Should Central Banks Engage in “Green Quantitative Easing”?

Over the past year, calls for central banks to play a larger role in fighting climate change have grown louder. Various research conducted by Network for Greening the Financial System (NGFS), a group of central banks and financial supervisors, has helped to facilitate the debate around central banks’ role in the global climate agenda.

The proposals for central banks’ actions include incorporating climate risk considerations in micro- and macroprudential supervision and monetary policy, including quantitative easing (QE).

It is hard to disagree that climate risk should be reflected in the regulation and supervision of banks, insurance companies and other financial institutions. Indeed, climate risk stemming from adverse natural events and transition to a low-carbon economy entails financial consequences for individual institutions and the financial system as a whole. Hence, central banks and other regulators should require greater disclosure of climate related risks. This process is already under way. A number of major economies have started or plan to mandate their publicly traded companies, including financial institutions, to publish climate risk disclosures consistent with the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD). By adjusting requirements for capital and reserves of banks and insurers to factor in environmental risks, central banks and regulators will accelerate these institutions’ transition to sustainable finance.

In monetary policy too, central banks should focus more on climate risk and other environmental, social and governance (ESG) considerations in macroeconomic forecasting, devising eligibility criteria for collateral and counterparties, and mandatory reserve requirements.

However, purchasing green or other sustainable-labelled bonds by central banks as part of their QE programs will not be an effective move, at least over the next several years. The inefficacy of a “green QE” applies to both monetary policy and environmental and social impact.

Implications of the “green QE” on monetary policy and financial markets

Central banks mainly purchase their home countries’ government bonds to drive down borrowing costs for the government and private sector issuers. The total global sovereign sustainable bonds of just over USD 40 billion make up a fraction of the USD 2 trillion worth of sustainable bond market. Moreover, the amount of sovereign sustainable bonds is negligible (less than 0.2%) compared to the USD 25 trillion worth of government bond market and USD 28 trillion worth of total assets of the four major central banks – US Federal Reserve, European Central Bank, People’s Bank of China and Bank of Japan.

Sources: Environmental Finance, BIS, US Federal Reserve, European Central Bank, People’s Bank of China and Bank of Japan.

While new governments are joining the ranks of sustainable bond issuers, it is unlikely that sovereign sustainable bonds will make up a significant share of the government bond market or central banks’ balance sheets over the next five years. Therefore, adding sovereign green or social bonds to central banks’ assets will be a mere symbolic move with virtually no impact on the outcomes of QE programs.

On the other hand, purchasing corporate sustainable bonds by central banks will have a bigger effect on the general yield levels. However, demand for sustainable bonds is far greater than supply. As a result, investors often have to pay a green premium or “greenium” over conventional bonds of the same issuer. Therefore, these instruments do not require a demand stimulus, and any significant intervention by central banks risks distorting the market and crowding out private investors.

Environmental and social impact

The environmental and social benefits of the “green QE” are also questionable. To begin with, the objectives of QE and climate action are not exactly compatible. The ultimate goal of a QE program is to boost consumption in the economy. But a successful climate action requires, among other things, moderation of consumption levels, particularly in the developed countries with massive QE programs. Excessive manufacturing and consumption powered by burning of fossil fuels is the major cause of climate change.

Then the question is if purchasing “green” assets instead of “non-green” or “brown” ones by central banks will help the climate. Not really. Because of the small size of the sustainable bond market and existing strong demand from the private sector, central banks’ purchases will not bring about meaningful additionality. True, some central banks may consider a broader set of assets to purchase, including ESG-labelled mutual funds and ETFs. However, given the lack of standardisation in ESG classification and the resulting commonplace greenwashing of many funds, central banks could risk to run into a controversy.

Finally, the social impact of the “green QE” will not be straightforward. Financing investments that provide positive social outcomes such as increased employment, improved healthcare and education is welcome. But QE also contributes to rising wealth inequality because financial assets’ appreciation driven by central banks’ purchases benefits only a small minority of the population that owns most of these assets.

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