Central banks and sustainable finance

Central banks have long been responsible for ensuring economic stability, traditionally by setting interest rates and controlling the amount of money circulating in the economy. However, a new element has come into their purview in recent years: sustainability.

While their core mandate hasn’t changed, central banks can be seen incorporating the language of sustainability alongside their traditional responsibilities. This subtle shift may reflect the growing recognition that environmental factors, particularly climate change, could influence long-term financial stability.

What are central banks, and what do they do?

Before diving into the intersection of central banks and sustainable finance, it’s important to understand the basic functions of central banks. Their primary role is to maintain the stability of a country’s monetary system. The main objectives include:

• Price stability: Central banks aim to keep inflation low and stable, typically through managing interest rates and regulating the money supply. This often involves raising rates when inflation is too high or lowering them when the economy needs stimulus.
• Financial stability: Central banks regulate commercial banks and act as the lender of last resort to prevent crises and maintain confidence in the financial system.

Ultimately, central banks aim to encourage sustainable economic growth and avoid periods of high growth followed by recession, known as “boom-bust” cycles. In the case of the Federal Reserve in the US, this includes a specific mandate on maximising employment in the economy.

Major institutions like the Federal Reserve in the US, the European Central Bank (ECB), the Bank of Japan (BOJ), and the Bank of England (BOE) have significant global influence. Their decisions on interest rates and other economic policies affect not only their domestic economies but also international financial markets.

How central banks are approaching sustainable finance

While central banks are not directly responsible for driving environmental policy, they’re increasingly incorporating the language of sustainability into their communications. This shift acknowledges that climate change poses risks to financial systems, risks that need to be managed in much the same way as traditional economic factors.

However, it’s important to emphasise that central banks and sustainable finance are not synonymous in the sense that central banks have taken on a completely new role. Instead, they’re simply widening their focus to ensure that climate-related risks are considered alongside their core objectives.

1. Climate risk management:

One way central banks are addressing climate risks is by conducting climate stress tests for financial institutions. These tests assess how banks and other financial organisations would perform under various climate-related scenarios, such as extreme weather events or the transition to a low-carbon economy. This helps central banks ensure that financial institutions are resilient enough to withstand the risks posed by climate change.

2. Green bond programmes:

Central banks can play an important role in the development of a country’s green bond programme. These are financial instruments that raise capital for environmentally friendly projects like renewable energy and energy-efficient infrastructure. Central banks such as the Bank of England, have included green bonds in their normal purchasing programmes, helping to provide stability to the market.

Furthermore, central banks can advise governments on the terms and structure of green bonds that would make the bonds most appealing to investors. This is where a central bank’s close relationship with institutional investors is particularly helpful. By supporting the green bond market, central banks can help channel investments towards projects that contribute to sustainability, while maintaining their core focus on financial stability.

3. Standards and disclosure:

Central banks are also promoting greater transparency in sustainable finance. They’re encouraging the use of standardised taxonomies to define what qualifies as a sustainable investment. This helps investors and businesses alike to navigate the complexities of green finance.

For example, the Network for Greening the Financial System (NGFS) is an international initiative that brings together central banks and regulators to share knowledge on sustainable finance practices.

Opportunities for central banks in sustainable finance

As central banks incorporate sustainability into their frameworks, they face a range of opportunities. These opportunities allow them to enhance their core objectives while contributing to a more resilient financial system that is better equipped to deal with environmental risks.

1. Enhancing financial stability:

By addressing climate risks, central banks can play a key role in strengthening the financial system. Climate change presents both physical risks—such as damage from natural disasters—and transition risks, which relate to the economic adjustments needed to move towards a low-carbon economy. By managing these risks proactively, central banks help prevent financial instability.

For example, by integrating climate risk into their stress testing of financial institutions, central banks can better assess how prepared banks are for the impacts of climate change. This reduces the likelihood of a financial crisis caused by sudden environmental shifts.

2. Supporting green investment:

While central banks are not responsible for environmental policy, they can support the transition to a greener economy by encouraging green investments. Their actions, such as purchasing green bonds or promoting sustainable financial products, can direct capital towards environmentally beneficial projects, helping to reduce carbon emissions and support sustainable growth.

