Central Bank "Brown" Collateral Haircuts

Climate change takes place in a socio-economic context fraught with barriers and limitations that inhibit effective mitigation. Despite the increased frequency and intensity of extreme weather events associated with climate change and our ever improving understanding of the dramatic consequences of inaction, politicians are still failing to enact adequate policy measures. Structural characteristics of liberal democracies, credibility, short-termism, high levels of public and private indebtedness, and a failure to adequately price climate risk in the financial sector are among the key limiting factors impeding conventional climate policy. In light of these limitations, increased attention has been devoted to the role of central banks in climate mitigation and how green monetary policy might be able to circumvent many of the pitfalls of conventional climate policy. Despite their enormous power to influence markets, central bankers are hesitant act for climate mitigation.

However, unlike other “green” monetary policy instruments, reducing the value of collateral posted with the central bank based on its carbon intensity is an effective and unobtrusive way to shift investment from “brown” to “green”. As we have seen with COVID19, effective crises responses require strong policy initiatives from both governments and central banks. Given that the effects of climate change on both human life and economics will be considerably larger than those of COVID19 we will require central bank intervention in the mitigation process. A “green” reformulation of central bank collateral frameworks is a good place to start.

 

Actor(s)

Central Banks (specifically the ECB)

 

Trigger (intervention)

Introducing brown collateral constraints for central bank liquidity issuances.

 

Criticality

Currently there is significant interest and willingness by central bankers to participate in climate mitigation. That sentiment should be capitalised upon with the implementation of a policy.

 

Feedback Dynamics

If even one of the major central bank starts to include brown haircuts into their collateral framework the financial industry will knock on the carbon risk price adjustments into assets markets. These price adjustments would then perpetuate to some extent through the global financial system without the need for international political agreements. Additionally, if one of the major central banks introduced brown haircuts it will set a strong precedent in policy for others to follow, in turn strengthening the price adjustments.

 

Timescale and scaleability

Given that most central banks already have a comprehensive collateral framework and already apply collateral haircuts adding an additional carbon risk parameter could be quickly implemented. Furthermore, the carbon risk assessment used by central banks could be used as a template for fund and assets managers.

 

Resistance

 

Author

Andrew McConnell

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