Projects: TOOLBOX

Sustainable management of central banks’ foreign exchange (FX) reserves

Central banks are playing an increasingly active role in promoting the move towards a sustainable global economy. One key motivation is the need to mobilise funds for the large-scale public sector investment required to reach the goals of the Paris Agreement on climate change. This paper explores the role central banks’ foreign exchange (FX) reserves portfolios can play in this context. Central banks’ frameworks for managing FX reserves have traditionally balanced a triad of objectives: liquidity, safety and return. Incorporating sustainability requires expanding this usual triad into a tetrad. This can be achieved either explicitly, by introducing new economic uses of reserves, or implicitly, by recognising the ways in which sustainability affects existing policy objectives – or through a combination of both approaches. Pursuing sustainability, however, may give rise to trade-offs over and above the usual tensions between liquidity and safety and return. This paper explores sustainability-enhanced reserve management in the context of these trade-offs and outlines 12 different channels (classified into four different types) that reserve managers can use to ‘green’ their operations. Each of these channels comes with its own advantages and limitations, so – given the constraints faced at the individual reserve manager’s level – choosing the right channels is key

Aligning financial and monetary policies with the concept of double materiality: rationales, proposals and challenges

The concept of double materiality is developing rapidly, with potential implications for monetary and financial policies. Double materiality builds on the historical accounting and auditing convention of materiality and expands it by considering that non-financial and financial corporations are not only materially vulnerable to environment-related events and risks, but also materially contribute to enabling dirty activities and environmental degradation.

Three rationales that support the use of double materiality are distinguished in this paper, each with different policy implications: i) an idiosyncratic perspective – closely connected to the concept of dynamic materiality – which considers that an entity’s environmental impacts are relevant as they provide information on the institution’s own risks; ii) a systemic risk perspective – closely connected to the concept of endogeneity of financial risks – which seeks to reduce financial institutions’ contribution to negative environmental externalities because of the systemic financial risks that could result from them; and iii) a transformative perspective seeking to reshape financial and corporate practices and values in order to make them more inclusive of different stakeholders’ interests and compatible with the actions needed for an ecological transition. Each of these rationales has potential implications for monetary and financial policies, as well as possible theoretical and practical challenges.

While the adoption of a double materiality perspective remains an open question, the concept proposes the opportunity to think more comprehensively about the role of the financial system in urgently addressing the ecological challenges of our times.

This paper is part of a toolbox designed to support central bankers and financial supervisors in calibrating monetary, prudential and other instruments in accordance with sustainability goals, as they address the ramifications of climate change and other environmental challenges. The papers have been written and peer-reviewed by leading experts from academia, think tanks and central banks and are based on cutting-edge research, drawing from best practice in central banking and supervision.

Sustainable and responsible management of central banks’ pension and own portfolios

Central banks are increasingly looking to align their operations with sustainability objectives within the constraints of their mandates. This agenda mainly originated in central banks within the broader remit of financial stability, in their capacity as supervisors. However, some central banks have also begun to explore and act on the sustainability implications for their identity as managers of investment portfolios, including sustainable and responsible investment of their pension and own portfolios. The drivers for doing so range from managing sustainability-related risks to aligning their activities with wider government policies and commitments, including with net-zero emissions targets. This challenges the conventional approach that calls for investments to be guided by the trinity of objectives of ‘liquidity, safety and return’, which overlooks the value of an environmental, social and governance (ESG) approach as a means to identify risks and opportunities.

Yet central banks’ progress on this agenda to date has been relatively muted compared with their peers from the wider public investor community such as pension funds and sovereign wealth funds. Only a few central banks are signatories to the UN-supported Principles for Responsible Investment, have climate-related targets, or have made their responsible investment principles public. Low rates of adoption may be due to challenges relating to the availability of data, information and resources, to the particular characteristics of a typical central bank portfolio, or to issues of institutional independence and mandates.

Central banks can learn from their peers from the central banking community that are more advanced in this process, as well as from the wider public investor community in implementing sustainable and responsible investment through strategies including active ownership, ESG integration, impact investing, screening and thematic investing. This paper identifies a recommended course of action for central banks in sequence across the different phases from developing and implementing relevant policy, to monitoring and reporting outcomes, to identifying further adjustments to the policy and its implementation.

This paper is part of a toolbox designed to support central bankers and financial supervisors in calibrating monetary, prudential and other instruments in accordance with sustainability goals, as they address the ramifications of climate change and other environmental challenges. The papers have been written and peer-reviewed by leading experts from academia, think tanks and central banks and are based on cutting-edge research, drawing from best practice in central banking and supervision.

