Speech Olaf Sleijpen - “Effective investment in climate action: what can central banks do?”

Datum: 21 januari 2021
Locatie: Oxford Conference on European Climate Action
Spreker: Olaf Sleijpen

Good afternoon and thank you very much for having me here today. As we all know, getting the world economy sustainable for future generations requires large investments. A big part of these investments need to be made by the private sector. And for these private investments to scale up sufficiently, we need to get the right conditions in place. This is first and foremost a task of governments. But other stakeholders must play their role in the energy transition too. Including the financial sector, and central banks and supervisors.

Central banks do not all have exactly the same mandate. But what they do all have in common is that it is their job to safeguard the stability of the financial system. And to keep prices stables. In quite a few cases they also act as supervisor, ensuring that financial institutions remain safe and sound. Thereby contributing to a prosperous economy.

And that’s why climate change is also a concern for central banks. Because there is no doubt that climate change, and other environmental challenges such as biodiversity loss, threaten the economy and hence the financial system on a global scale.

Indeed, by implication, climate change falls squarely within our mandate, and you could even say it is our obligation, to address these concerns. Today I would like to discuss with you  what central banks can  do to help mobilize more sustainable finance. Where do they have a mandate to play an active role, and where do other players need to contribute?

I think I can best explain my views by starting with the factors that play a role in private investment decisions. Along the way, I will also touch on some things that are important, but which lie outside the realm of central banks. But as I continue, sure enough central banks will enter the stage. So bear with me.

Let’s look at private investment. Private investment in sustainable, carbon-neutral projects still lags behind what we need for a timely energy transition. Why is that the case? In short: many green projects still do not have a viable business case. In other words, the risks outweigh the returns.

When we look at the returns we see they often lag behind, because carbon and other harmful emissions are insufficiently priced. As a result, sustainable investment plans often still cannot compete with fossil fuel alternatives. The average effective emission tax in most countries is often not high enough to present a viable business case for climate investments.

And then there is the risk side. Green investment projects often bear a relatively high risk, for various reasons. For one thing, green investments usually involve new activities. With start-ups employing new technologies. It typically takes a long time to generate any returns. And it is often uncertain how cash flows will develop further down the road. This uncertainty is not only due to the parameters of the projects themselves. Often, it is also due to a lack of clarity on what government climate regulation will look like in the future, and how that will shape consumer behavior and social acceptance.

And then there is the question of what is green and what is not. It is unclear whether, and by how much, companies and investment projects actually contribute to lower carbon emissions. This not only applies to new projects and start-ups. It also concerns major investments needed to make existing carbon-intensive firms more sustainable.

That’s partly because many companies do not disclose the information that investors need to make an informed decision. And if they do, their reports lack uniform criteria. As a result, investors cannot compare between alternative projects. Climate reporting by companies is still in many cases voluntary and different standards are applied.

All this uncertainty gives rise to risk premia for sustainable investment that are often higher than for conventional investment. Therefore, banks, institutional investors and others are less willing to provide the necessary funding.

If you look at this overall picture, it is more or less clear what needs to happen. First of all, we need a better business case for green investments. One policy instrument is absolutely key here, and that is to raise the effective price of carbon emissions. This ball lies squarely in the court of governments, preferably on a European level. The EU Green Deal contains ambitious plans for this, and it is crucial they are not watered down. This is the one thing that make all the other things that we do, much more effective.

Next, we need to reduce risk. In order to realize this, first of all it is key that governments commit themselves to a clear and credible transition plan. A plan that provides answers to questions like: what emission targets will be met and when? What actions are necessary to achieve these targets? What regulation is going to be implemented, and when? What investments will the government do itself? Etcetera. This gives investors more certainty about future returns, which enhances the business case.

And now central banks enter the stage. What should they do?

First, As independent economic advisors, they can help governments in making informed decisions and in garnering support for new policies. They can do this through research on the impact policy measures have on the economy and on climate. And also by showing what the impact will be if we delay action. My experience at the Dutch central bank over the past few years has been that people listen to central banks if they stick to their mandates and produce high-quality research that shows the impact of the policy choices we make as a society.

Cooperation can make a big difference in this respect. That is why central banks and experts from all disciplines, many of you participating today, should work together more. This way, we can further improve the quality of our advice. In the Netherlands, we gained valuable experience in working closely with the national Environmental Assessment Agency. Last year we co-produced a report in which we assessed the financial risks associated with biodiversity loss. The report generated a lot of publicity and political traction. This was partly because of the combined warning issued by two research power houses.

Second, in their supervisory role central banks can push financial institutions to take climate change into account in the latter’s risk management. More and more supervisors, like us, require financial institutions under their supervision to adequately manage climate-related risk in their portfolios. Just as they do with other relevant financial risks that they face. For financial institutions to manage their risks and play their role in the transition, they must however have access to information regarding the impact of environmental challenges on a company. They must also be aware of the impact of the company on the wider environment. The information that the financial sector uses is only as strong as the corporate disclosures it is built upon. That is why the quantity, quality and consistency of corporate reporting on sustainability-related information must improve. Credible and comparable information should be readily available for all market participants, shareholders and other stakeholders.

Third, next to pushing banks to improve their risk management, central banks can also play a catalyst role by taking climate risk on board in their own risk management. To start with, central banks might consider including carbon emissions disclosure as a requirement in asset purchase programs. This would further promote transparency. But to do that we need help. Help from credit rating agencies for instance. Credit ratings need to better reflect climate related exposures so that the market can properly identify and price these risks. Central banks could engage with them, and incentivize rating agencies to better reflect climate change-related risks in their judgement.

Lastly, and definitely not least, central banks should incorporate the impact of climate change in their monetary policy decisions. Climate change and its impact on the economy will impact price stability, which is at the heart of most central banks’ mandate. And central banks often have the responsibility to support the overall economy, without prejudice to the primary objective of price stability. Indeed, how climate change should be incorporated in monetary policy making is currently under debate in the context of the monetary policy strategy review of the European Central Bank.

Today I have talked about how we can facilitate and encourage private green investment. But let me make a disclaimer here. I may have inadvertently left you with the impression that finance always follows the real economy. That if governments and central banks and other policymakers and standard setters provide all the right conditions, then funding for the green transition will follow suit. Although I think this is largely true, it is not entirely how I see the role of the financial sector. Financial market players need and should not wait for all the regulations, and conditions, and perfect data sets to be in place before they can have impact. They also have a social responsibility of their own to make sure that their business models support a sustainable economy. It is good to see that many financial institutions are very active in reducing their footprint. To them I would say, keep up the good work, and extend it where possible. And to the others I say, let’s not only talk the talk, but also walk the walk.

Summing up, central banks, in their various roles and capacities, have a lot of leverage over the financial sector and the real economy. Leverage that they can put to use to facilitate the financial sector in funding the transition to a carbon-neutral economy. However, central banks cannot do it alone. In fact, their contribution, however substantial, can only be complementary to the major government policy measures that I mentioned earlier. Like raising the effective price of carbon emissions, enforcing better disclosure, and providing a clear and credible transition plan. The EU Green Deal, if successful, will go a long way to putting these necessary measures in place. Governments, both EU and non-EU alike, like the UK, regulators, private investors, financial sector, climate experts, and also central banks, need to work together to overcome the policy and implementation challenges. And to make sure that Europe can continue to make a key contribution to the worldwide effort to meet the Paris Agreement and tackle climate change.