Author : Renita D'souza

Expert Speak Terra Nova
Published on Jan 08, 2020
Central banks’ intervention and the climate crisis

The key topic of contemplation in the recently concluded COP25 summit in Madrid was about the inter-dependence of the world’s natural resources with the global economy and its subsequent impact on climate change. The consensus that emerged was that sustainable economic growth cannot exist without a healthy environment and our encroachment upon the environment, erodes our ability to grow. This is a significant debate in the world of economics which concerns itself with boosting levels of productivity by reducing costs and minimising wastages. In the face of climate change, can central banks – which principally are tasked with maintaining global economic and financial stability to ensure sustainable economic growth – underwrite the globe against the vulnerability of this impending crisis? Can the central bank, given its current institutional wherewithal, expand its mandate to tackle the climate change crisis?

Green climate banking can be defined as “central banking that takes account of environmental risks, including risks from climate change, which may have a material impact on the short - and long-term stability and development of the financial sector and the macro-economy.” Mark Carney, the governor of the Bank of England, is a front-runner amongst the supporters from banking institutions foreseeing the potential impact of climate change on financial stability. Other central bankers took heed from his concerns and are now beginning to assess the next big emergency.

Some observers, including the International Monetary Fund (IMF), have begun taking responsibility to mitigate the effects of climate change and set up a mandate for propagating green financing activities. The Network for Greening the Financial System (NGFS), a group of 54 central banks and 12 observers, work on a voluntary basis to share the best practices in environmental management and alleviating climate risks within economies. Certain activities concerning this challenge are being pursued independently by central banks across the globe. The Bank of England requires banks, insurance companies and other loaning agencies to plan for climate risks. Developing countries’ central banks such as Bangladesh Bank, Banco Central do Brasil (Brazil), and the People's Bank of China, have set up far-reaching objectives of promoting green finance and sustainable development.

As a result of the climate crisis, several types of risks that will threaten global financial stability have been identified. First, climate change entails the catastrophic risks that the insurance industry will find untenable to insure. The insurance industry is a profitable model as long as it can assess the risks it insures accurately and the risks insured are uncorrelated in nature. Climate change has adversely affected this ability of the insurance sector. In the absence of the capacity to insure against catastrophic risks entailed by climate change, the global credit system will face an existential crisis.

Second, the world has reached a point where proactive decarbonisation is no longer a choice to be contemplated upon, but an inevitable step that cannot be sidelined. Yet, nations do not seem to take their commitment to a zero-emission economy seriously. It is feared that what could have been a smooth transition will be replaced by a panic-stricken decarbonisation process triggering a financial crisis as in 2008. This gives rise to “in transition” risks.

The third type of risk refers to the liability risk associated with the compensations needed to be doled out to the victims of the climate crisis by those who are seen as perpetrators of the crisis. The risk of natural calamities and extreme climatic conditions can affect the availability of natural resources required for agricultural production and development of social sector enterprises. This, in turn, can affect the aggregate demand, employment and price stability in the economy. Natural calamities can completely destroy the economy of a region.

The obvious next question is what constitutes green banking and how does it mitigate the above-mentioned risks. There is a sense of agreement that central banks should go beyond macro-prudential regulation for ensuring financial stability to actions that steer the global trajectory of economic growth to prevent climatic catastrophes which will spur financial crisis. The NGFS has been focussing on the development of markets for green bonds. The central banks intend to articulate legal standards and clear-cut classifications about what constitutes green finance. There is only that much central banks can do by using the conventional tools accessible to them and in isolation. Therefore, there is a need for central banks to collaborate with other institutional stakeholders to become a part of a more comprehensive and coordinated plan which is required to avert the impending climate crisis.

India is confronting a severe agrarian crisis that has adversely affected the rural economy. As pointed out by the Economic Survey 2017-18, farmer income losses in India due to climate change have been projected at 15-18 percent on average, increasing to anywhere between 20-25 percent in unirrigated areas. The agrarian crisis has contributed to the current economic slowdown in the country. What the future brings in the form of climatic catastrophes for the health of the agrarian economy cannot be ignored. However, this is only one of the many concerns that follow climate change in India.

A study published by the National Bureau of Economic Research (NBER) claims that the Indian GDP is set to shrink by 10 percent at the end of the century if the predetermined targets under the Paris accord are not upheld. Ignoring predictions such as Mumbai sinking underwater by 2050, is tantamount to ignoring potential catastrophic risks and related financial crisis approaching the country. India faces the stark prospect of incurring the highest social cost from carbon emissions at USD 86 per ton. This component is not taken into account while setting the benchmark interest rate. The opportunity cost of the USD 79.5 million lost due to climate-related disasters for one of the world’s fastest-growing nations is huge.

Learning from the other central banks, the Reserve Bank of India (RBI) needs to understand the urgency of managing climate change as part of its mandate. However, such an initiative comes with its own set of challenges. How will the expansion of RBI’s mandate impact the cost of its overall operations? What kind of impediments will this transition face? How effectively will the RBI be able to address the impact of climate change on financial and price stability? These questions are crucial to the RBI’s success of dealing with climate change.

The role central banks have conventionally assumed in this context is that of prevention – either in the form of macro-prudential regulation or promotion of decarbonised economic growth to prevent catastrophes. The RBI can commence by doing the same.

It is crucial that while recognising the gravity of the problem that besets the economy in the long-run, the RBI collaborates with its peers on this issue to articulate appropriate climate-smart strategies for maintaining the well-being of the Indian economy.

Tanya Rana is a research intern at ORF in Mumbai.

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Renita D'souza

Renita D'souza

Renita DSouza is a PhD in Economics and was a Fellow at Observer Research Foundation Mumbai under the Inclusive Growth and SDGs programme. Her research ...

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