Climate change and central bank asset purchases: An empirical investigation for the euro area and the UK

The aim of this project is to provide the first integrated analysis of how the corporate asset purchases of the Bank of England and the European Central Bank can become climate-aligned, as well as the impact that this could have on economic/financial factors and emissions. We explore the implications of two different approaches for the incorporation of climate issues into central bank asset purchases: (i) the ‘climate footprint’ approach whereby the asset purchases are adjusted based on the climate performance of the bond issuers and (ii) the ‘climate risk’ approach in which the recalibration of asset purchases relies on the exposure of companies to climate risks under different climate scenarios.


For each approach, we explore several options that include both the ‘tilting’ of purchases and the exclusion/inclusion of corporate bonds. In the case of the ‘climate footprint’ approach, the adjustment of purchases relies on the combined use of backward-looking and forward-looking metrics about the emissions of companies and other environmental factors. In the ‘climate footprint’ approach, the adjustment is based on the credit risk that the bond issuers face under the NGFS climate scenarios. We use econometric techniques to investigate the potential effects of the different policy options on the climate performance of bond issuers.  

Optimal Climate Change Mitigation through Green Quantitative Easing and Fiscal Policy

We address the question of how green quantitative easing could complement governments’ toolkit for climate change mitigation. In our setup, green quantitative easing refers to a given outstanding stock of bonds held by the European Central Bank and its portfolio allocation between a clean and dirty sector of production. Our key research question is how the central bank can contribute to an optimal inter-generational sharing of the burden of climate change policies in comparison to, or in combination with, fiscal mitigation policies.

We develop a quantitative overlapping generations model in which households consume and allocate their savings and their work efforts between a clean and dirty production sector. A reallocation of the central bank portfolio toward the clean sector increases the capital stock employed for production in that sector relative to the capital stock in the dirty sector. This triggers a relative increase of labour demand in the clean sector and a relative expansion of output. Through this mechanism, the central bank can thus influence relative production across the two sectors in the economy. We then contrast this policy with fiscal policy measures to mitigate climate change. We will explore whether the central bank can improve the economic allocation beyond what is thus achieved through fiscal policy.

Holding constant the balance sheet of the central bank enables us to focus on the portfolio reallocation mechanism. However, it limits the interaction between fiscal and monetary policy in the model. As a next step, we extend the model by an explicit notion of money and the introduction of a distortion that requires bond purchases by the central bank, which will enable us to study the effects of an expansion of central bank bond holdings and of climate policy interactions.

Building a macro-financial integrated-assessment model for ordered transitions and fiscal-monetary policy interactions

Assessing the impacts of climate change-related physical and transition risks on the financial system and the macroeconomy is one of the most urgent and prominent needs to support climate policy design. However, the modelling toolbox for the assessment of these risks is currently rather scant.

We contribute to filling this gap by developing a macro-financial model that brings a detailed energy sector into a macroeconomic agent-based model with heterogenous banks and cross-sectoral exposures. The advantage of the proposed framework is twofold: It builds on two consolidated models in their respective domains (macro-financial and integrated assessment modelling) and includes a representation of both micro-level indicators of economic activity (e.g., insolvency rates, mark-ups, productivity dispersion, non-performing loans) and macro-level indicators (e.g., output growth, volatility, unemployment, public debt). Crucially, the macroeconomic properties will emerge indirectly from the decentralised interactions of individual agents and will possibly show non-linear and threshold effects (e.g., due to contagion).

After calibrating the model, we structure the project around two main applications. First, the model will be used to assess how the transition pathways of major emission/socio-economic scenarios and the associated changes in the climate would affect macroeconomic fundamentals and financial stability. Our results will add a macro-financial perspective to the scenario narratives. Second, building on previous work of the project team, we are testing a variety of climate-related fiscal, monetary, and macroprudential policies, with the aim of studying whether a target to physical or transition risks from climate change could hide trade-offs or double-dividends.

The Optimal Mix of Monetary and Climate Policy

This research theoretically investigates the mix of monetary and climate policy and provides insights for central banks that are considering their engagement in the climate change issue. The “climate-augmented” monetary policy is pioneeringly proposed and studied.

