Few dispute that there can be no green transition without a greening of finance. Yet, the greening of finance drags on and on. In fact, estimates suggest that current practices in the financial sector have us headed for temperature increases two-fold larger in magnitude than those aimed for with the Paris agreement. In this predicament, might a way forward be to engage central banks in fostering the much-needed greening of finance?
Several monetary policy instruments can be tailored to affect incentives in the financial sector, in favor of low-carbon assets at the expense of carbon-intensive ones. This has been elaborately documented by the Network for Greening the Financial System (NGFS), the think-tank organization established by central banks themselves (NGFS 2021). And several initiatives appear to suggest that central banks are in fact beginning to engage proactively, such as the formal adoption of a green mandate by the Bank of England and the creation of a Climate Change Centre by the European Central Bank. But steps taken so far remain mainly symbolic and it’s important to note that central bankers navigate in a political environment with strong countertendencies.
There is stout push-back from dominant players in the financial industry as well as from conservative politicians. While executives in the financial sector will express support for the objective of increasing funding for renewable energy, many fewer accept that lending to fossil fuel producers should be discontinued. For stakeholders with these views, the prospect of central banks deploying monetary policy tools to change relative incentives in the financial sector to promote the green transition appears almost atrocious. Yet, even within the financial industry and in the central bank establishment minority voices advocating that central banks should adopt a proactive approach are gathering momentum, not least as it becomes apparent that the hands-off, voluntary climate risk disclosure approach (advocated by Mark Carney and endorsed by the financial industry) is leading to little more than ever-escalating practices of “greenwashing.”
While green central banking is likely to continue to be a highly contested terrain in coming years, this does not absolve scholars of central banking and financial regulation from the duty of engaging with the issues. The aim of my new INET Working Paper is to contribute to preparing the ground analytically for green monetary policy-making. More specifically, the aim is to review a range of green monetary policy instruments in order to identify a policy mix likely to have a substantial climate change mitigation impact.
A Money View Perspective
Two things are needed if a proactive approach to green central banking is to gain traction. First, an intellectual armory is needed that can challenge the current conventional wisdom on central banking; and second; a policy strategy that is theoretically informed and feasible to implement. Revisiting the green central banking agenda from a Money View perspective provides both: a new theoretical foundation for thinking about monetary policy, as well as theory-based guidance on devising a policy strategy likely to be effective.
The Money View is an approach to monetary economics that combines the American institutionalist economics tradition of Young, Hansen, and Minsky with the British central banking tradition of Bagehot, Hawtrey, Hicks, and Goodhart. In Perry Mehrling’s own phrase, the Money View is “essentially a synthesis and restatement of the core ideas of these two traditions, reformulated for present institutional conditions” (Research Outreach, 2022). Conceptualizing banking as simultaneously a payments system and a market-making system, the Money View transcends the boundary between economics and finance and as such is particularly well-placed to reflect on central banking challenges in an era of market-based finance.
Addressing monetary policy issues from a money view perspective means taking a point of departure from the notion that all financial instruments from securities and bank deposits at one end to currency and gold at the other are constitutive elements of money hierarchies and subject to vertical convertibility, with gold as the most liquid asset and securities as the least liquid. Central bank haircuts are an integral element of money hierarchies; without them, securities would not be convertible into bank money through repos.
The convertibility of assets with different degrees of ‘moneyness’ in the hierarchy depends on intricate mechanisms of daily collateral valuation and margining. What this means is that collateral valuation is at the heart of modern systems of market-based finance. For climate change mitigation, the implication is that the policy instruments most directly influencing collateral values have to be at the core of any green central banking strategy hoping to be effective.
From a money view perspective, the interventions of central banks are seen as either providing elasticity or enforcing discipline on the monetary system. The distinction between elasticity and discipline can be expressed also in terms of expansion and contraction of market liquidity. When central banks provide elasticity to the system, market liquidity expands; when they provide discipline, market liquidity contracts. As the Working Paper details: “[A] reduction in the haircut of an asset unambiguously lowers its required return and can ease the funding constraints on all assets,” Ashcraft et al (2011: 143). In fact, each of the two main dimensions of collateral policy – haircuts and asset eligibility criteria – can be seen through a lens of elasticity and discipline; as instruments that can be tailored to engender either expansion or contraction, depending on financial market conditions and desired policy outcomes. Lower haircuts relax the settlement constraint for banks, while higher haircuts tighten it.