This doesn’t mean that central banks are abandoning their traditional responsibilities. Instead, they are finding ways to incorporate sustainability into their operations without compromising their core mandate of financial and price stability.

3. Developing expertise in climate finance:

Central banks are gaining valuable insights into climate finance as they develop their strategies around sustainability. This expertise helps them manage new types of risks more effectively and allows them to play a leadership role in guiding the financial system towards a more sustainable future.

4. International collaboration:

Climate change is a global issue, and central banks are working together across borders to address it. Through international organisations like the NGFS, central banks are collaborating to share best practices and promote sustainability in the global financial system. This international cooperation is crucial for ensuring that financial markets can support the transition to a low-carbon economy.

You might also like: Change-makers’ portfolio: Sustainable fixed income investing

Challenges facing central banks in sustainable finance

Despite the opportunities, central banks face several challenges as they navigate the integration of sustainability into their operations. These challenges underscore the complexities involved in managing both traditional economic objectives and new environmental risks.

1. Balancing sustainability with core objectives:

Central banks’ primary goals—managing inflation, ensuring economic growth, and maintaining financial stability—remain unchanged. Incorporating sustainability into these objectives isn’t always straightforward. For example, the transition to a low-carbon economy could drive up costs in the short term, potentially increasing inflation. Central banks must carefully balance their sustainability efforts with their core mandates, ensuring they don’t lose focus on their primary responsibilities.

2. Evolving methodologies:

Assessing climate risks requires new methodologies and tools. Central banks need to develop ways to accurately measure and incorporate these risks into their decision-making processes. This can be challenging, as climate risks are often long-term and uncertain, making them harder to quantify compared to traditional financial risks.

3. Building consensus among stakeholders:

Not all stakeholders agree on the role that central banks should play in promoting sustainability. Some argue that central banks should focus solely on their traditional objectives and leave environmental policy to governments. To navigate this, central banks must clearly communicate the importance of addressing climate risks as part of their financial stability goals and build consensus among financial institutions, governments, and the public.

How central bank decisions impact Tribe portfolios

The decisions of central banks affect the value of all financial assets, and we have seen this reflected in Tribe portfolios.

Following the post-COVID surge in inflation, central banks responded by rapidly increasing interest rates to bring inflation under control. Over time, these efforts seem to have worked, with inflation now appearing to stabilise. Central banks are now shifting their focus towards maintaining economic growth, which means they are likely to start lowering interest rates to stimulate further recovery.

The rising interest rate environment has been particularly challenging for investors, especially those focused on sustainability. Many sustainable companies tend to be smaller and are often focused on future growth or long-term infrastructure projects. Both these types of businesses suffer in high interest rate environments, as it costs them more to borrow the money they need to grow.

However, we believe there’s a silver lining. Many of these sustainable companies have used the opportunity to streamline their business models and improve efficiency. As interest rates start to come down, these companies should benefit from lower borrowing costs, positioning them for future growth. This highlights the interconnectedness between central banks and sustainable finance, as monetary policies directly influence the success of green businesses.

You might also like: The impact of interest rate changes on investment portfolios

Interest rates, inflation, and sustainable investments

As central banks manage inflation and interest rates, their actions directly impact sustainable investments. With inflation now stabilising, and interest rates expected to fall, we anticipate that lower borrowing costs will provide a more favourable environment for sustainability-driven companies. Historically, rate-cutting cycles aimed at boosting growth have supported equities, and this could be particularly beneficial for mid-sized green companies that have struggled in the recent high-rate environment.

You might also like: Why we favour investing in mid-cap companies over large-caps

The path forward for central banks and sustainable finance

While central banks’ core mandate has not changed, their growing focus on sustainability reflects the broader understanding that climate-related risks could have significant impacts on financial stability. Central banks are now incorporating these risks into their operations, while still prioritising their traditional goals of managing inflation and promoting economic growth.

By addressing climate risks, central banks can play an important role in creating a more resilient financial system. However, they must also navigate the challenges of balancing sustainability with their core objectives. As we move forward, the intersection of central banks and sustainable finance will continue to evolve, shaping the future of both financial markets and the global green transition.