested that this success story could be emulated by delegating climate policy to a new independent institution at the European level. Parliaments would have to equip it with both a clear mandate and the necessary instruments for carbon pricing. This agency could then pursue a stringent climate policy, with no regard for short-term electoral considerations. It would be committed to the long-term targets for reducing carbon emissions. For businesses and financial markets, this could create greater planning certainty for long-term investment.

Such an independent carbon agency would need to be transparent, publicly accountable and led by renowned experts in this field. The institution – just as in the case of central banks – would also need to rest on a broad political and societal consensus, as well as a solid legal foundation. However, in contrast to monetary policy in general, ambitious carbon pricing will significantly alter the distribution of resources and income – even across multiple generations. To what extent can we and should we forego democratic decision-making processes here?

Indeed, recommendations have come from other quarters for politicians not to hand over responsibility for setting the path of emissions. These observers stress the importance of retaining the flexibility to amend policy and having direct political accountability.[21] Essentially, governments can resolve commitment problems by curbing their discretionary powers via delegation. But having their hands tied like this also comes at a cost. Moreover, an independent European institution would not be a panacea for all the ailments climate policy suffers. Just think of the free-rider problem at the international level.

Overall, there are important pros and cons to weigh up when thinking about an independent carbon agency. At least, the case for delegation and independence does not appear as clear-cut as it is in the context of monetary policy. Indeed, a recent paper lists several conditions that would make an independent carbon agency a preferable option to strengthen commitment. And according to the researchers, it is debatable whether an institution can be designed to meet those requirements.[22]

However, without precluding further discussion, these considerations make one point quite clearly: Central banks should not slip into the role of a carbon agency. Ultimately, broadening the tasks of central banks could raise the impression that we are striving for multiple or fuzzy objectives, jeopardising the focus that is needed to establish credibility in the first place. It might also weaken accountability as discretionary decisions could then be justified by referring to one or the other of various objectives. To quote Jean Tirole once more: “[…] well-managed agencies may resist being granted new tasks.”

Let me be clear: Like Christine Lagarde, I am convinced that we all can do more to mitigate climate change, without risking conflict with our very own tasks. And we should do more!

At the same time, we need to safeguard the division of labour and the boundaries of clearly assigned responsibilities between policy areas. As economist Clemens Fuest put it recently: “Environmental policy [should] provide guidance by setting the carbon price. Other policy areas should incorporate the climate issue to the extent that it affects their core tasks, but they should not compete with environmental policy.”[23]

5 Conclusion

Ladies and gentlemen,

Did you know that Goethe was very proud of his scientific research? He valued his Theory of Colours even more than his poetry.[24] The irony is that his scientific explanation of light, colours and their origin is widely regarded as incorrect. Looking back, it is plain to see that Goethe overestimated his abilities as a natural scientist. You could say that Goethe was a “jack of all trades and master of some”. But even he was not a universal genius.

Applied to our current topic, it could be interpreted as warning central banks against overburdening themselves. We should not convey the impression that central banks are the better carbon agencies and can solve the problem of climate change on the side. This would raise expectations that we cannot meet.

Thank you for your attention.

Footnotes:

1. Deutsche Bundesbank (2020), The significance of climate change for the Bundesbank’s tasks, Annual Report 2019, pp. 22-24.
2. Network for Greening the Financial System (2019), A Call for Action: Climate Change as a Source of Financial Risk – First Comprehensive Report; Deutsche Bundesbank (2019), Impact of climate-related risks on financial stability, Financial Stability Review 2019, pp. 107-120.
3. Badenhop, P. (2016), Als der Tambora den Himmel verdunkelte, Frankfurter Allgemeine Zeitung, 11. September 2016, https://www.faz.net/aktuell/rhein-main/das-jahr-ohne-sommer-als-der-tambora-den-himmel-verdunkelte-14422262.html
4. Network for Greening the Financial System (2020), Overview of Environmental Risk Analysis by Financial Institutions, September 2020.
5. European Central Bank (2019), Financial Stability Review, May 2019, pp.120-133.
6. Network for Greening the Financial System (2020), Guide for Supervisors: Integrating climate-related and environmental risks into prudential supervision, May 2020.
7. Network for Greening the Financial System (2020), Guide to climate scenario analysis for central banks and supervisors, June 2020.
8. European Central Bank (2020), Guide on climate-related and environmental risks – Supervisory expectations relating to risk management and disclosure.
9. European Central Bank (2020), op. cit.
10. Deutsche Bundesbank (2019), Ergebnisse des LSI-Stresstests 2019, press conference on 23 September 2019, https://www.bundesbank.de/resource/blob/807590/8cd2b931f02825341c51c1de19b62354/mL/2019-09-23-stresstest-anlage-data.pdf
11. Tinbergen, J. (1952), On the Theory of Economic Policy, North-Holland Publishing Company, Amsterdam.
12. Tirole, J. (2019), Institutional and economic challenges for central banking, European Central Bank, Monetary policy: the challenges ahead (Colloquium in honour of Benoît Cœuré, held on 17-18 Decem-ber 2019), pp. 34-40.
13. European Banking Authority (2016), EBA Report on SMEs and SME Supporting Factor, EBA/OP/2016/04, https://eba.europa.eu/eba-publishes-the-report-on-smes-and-the-sme-supporting-factor
14. Weidmann, J. (2020), Combating climate change – What central banks can and cannot do, speech delivered at the European Banking Congress on 20 November 2020.
15. Weidmann, J. (2020), Too close for comfort? The relationship between monetary and fiscal policy, speech delivered at the OMFIF Virtual Panel on 5 November 2020.
16. Mundell, R. A. (1960), The Monetary Dynamics of International Adjustment under Fixed and Flexible Exchange Rates, Quarterly Journal of Economics, Vol. 74, pp. 227-257.
17. Carney, M. (2015), Breaking the tragedy of the horizon – climate change and financial stability, speech delivered at Lloyd’s of London on 29 September 2015.
18. See for example Helm, D., C. Hepburn and R. Mash (2003), Credible carbon policy, Oxford Review of Economic Policy, Vol. 19, pp. 438-450; Brunner, S., C. Flachsland and R. Marschinski (2012), Credible commitment in carbon policy, Climate Policy, Vol. 12, pp. 255-271.
19. Weidmann, J. (2020), Zu möglichen langfristigen Folgen der Coronakrise für Wirtschaft und Geldpolitik, speech at the Humboldt University of Berlin on 16 December 2020.
20. Alesina, A. and L. H. Summers (1993), Central Bank Independence and Macroeconomic Performance: Some Comparative Evidence, Journal of Money, Credit and Banking, Vol. 25, pp. 151-162; Cukierman, A. (2008), Central bank independence and monetary policymaking institutions – Past, present and future, European Journal of Political Economy, Vol. 24, pp. 722-736.
21. Ergas, H. (2010), New policies create new politics: issues of institutional design in climate change policy, The Australian Journal of Agriculture and Resource Economics, Vol. 54, pp. 143-164.
22. Edenhofer, O., M. Franks and M. Kalkuhl (2021), Pigou in the 21st Century: a tribute on the occasion of the 100th anniversary of the publication of The Economics of Welfare, International Tax and Public Finance, published online, https://doi.org/10.1007/s10797-020-09653-y
23. Fuest, C. (2020), Klimapolitik: Vorzüge der richtigen Arbeitsteilung, Frankfurter Allgemeine Zeitung, 11. December 2020.
24. Donat, S. and H. Birus (1999), Goethe – ein letztes Universalgenie?, Wallstein-Verlag, Göttingen.