Climate change and its mitigation pose significant risks to the economy and financial sector. This is why a growing number of central banks have committed to integrating climate change considerations into their monetary policy frameworks. But what can central banks actually do to fight climate change and how effective are their measures?
Central banks and climate change
While there is a broad consensus that carbon pricing (i.e. a carbon tax) is an effective instrument to tackle climate change, the potential contribution of central banks is still debated. . Central banks around the world have explored various strategies to incorporate climate change into their monetary policy frameworks. Potential tools include greener collateral frameworks, green lending facilities and green quantitative easing (QE), whereby central banks “tilt” their balance sheets towards bonds issued by companies in “clean” or non-clean sectors. pollutants. To what extent can central banks contribute to climate change mitigation in this way? How effective are these tools in reducing carbon emissions compared to a carbon tax? Are they complementary to carbon pricing?
In Abiry, Ferdinandusse, Ludwig and Nerlich (2022), we contribute to this debate by evaluating the effectiveness of green QE in limiting global warming compared to a carbon tax. We define green QE as a complete reallocation of the portfolio from the stock of private bonds held by central banks to a portfolio composed exclusively of green bonds.
To this end, we develop a stylized two-sector integrated valuation model where aggregate global output is produced using clean and “dirty” (carbon-intensive) intermediate goods. Intermediate goods are produced using the inputs of capital, labor and energy (which can be clean or dirty). Dirty energy production emits carbon which accumulates in the atmosphere and drives up global temperatures, which in turn harms the global economy. Chart 1 illustrates these stylized interactions. Without further policy intervention, global temperatures will rise to 3.5°C above pre-industrial levels by 2100. This is well above the 1.5°C target of the Paris.
Stylized interactions between global economy and climate
In our model, we look at two types of policy makers: tax authorities who are responsible for setting a carbon tax and central banks who hold privately issued assets on their balance sheets. In the reference scenario, carbon is not taxed. The introduction of a carbon tax increases the price of dirty energy, which reduces its use in the economy via two channels: first, dirty energy is partly replaced by labor and capital in the intermediate goods; and, second, the higher relative price of dirty intermediate goods due to higher dirty energy prices dampens demand.
In the case of central banks, the stock of corporate bonds they hold is calibrated to 2021 data and set at 10% of global GDP over time. We do not model the rationale for QE but assume it is a long-term characteristic. Without political intervention, the distribution of clean and dirty assets held by central banks is proportional to that of private assets. With political intervention (green QE), all central bank portfolios are entirely diverted from dirty assets. We choose this extreme scenario to generate the maximum impact for a given portfolio. A key assumption of the model is that the returns of the two asset classes are not perfectly correlated. Therefore, the central banks’ portfolio reallocation decision is not fully compensated by the reverse portfolio shifts of private investors.
Green QE impacts the economy through higher costs of dirty capital. Looking more closely at this impact, we find at least two antagonistic forces at play in our model: on the one hand, the demand for dirty intermediate goods contracts due to an increase in relative prices. On the other hand, this positive impact is partly offset by a substitution of input factors in the production of dirty intermediate goods, in particular from more expensive capital to energy.
How effective is green EQ?
We find that green QE is effective, even if its impact is modest since it would limit the rise in global temperature to a maximum of 0.04°C by 2100, compared to a situation without policy change (Graph 2 ). With a less extreme scenario where only part of the central banks’ portfolio is leaned, the climate impact of green QE is even more limited. The two opposing forces of green QE described above explain why the overall effectiveness of green QE, even with a complete portfolio shift, is more limited compared to other policy tools, such as a carbon tax. For illustrative purposes, we assume a low carbon tax of $13.6 per tonne of CO2 (which corresponds to USD 50 per tonne of carbon) and find that its impact is four times more effective than that of green QE (Figure 2). Our results are broadly consistent with those of other studies, for example Benmir and Roman (2020) and Ferrari and Landi (2022).
Temperature Reduction Scenarios
What level of carbon tax would it take to achieve the same drop in temperature as a green QE? We calculate the equivalent level of carbon tax at 3 USD per ton of CO2. This is low compared to, for example, the price of carbon which peaks at 98 USD per tonne of CO2 under the EU Emissions Trading Scheme in mid-August 2022, even though it only covers around 40% of EU greenhouse gas emissions. The Organization for Economic Co-operation and Development suggests that the uniform carbon price across all sectors should increase to around $120 per tonne of CO2 by 2030 to align with the goals of the Paris Agreement.
While the effects of increasing a carbon tax overshadow the effects of green QE, the latter can still be an effective complementary tool, especially if there is no coordination of fiscal policy to put in place a sufficiently ambitious carbon tax on a global scale. In such a situation, we find that green QE can help mitigate climate change when added to a carbon tax, although the impact is somewhat less effective than if the policies were implemented in isolation (Figure 2 ). The reason for this non-linearity is that the respective substitution effects of these instruments on inputs slightly offset each other.
Although the overall results are robust, they vary with changes in assumptions. For example, we find that the more central banks hold dirty assets in the initial period – consistent with the finding of Papoutsi et al. (2021) that the ECB’s corporate bond portfolio is biased towards dirty assets – the higher the efficiency of green QE. . On the other hand, assuming a lower elasticity of substitution, the demand for dirty intermediate goods would react much less to price variations. In this case, green EQ would be less effective.
While a carbon tax is the most effective way to tackle climate change, the analysis shows that the role of central banks can also be limited. Our model focuses on steering the portfolio of private bonds held by central banks around the world away from carbon-intensive assets. Other instruments available to central banks can also contribute to climate change mitigation. Their impact deserves further analysis.
Abiry, R., Ferdinandusse, M., Ludwig, A. and Nerlich, C. (2022), “Climate Change Mitigation: How Effective is Green Quantitative Easing? » Series of working papers, No. 2701, ECB.
Benmir, G. and Roman, J. (2020), “Policy interactions and the transition to clean technologies”, Center for Climate Change Economics and Policy Work documentNope 368.
Ferrari, A. and Landi, VN (2020), “All it takes to save the planet? Central banks and unconventional green policy”, Series of working papers, No 2500, ECB.
OECD (2021), Effective carbon rates 2021.
Papoutsi, M., Piazzesi, M. and Schneider, M. (2021). “How Unconventional Is Green Monetary Policy? Working Paper”, JEEA-FBBVA Conference at ASSA (January 2021), .