Central banks' misguided plan to become climate warriors is doomed to fail

Central banks' misguided plan to become climate warriors is doomed to fail
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As if central banks today did not already have enough to do printing all the paper money needed to finance proliferating government spending. Regardless, they are taking on a new responsibility, the “greening of the financial system.” 

According to the Wall Street Journal, they have pledged to join forces with financial regulators, “to limit climate change by steering their financial systems away from funding fossil fuels.” Given central banks’ collective history of causing inflations, recessions and financial crises while managing monetary policy, what could possibly go wrong if they start using the financial system to promote ”environmental sustainability”?   

The Central Banks and Supervisors Network for Greening the Financial System (NGFS), an organization chartered in 2017, now includes 90 members and 14 observers, including the Bank of China as a founding member and the Federal Reserve System which joined last December.

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The NGFS is committed to the belief that climate change and environmental risks endanger the safety and soundness of the financial system in the guise of floods from rising sea level, greater storm intensity, wildfires, and other real or imagined environmental plagues, like “air pollution, water pollution and scarcity of fresh water, land contamination, reduced biodiversity and deforestation.” The NGFS even creates a new catchall category of “transitional risk.” Transitional risk is a euphemism for regulatory risk — the risk that future government decrees might make certain types of current business activities illegal thereby compromising existing customers’ ability to repay outstanding obligations.  In other words, financial institutions must plan to protect themselves against potential future misguided government regulatory policies.   

The NGFS boasts all of the international regulatory standard-setting bodies in its ranks including, The International Monetary Fund, The World Bank, The Basel Committee on Banking Supervision, The Bank for International Settlements, the Financial Stability Board and The Organization for Economic Cooperation and Development. I am fully confident that these members will spare no amount of jet fuel or poured fine wine to ensure that the NGFS hammers out a non-binding international agreement on “best central bank and regulatory practices” for controlling climate change through financial suppression. 

Make no mistake, the NGFS’s goal is a new type of industrial policy administered through the financial system. Bank and securities market regulators will introduce new rules and requirements to discourage financial institutions from lending to or investing in businesses or projects that are deemed to be “environmentally unsustainable”— whatever that means. Ambiguity is an attractive feature for politicians and their bureaucrat enablers. Consumers should demand transparency. Central banks and financial market regulators have no expertise in judging which investments will lead to economic growth, a higher standard of living and a healthier environment for the citizens at whose pleasure they serve. 

How exactly will the ultimate NGFS “best practice standards'' suppress loans and investments deemed to be unsustainable by the central bank and regulatory ruling class? The details are yet to be determined, but efforts are underway to translate specific categories of the NGFS’s enumerated environmental risks into the market, credit, legal and reputational risk framework that underpins international bank minimum regulatory standards.  An alternative approach may be to argue that disfavored activities create a new type of risk — “environmental systemic risk” — that requires a new minimum regulatory capital surcharge. 

For example, financial institutions that choose to invest in disfavored activities could be held to higher minimum regulatory capital requirements. This will lower returns on and discourage investments in activities claimed to create environmental risk for the financial system. Naturally, central bank and regulatory experts will argue that they are best situated to choose the right amount of extra capital needed to balance “environmental sustainability” against the need for economic growth.

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The real risk for businesses and consumers is that central banks and financial regulators will be as successful as stewards of “environmental sustainability” as they have been of ensuring monetary stability. The past 50 years have witnessed huge changes in the way central banks think about and manage monetary policy. For the most part, policy changes have been enacted because earlier policies failed to achieve expectations or ended in crisis. No doubt environmentally sustainable financial policies will experience a similar cycle of failure and revision. 

For example, the Federal Reserve’s strategy for conducting monetary policy has changed many times in the past 60 years. Today the Fed follows a modified inflation targeting strategy which only recently evolved from a simple inflation targeting strategy because the latter approach wasn’t working. What will central banks and financial regulators target to ensure environmental sustainability? Selected greenhouse gas emissions, the frequency and intensity of the storms, floods and wildfires they seek to eradicate, the rate of deforestation in the Amazon basin, all of the above?   

Then there is the issue of international coordination. Policies that discourage the continued production and development of fossil fuels will increase the cost of energy adding inflationary price pressures while reducing economic growth. International cooperation is an admirable goal, but competition between nation states is a reality. Is anyone so naïve as to believe that China or India will impose the same “environmentally sustainable” financial policies as Norway or Switzerland?

Imagine waiting for the Federal Open Market Climate Committee (FOMCC) policy statement following a meeting held in the midst of an exceptionally active Atlantic hurricane season. Then, 24-hour news cycle stories would, without evidence, link recent storms to climate change. Will the FOMCC buckle to congressional climate alarmists’ pressure to increase the financial system’s “environmental stability capital buffer” and further starve the fossil fuel industry of credit? Stated differently, will the NGFS successfully create a new form of “transitional risk” linked to climate-change fanaticism? Time will tell. 

Paul H. Kupiec is a resident scholar at the American Enterprise Institute (AEI), where he studies systemic risk and the management and regulations of banks and financial markets.