Climate change and the role of central banks

By Andreas Charalambous and Omiros Pissarides

Recent developments confirm that without worldwide coordinated action and = implementation of additional far-reaching measures aimed at fighting climate change, the risk of serious environmental damage is huge. They also confirm that the transition from conventional energy sources to renewable energy is challenging. The repercussions for energy prices, inflation and, as a consequence, the living standards of households and particularly low-income families are already visible.

Central banks are in a position to facilitate the transition, either directly via adjusting their asset purchase programme in a way that takes into account the impact on climate change, or indirectly via supervisory measures.

As far as supervisory measures are concerned, the main policy instrument is specific stress tests, aimed at identifying the exposure of banks to climate change risks.

The ECB has already initiated such stress tests, which also include Cypriot banks. The outcome of this exercise is expected in June 2022 and the intention is to utilise the findings for a dialogue with banks, concerning the necessary adjustment measures that need to be taken, mostly related to their loan portfolio and governance issues.

The involvement of central banks in climate change issues is a necessity, although all related risks should be seriously considered.

So far, the involvement of the ECB is confined to its traditional mandate. However, in the future, an extension of its mandate to facilitate achieving its goals of reducing banks’ exposure to climate change risks may prove necessary.

At some juncture, the exposure of banks to emission burdening activities could be penalised by the imposition of additional capital requirements.

Commercial banks can exert a crucial role, primarily via adjusting their loan portfolio in favour of emission cutting activities. The main sectors in need of financing include energy production and transport.

Furthermore, important sectors for the Cyprus economy, such as construction and tourism, will require additional capital to adjust to the new market conditions. Vital elements of such investments have come to be known under the name of cyclical economy and include utilisation of renewable energy and environmentally friendly raw materials, as well as the introduction of legal requirements for compulsory repair and recycling of products.

The total public and private investment needed is estimated at a minimum of 3 per cent of global GDP. Hence, beyond bank financing, new equity type instruments have been established, which usually take the form of dedicated funds.

In conclusion, combatting climate change will be challenging and time consuming and will require timely action by governments but also radical adjustments in the banking and the broader financial sector.

Andreas Charalambous is an economist and a former director at the Ministry of Finance. Omiros Pissarides is the managing director of PricewaterhouseCoopers Investment Services