In late August, five members of the US House of Representatives issued a statement urging President Joe Biden not to reappoint Jerome Powell, the chairman of the Federal Reserve, when his term expires in February 2022. The group, which included Alexandria Ocasio-Cortez (Democrat of New York), cited two concerns with Powell’s leadership: the Fed’s relaxation of banking regulations and its lack of action “to mitigate the risk climate change poses to our financial system.” 

Ocasio-Cortez and her fellow members of Congress are not the first to suggest that central banks—whose policies have traditionally focused on objectives such as price stability and low unemployment—have a role to play in fighting climate change. The British Parliament’s Environmental Audit Committee (EAC) has encouraged the Bank of England to conduct its bond purchases with borrowers’ carbon emissions in mind. Many central banks themselves have also accepted some responsibility for fighting climate change: the European Central Bank says it is “committed to taking the impact of climate change into consideration in our monetary policy framework.” 

But Chicago Booth’s Lars Peter Hansen cautions that monetary policy is a weak substitute for fiscal policy, which is far better suited to address climate change through tools such as carbon taxation and investment in green technologies. Asking central bankers to step in where fiscal policy makers can’t or won’t risks exposing central banks to reputational damage and a loss of political independence, he argues. 

Many observers within and outside of central banks have noted that climate change is a risk to the financial system, and some suggest that central banks are therefore responsible for assessing that risk and issuing regulations to mitigate it. However, Hansen argues that our understanding of the economy’s exposure to climate change is still in its relatively primitive stages. While there are short-term concerns about the impact of climate change, the larger consequences will play out over decades rather than years. These longer time horizons, combined with limited historical experience and broad speculation over possible policy responses, make quantitative assessments of the potential consequences challenging. This, in turn, makes it difficult for central bankers to craft transparent policies that are socially productive. 

Although there is ample evidence that humans are having a deleterious effect on the environment, he writes, there is considerable dispersion among the quantitative geoscientific models as to what a given level of emissions or carbon in the atmosphere will mean for the climate in the future—and perhaps even more disagreement among economic models about what those climate repercussions will mean for the economy. 

This uncertainty about how climate change will play out and how economies will respond to it shouldn’t discourage climate scientists and economists, including those employed by central banks, from attempting to model and measure the relationship between the changing climate and the financial system. But central banks should be cautious about building monetary policy around those models until some of the gaps in our scientific knowledge are filled in, Hansen warns. 

“Including climate change as part of a direct or indirect financial stability mandate leaves quite a bit of guess work left for prudent decision-making,” he writes, adding, “Any excessive confidence in our understanding could backfire over the longer haul and hinder credibility through false promises of success.”

Neither are central banks currently well-equipped to use their authority to monitor individual institutions regarding their exposure to climate-related uncertainties. Banks and other financial institutions face the consequences of climate change if the assets they hold or the borrowers in their lending portfolio are adversely affected by it. But gauging their vulnerabilities involves resolving the uncertainties about not just the course of climate change and the resulting economic effects, but also the response of policy makers and technology to those effects. “Both the regulators and the regulated are exploring new territory in terms of uncertainty quantification,” Hansen writes.

In his view, a productive role central bankers could play in this area would be that of collaborators—with people in financial institutions’ risk-assessment departments as well as with academic economists—to help devise ways to measure and cope with these uncertainties. Private banks are motivated to understand their own exposures, but because their incentives are not fully aligned with the system-wide concerns of regulators, the task of modeling that can’t be left entirely to them. Working together to understand how unknown variables will affect the outcomes predicted by climate and economic models would be an important step toward any efforts to assess the dangers climate change poses to the financial system, Hansen argues.

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Likewise, efforts to incorporate climate uncertainty into the stress testing of financial institutions could be useful, he says, but they require a careful and creative approach. Many central banks use stress tests to assess whether large banks are prepared for periods of economic hardship. But the financial-market disruptions under consideration play out on a relatively short time scale in comparison to climate change. Some central banks, including the Bank of England, have begun conducting tests involving 30-year climate-based scenarios. Currently, Hansen says, climate-based stress testing is of limited use because these long-horizon scenarios are not assessed as to their probabilities of playing out and do not allow for dynamic responses to new information or policy changes as the climate uncertainty becomes at least partially resolved. For instance, a prespecified C02 emission scenario that looks plausible today may look much less so after we gain more information in the future about the environmental and economic consequences of climate change. 

Instead, central bankers could encourage private banks to establish a decision-making framework that prepares them for a broad range of contingencies, rather than focusing on 30-year scenarios specified in a static manner.

When it comes to central banks orienting the large portfolios they manage—and the asset purchases they make through programs such as quantitative easing—toward green companies and investments, as the EAC urged the Bank of England to do, Hansen is skeptical. Not only do central banks lack the expertise to make such investments or evaluate companies on their environmental credentials, but, by becoming what Hansen calls “green venture capitalists,” they also run the risk of losing their distance from the political arena, where some policy makers will surely have biases about which investments to support that are divorced from their economic and social merit. 

For now, Hansen writes, monetary and regulatory policy aren’t well-suited to taking on climate change directly. But central bankers who feel compelled—or are compelled by others—to take action would best focus their energies on assisting financial institutions and fiscal policy makers in quantifying and managing the uncertainty surrounding the intersection of climate science and economics.

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