Our research method is an extended Environmental Dynamic Stochastic General Equilibrium (E-DSGE) model. The basic DSGE setting is in line with the standard New Keynesian framework. The “Environmental” features are introduced by incorporating the greenhouse gas emissions from production, their negative externality on productivity, and the climate policy that controls emissions, i.e., cap-and-trade or carbon tax.

Based on the model, we preliminarily find the following results:

  • The process of developing monetary policy should consider the existing climate policy since it is a factor that can influence price level and inflation.
  • The reaction coefficients in traditional monetary policy rule can be better set to enhance welfare when climate policy is given. This provides a way to optimise the policy mix.
  • If a typical-form climate target is augmented into the monetary policy rule, a dilemma could be created. This means that it has some risks for central banks to care for the climate proactively by using the narrow monetary policy (interest rate).

Implications for Emissions, Investment, and Inflation

Over recent years several instruments for green central bank monetary policy have been proposed but little to no modelling rigour has been applied to further substantiate the debate. We draw on theoretical modelling and numerical simulation to assess two specific proposals of green monetary policy: the greening of central bank collateral frameworks, and targeted green refinancing operations. We hope to deepen our theoretical understanding of these instruments and quantify their impact on the economy and environment. To do so, we draw on formal modelling that can account for cumulative emissions, differentiated investment (based on carbon emissions), economic growth, monetary policy, and inflation.

Our model will be the first to integrate all of these five aspects which are all essential to our research question. The inclusion of monetary policy is self‐explanatory. However, the final requirement, inflation, is often neglected within climate policy analysis. Within the context of green monetary policy, inflation becomes particularly important as it is the principle aim of modern central bank mandates and climate change might create “cost‐push” or “demand‐pull” inflation.

In order to inform policymakers of the potential effects of green collateral frameworks and green refinancing operations, we propose including inflation and monetary policy into a dynamic general equilibrium model that includes a banking model, differentiated sectors (based on carbon emissions), and conventional climate polity. In addition to observing the effects of green monetary policy on emissions and investment, this model would also allow us to analyse the potential trade‐off between climate change mitigation and inflation, which might have large-scale ramifications for social welfare.

Climate Risk and Central Bank Refinancing Operations

We analyse the impact of central bank refinancing operations on bank lending, investment in the real economy, and financial stability. In particular, we assess whether and how much climate risk-adjusted refinancing operations that apply differentiated interest rates based on the climate risk exposures of bank loans would improve financial market outcomes in terms of lower-carbon investment.

We base our analysis in the context of a financial market failure, where firms and banks underestimate climate risks. For that, we use a model where underestimating climate risks on the side of firms causes under-investment into climate risk mitigation (CRM), and underestimating climate risks on the side of banks induces excessive lending to firms exposed to climate risk. Misallocation of resources in the real economy and bank defaults induce a welfare loss in the economy. Banks’ lending decisions can be steered through climate risk-adjusted refinancing operations by the central bank, which, in turn, reduce the misallocation of resources in the real economy. This outcome is reinforced by a subsidy to companies for CRM. Specifically, the interest rate policy adopted by the central bank is such that banks’ cost of refinancing depends on the allocation of loans to more and less risky firms. This way the central bank can correct the belief-distorted lending decisions. The socially optimal allocation is achieved by a combination of subsidies and targeted refinancing operations, i.e., fiscal and monetary policy are complementary.

Greening the Eurosystem Collateral Framework

The collateral framework of the Eurosystem is a crucial component of the eurozone financial system, since it determines the way by which commercial banks obtain central bank liquidity and affects the credit conditions facing the non-financial sector. However, in its existing form, it does not capture climate risks and is not conducive to the decarbonisation of EU economies. Our analysis shows that carbon-intensive sectors are overrepresented in the list of eligible corporate bonds: 59% of the eligible bonds have been issued by carbon-intensive sectors, while the contribution of these sectors to the EU gross value added and employment are 29% and 24%, respectively.

