Green Transition: Why Is It Important for the Central Bank?

Green Transition: Why Is It Important for the Central Bank?

Photo: ua.depositphotos.com / VitaliiStock
4 December 2023
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Central banks not only respond to shocks “here and now” but also consider long-term trends to prepare for future challenges. One of such challenges is climate change, which is already impacting the economy, specifically the financial sector, and probably this impact will only grow. How do central banks prepare for changes in the economic landscape caused by global warming?

In recent years, many central banks started studying the economic consequences of climate change and green transition policies in the context of their missions and functions. On the one hand, achieving green transition goals requires central banks to implement sustainable financing standards. On the other hand, it poses challenges to the central banks’ main objectives of price and financial stability. The analytical efforts of central banks are focused on understanding the channels through which climate change affects the economy and the financial system. These channels of influence are highly diverse, ranging from changes in consumer behavior to the volatility of financial markets and changes in non-financial reporting standards.

New types of inflation are emerging, such as climateflation (an increase in prices due to ecological disasters), fossilflation (an increase in prices due to rising cost of fossil fuels), and greenflation (an increase in prices of specific resources used in green technologies). These inflation types are related to both rising costs (climateflation, fossilflation) and increasing demand (greenflation). For example, the growing demand for electric vehicles leads to higher costs of lithium and other critical minerals used in battery production.

So, what challenges does the green transition pose for central banks, and how do monetary authorities in different countries respond to these challenges?

Firstly, monetary transmission weakens due to environmental impacts:

  • Increased uncertainty forces people to increase savings, reducing the responsiveness of aggregate demand to changes in interest rates.
  • Rising uncertainty leads to increased volatility in both currency and financial markets, consequently increasing the risk premium. This weakens the interest rate and exchange rate channels.
  • Environmental losses incurred by businesses and accounting for “environmental friendliness” in estimation of the quality  of collateral weaken companies’ creditworthiness, leading to banks’ decreased willingness to lend to businesses and an increase in the proportion of non-performing loans.

Secondly, implementing green transition policies affects central banks‘ portfolios. Some central banks purchase “green” securities, such as sustainable development bonds issued by governments or companies, which impacts the effectiveness of monetary transmission and central bank balance sheets. Some central banks adjust their strategies and/or collateral requirements when providing loans to commercial banks to account for climate-related risks. Despite recent interest rate hikes by central banks worldwide to curb inflation, support for sustainable development projects, especially in low- and middle-income countries, remains on the agenda of the World Bank and the IMF.

Sustainability bonds are bonds whose proceeds are exclusively used to finance or refinance environmentally and socially sustainable development projects. The issuance of these bonds rests on four principles: 1) intended use, 2) transparency and reporting, 3) funds management mechanisms, and 4) outcome assessment.

The Network for Greening the Financial System (NGFS) plays a crucial role in the study of the impact of ecology on monetary transmission. Currently, NGFS brings together 127 central banks and supervisory authorities (including the NBU) and 20 observers. Central banks that are members of NGFS exchange best practices in managing environmental and climate risks in the financial sector. NGFS develops scenarios for the impact of climate change on macroeconomic indicators and assesses the consequences of ecological impacts on monetary policy. For instance, if emissions taxes or demand for skilled labor in “green” industries lead to inflation, it would require a more stringent monetary policy. At the same time, NGFS explores possible compromises for monetary policy in the context of achieving climate neutrality goals. NGFS considers directions for “climate” modifications of central banks’ monetary designs in three areas: credit policy, collateral policy, and asset purchase policy.

Central banks increasingly use stress tests to assess whether credit and insurance institutions are vulnerable to climate change and “green transition” policies. Some central banks are concerned whether climate risks are being addressed in financial markets in the framework of identifying risks to financial stability.

Many central banks adhere to responsible investment principles to reduce investments in “non-green” assets. Some central banks are also exploring whether they can ensure that the activities of the companies they invest in align with the Paris Agreement. Central banks can create conditions under which the cost of credit for projects with high eco-social risks is relatively high. However, this work is complicated by challenges related to the systematization and standardization of data on emissions from companies.