When collateral policy is approached from the perspective of Green Central Banking objectives, the question is not whether to aim for elasticity or discipline. We need elasticity for the low-carbon (green) assets that we wish to promote, and discipline for the carbon-intensive (brown) projects we oppose. But is this even possible? Can we achieve elasticity in one direction and discipline in another? Can we instigate a collateral expansion in green assets and a collateral contraction in brown assets?
The answer is affirmative. Just as money can be seen as a hierarchy of promises to pay, collateral too can be understood in hierarchical terms. We can understand collateral as a spectrum of assets that have different values when actors meet requirements to secure their borrowing with the central bank. The key question for the concerns here then becomes how we may reshape collateral hierarchies in a manner that favors green assets and disfavor brown assets. How can central banks shape collateral hierarchies such that green assets ascend while brown assets descend?
Important Lessons for Green Monetary Policy
A core principle of the Money View is the notion of an inherent hierarchy of money and the observation that haircuts are crucial in enabling the convertibility of money in the hierarchy. This means that money hierarchies are predicated upon hierarchies of collateral, pledged in the repo operations that ensure the smooth functioning of the money and payment system. This implies, in turn, that there are no other, more profound effects on monetary and payment systems than those that stem from changes to the underlying collateral hierarchies.
Beyond this key principle of affording a central role to instruments that directly affect collateral hierarchies – such as haircuts and eligibility criteria – two further principles can be derived from the Money View perspective. First, measures that differentiate are preferable to those that exclude. For instance, tilted asset purchases are preferable to a negative screening of brown assets from asset purchase programs. A disciplinary mechanism that operates on a continuum is more effective in changing collateral hierarchies than a binary one (included vs excluded). In its most elementary form, a continuum requires two thresholds that jointly constitute a spectrum from green to grey to brown assets.
Second, targeting assets is preferable to targeting institutions. If counterparties are targeted, it will take the form of differential treatment based on the average level of low-carbon assets in the portfolio of those institutions or the collateral they pledge. This will inevitably be a blunt disciplinary modality since a counterparty could hold a high share of low-carbon assets, but also have a substantial amount of highly carbon-intensive assets and still get the preferential rate. Measures that target institutions should therefore be secondary and only considered in combination with measures that target assets.
A Policy Strategy for Green Monetary Policy
Based on a Money View analysis, I identify a policy mix that meets the three-fold objective of (i) having a substantive mitigating effect on climate change, (ii) entailing no significant, negative impact on monetary policy effectiveness, and (iii) not causing a contraction of collateral space, with potential negative consequences for market liquidity.
The report by the NGFS reviewed nine monetary policy options in three overall categories and although it proclaims a desire not to “give recommendations,” it does nevertheless effectively provide a shortlist of monetary policy instruments suitable for a proactive agenda. Interestingly, the shortlist that results from this paper’s analysis, based on the Money View, turns matters upside down. Notably, adjusted collateral haircuts – disqualified by the NGFS as not of much significance or impact, indeed of “second order” – take center stage in the green monetary policy strategy informed by Money View principles.
More specifically, the core finding is that a promising policy strategy would be to combine i) an expansion of collateral eligibility through positive screening with ii) a widening of haircut spreads to change relative incentives in favor of green over brown assets, reshaping collateral hierarchies in the process, and iii) tilted asset purchases, to further reinforce that effect. This may be combined with differentiated lending rates for counterparties, according to the share of low-carbon assets in the collateral they pledge to access funding.
Given the key importance of differentiated haircuts for the reshaping of collateral hierarchies, I discuss several approaches. First, a sliding scale approach can be adopted, using industry emission averages as a benchmark around which haircuts are increased, for assets with higher-than-average carbon emissions; or decreased, for assets with lower-than-average emissions. Second, haircuts can be tilted according to the carbon intensity of the assets, as proposed by Dirk Schoenmaker (2021). And third, technical screening criteria for green and brown economic activities developed in the EU taxonomy could be used as an upper and lower threshold for differentiated haircuts. I advocate the latter option on the grounds that it would anchor green monetary policies in a comprehensive and ambitious classification of green economic activities – and thereby have the added benefit of potentially reining in widespread greenwashing practices in finance.