We investigate how the Eurosystem collateral framework can become climate-aligned using two different approaches. In the first, ‘climate footprint’ approach, haircuts and bond eligibility are adjusted based on the climate impact of bond issuers, which in our analysis is captured by using both backward-looking and forward-looking metrics. The second, ‘climate risk’ approach, relies on the use of the NGFS climate scenarios for estimating the financial effects of climate risks on bond issuers. For both approaches we explore several policy options and show the implications for the haircuts per sector, the haircut-adjusted outstanding amount of bonds and the weighted average carbon intensity of the list of eligible bonds. We also analyse the channels via which a climate-aligned collateral framework can affect the climate performance of companies. We show that the ‘climate footprint’ approach can be more conducive to decarbonisation compared to the ‘climate risk’ approach, without reducing the amount of corporate bonds that euro area banks can post as collateral.

Central Banks’ Mandate in Green Credit Guidance: Beyond Prudential Regulation

The success of the Paris Agreement in enhancing the implementation of the U.N. Framework Convention on Climate Change and strengthening the global response to climate change in part owes to the integration of finance considerations. A legally binding document ratified by 187 parties, Article 2.1c of the agreement stipulates financial flows must be made consistent with a pathway toward low greenhouse gas emissions and climate-resilient development, and Article 9 sets out provision of financial resources. While financial flows directed toward climate change mitigation and adaptation are increasing, they remain significantly below those required under the Paris Agreement. This points to the need to leverage private sector finance in order to mitigate this funding gap.

This research assesses the potential role for central banks in implementing green credit guidance for commercial banks to mobilise the much-needed climate finance. Given the enormity of the green financing gap, central banks arguably have a role to play in redirecting private sector capital flows from high-carbon sectors to low-carbon sectors. We critically assess the various objections against green credit guidance by central banks and argue for a promotional role. We collect and analyse primary data through key stakeholder interviews at select central and commercial banks and supplement the findings through document analysis of banks’ financial reports and other relevant academic literature. The empirical findings highlight the concerns and views of the affected stakeholders.

The Role of Monetary Policy Under a Low-carbon Transition

We assess the implications for monetary policy action under a zero-carbon transition. Via a more stringent climate policy, the transition can result in both demand- and supply-side shocks. We seek to provide insights on the potential monetary policy responses to a climate policy shock by modelling the economic impacts using the multi-country, multi-sector model of the global economy, G-cubed. We draw on literature to define robust rules and we will consider rules that are uniform across regions, as well as differing rules in order to better replicate real-world monetary policy responses.

Our results suggest that a carbon tax consistent with 2° C of warming leads to a clear monetary policy trade-off, with higher inflation and a negative output gap. For the majority of countries, the impact on inflation outweighs that on output growth in the short term, whereas in the long term, the impact on output growth dominates, leading to a reduction in policy rates. The policy rate remains permanently lower once the shock has dissipated, suggesting that a persistent tax on carbon will lead to lower potential output and a lower neutral interest rate. Such a large tax on carbon would need to be accompanied by a large increase in productivity to offset the impact on potential output and long-term interest rates.

The shocks required to achieve ambitious targets lead to large negative impacts on emissions-intensive sectors. It’s difficult to assess how the transition to low-carbon energy sources will occur whilst also capturing the impacts on the rest of the economy.

Engaging central banks in climate change? The mix of monetary and climate policy

Given the recent debate on the role of central banks under climate change, this research theoretically investigates the mix of monetary and climate policy and provides insights for central banks who are considering their engagement in the climate change issue. The “climate-augmented” monetary policy is pioneeringly proposed and studied. We build an extended Environmental Dynamic Stochastic General Equilibrium (E-DSGE) model as the method. By this model, we find the following results. First, the making process of monetary policy should consider the existing climate policy since it is a factor that can influence price level and inflation. Second, the reaction coefficients in traditional monetary policy rule can be better set to enhance welfare when climate policy is given. This provides a way to optimise the policy mix. Third, if a typical-form climate target is augmented into the monetary policy rule, a dilemma could be created. This means that it has some risks for central banks to care for the climate proactively by using the narrow monetary policy (interest rate).