Central banks and climate-related disclosures: applying the TCFD’s recommendations

Central banks are increasingly exploring how climate-related financial risks and opportunities impact their price and financial stability mandates, as well as their own operations. They are also beginning to consider how their own actions, and those of the financial institutions they supervise, may contribute to and exacerbate climate change risks and opportunities.

Measuring and reporting – or disclosing – climate-related risks and opportunities is a key step in addressing these issues, for both individual institutions and the financial system as a whole. With this recognition, the Task Force on Climate-related Financial Disclosures (TCFD) was established, to guide financial institutions to make effective climate disclosures. The development of high quality, reliable, comparable and transparent climate disclosures can support decision-making and enable better understanding of the implications of climate change for central banks. Further, central banks can lead by example by demonstrating lessons learned from their own climate-related disclosures to other financial institutions and by using their influence over the financial rulebook to build the broader system architecture.

This paper reviews key elements of the recommendations made by the TCFD – first released in 2017 – and their application by central banks to date. The paper also considers potential enhancements for central banks’ climate disclosures and their possible implications for the wider financial system. The fact that definitions, data, and methodologies for assessing climate-related issues are constantly evolving means that efforts to develop climate-related disclosures will need to follow a progressive approach, with the quantity and quality of disclosures improving in parallel with the progress made in these areas. A flexible framework also suits the distinct operational models and different mandates of central banks.

The recommendations made in this paper can be applied to the different central bank portfolios, including monetary and non-monetary and credit facilities, as well as financial stability and physical operations. They are designed to support a wider and more practical application of the TCFD recommendations by central banks.

This paper is part of a toolbox designed to support central bankers and financial supervisors in calibrating monetary, prudential and other instruments in accordance with sustainability goals, as they address the ramifications of climate change and other environmental challenges. The papers have been written and peer-reviewed by leading experts from academia, think tanks and central banks and are based on cutting-edge research, drawing from best practice in central banking and supervision.

Developing a precautionary approach to financial policy – from climate to biodiversity

Climate change and biodiversity loss have primarily been approached by financial authorities (central banks and supervisors) from the perspective of financial risk. The prevailing view is that there is insufficient information and understanding of environment-related financial risks within financial institutions. If such financial risks can be discovered, measured and disclosed, they can be priced into financial markets to support a smooth environmental transition and this market failure can be addressed.

However, environment-related financial risks have particular features that make them less amenable than other types of risk to standard financial risk management approaches. In particular, the ‘radical uncertainty’ characterising the long time horizons and the endogenous and non-linear dynamics involved with environmental change make quantitative calculations of financial risk challenging, if not impossible.

The authors propose in this paper an alternative, precautionary approach to financial policy, incorporating both prudential and monetary policies. As a framework it draws on the ‘precautionary principle’ and modern macroprudential policy traditions. A precautionary financial policy mindset acknowledges the importance of measurement practices and price discovery but justifies bolder policy action to shift the allocation of capital to shorter time frames better aligned with the uncertain and potentially catastrophic nature of environment-related threats, including the risks to, and posed by, financial institutions. The paper considers financial authorities’ tentative steps and possible tools in such a precautionary policy direction – and how these could be scaled up and mainstreamed.

This paper is part of a toolbox designed to support central bankers and financial supervisors in calibrating monetary, prudential and other instruments in accordance with sustainability goals, as they address the ramifications of climate change and other environmental challenges. The papers have been written and peer-reviewed by leading experts from academia, think tanks and central banks and are based on cutting-edge research, drawing from best practice in central banking and supervision.

Inflation and climate change: the role of climate variables in inflation forecasting and macro modelling

Climate change is increasingly affecting the objective, conduct and transmission of monetary policy. Yet, climate-related shocks and trends are still generally absent from the canonical models used by central banks for their policy analysis and forecasting. This briefing paper reviews the potential pitfalls of using a modelling framework that omits climate-related information and provides some reflections on how central banks can integrate climate change considerations into their ‘workhorse’ models.

This includes: accounting for an explicit role of the energy sector in the production structure and for specific climate change policies; improving the ability of models to cope with various sources of heterogeneity; and incorporating a more realistic representation of the financial sector, to analyse the possible stranding of assets and impairments in the transmission mechanism of monetary policy. It argues that a ‘suite-of-models’ strategy is a promising approach for central banks to cope with the climate challenge when designing a new generation of models.

To complement theory with practice, several examples of central banks that have already integrated climate-related information into their analytical frameworks are provided. The paper concludes with some specific recommendations.

 

This paper is part of a toolbox designed to support central bankers and financial supervisors in calibrating monetary, prudential and other instruments in accordance with sustainability goals, as they address the ramifications of climate change and other environmental challenges. The papers have been written and peer-reviewed by leading experts from academia, think tanks and central banks and are based on cutting-edge research, drawing from best practice in central banking and supervision.