Today the global practice uses specialized non-financial reporting standards to measure the impact of environmental factors. These standards fall under the ESG framework, where E stands for Environmental, S for Social, and G for Governance. The metrics within this reporting focus on environmental issues, social responsibility, and the effectiveness of governance practices. One of the key documents that served as the foundation for developing the ESG standard is the “UN Principles for Responsible Investment” (PRI), which was proposed in 2006. In June 2023, the International Sustainability Standards Board (ISSB), operating under the IFRS Foundation, adopted a new edition of international sustainability standards. 

Some central banks disclose their financial risks related to climate change. The carbon footprint of a central bank is often used as an indicator of risks associated with the transition period. 

What the National Bank of Ukraine is doing

The National Bank of Ukraine (NBU) contributes to Ukraine’s environmental transition by fulfilling its tasks of ensuring price and financial stability. Longer planning horizons for households and companies are necessary for long-term green investments. Stability also expands the fiscal space and reduces financing costs, ultimately making “green” investments more accessible.

In November 2020, the National Bank joined the Sustainable Banking Network (SBN), which brings together central banks of developing countries. By doing this, the National Bank affirmed its intention to work toward establishing a resilient financial system for sustainable economic development, expanding “green” investments in the economy, and supporting financial products that positively impact climate.

In April 2021, the NBU and the International Finance Corporation (IFC) signed a cooperation agreement to implement the Sustainable Finance Development project in Ukraine. The project’s goal is to integrate environmental, social, and governance standards into the practices of financial institutions in Ukraine. This collaboration operates through two IFC programs: “Green Finance” and the “Integrated Environmental, Social, Governance Standards Program in Europe and Central Asia” (the ESG Program), implemented together with the Federal Ministry of Finance of Austria and the State Secretariat for Economic Affairs of Switzerland (SECO).

In November 2021, the National Bank of Ukraine (NBU) adopted the “Sustainable Finance Development Policy 2025.” In this policy document, the NBU outlined the key principles for the development of sustainable finance and provided a roadmap with specific directions of action, types of activities, and timelines for implementation.

The roadmap for implementing the Policy on Sustainable Finance Development includes the following key components:

  1. Implementing environmental, social, and governance (ESG) factors into the corporate governance systems of banks and non-bank financial institutions.
  2. Integrating environmental and social risk management (ESRM) into financial institutions’ overall risk management framework.
  3. Implementing criteria for assessment and selection of projects for financing taking into account their contribution to sustainable development.
  4. Implementing disclosure requirements for financial institutions to provide information about the sustainability of their activities.

When selecting projects for financing, financial institutions will be required to assess their impact on the environment, the sustainability of economic activities, and energy efficiency. They will also be obliged to disclose information on technical criteria and classifications of economic activities and ESG indicators, which have been used for assessing and selecting such projects, following the best global practices. Financial resources should primarily be allocated to projects that align with ESG standards.

Financial institutions will have to disclose information about sustainability of their operations, their impact on the environment, and reputational and financial risks associated with the environmental impact of their activities.

Initially, the NBU planned to develop recommendations for banks on disclosing information about ESG risks and their management by the end of 2023. However, the war “corrected” this timeline. The NBU now plans to analyze approaches to implementing disclosure requirements starting from the second quarter of 2024, based on the results of surveys of banks regarding their current ESG risks. The NBU intends to assess ESG risks in the banking sector and implement stress tests to evaluate the impact of ESG risks on bank clients’ businesses, as well as on the resilience of banks and their capital. The practical implementation of ESG requirements is planned for after the war ends, likely over several years.

Introducing new “green” financial instruments will bring Ukrainian financial institutions closer to global best practices. According to the IFC, there are opportunities for climate investments of approximately $23 trillion in developing markets by 2030. By developing and implementing the Sustainable Finance Development Policy, Ukraine will enhance its ability to tap into this potential.

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