March 5, 2024

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How do you incorporate climate change into macroeconomic models?

How do you incorporate climate change into macroeconomic models?

The European Central Bank is examining how to incorporate climate change into the macroeconomic models that underlie interest rate policy. This was stated by ECB Governing Council member Frank Elderson on Tuesday during a presentation The climate plan and the new nature of the central bank.

According to the European Central Bank, climate change is bound to have an impact on the central bank's main objective: encouraging “price stability.” The central bank aims for an inflation rate of 2% in the medium term. According to Ederson, it is clear that global warming is putting price stability at risk. Unfortunately, we are currently headed for three degrees of warming, twice what was agreed upon in the Paris Climate Agreement. This causes droughts, floods and storms, causing widespread damage. “We are paying the price for that.”

Part of the impact on rising prices is a direct effect, according to Elderson: Food becomes more expensive due to crop failures and floods. But according to him, the ECB also sees more indirect effects: banks see the value of collateral for mortgage loans being destroyed by forest fires or floods.

Fighting climate change and limiting temperature rise to 1.5 degrees will require a “deep and far-reaching transformation” of the economy, Elderson said in an online news conference. This costs money: €620 billion in Europe alone. This also has an upward effect on prices, as does investments, for example, in dams, sturdier homes and commercial buildings to withstand more extreme weather conditions. “Some people think it's not a central bank's job to deal with climate,” Elderson said. “But if we don’t take that into account, we are actually ignoring a major risk to our politics.”

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Two years ago, in its first nature plan, the European Central Bank decided to take climate criteria more into account when buying corporate bonds. Environmentally friendly companies are preferred over dirty ones. But because purchasing programs were phased out last year, the effect of this greening is now less impactful.

Truly sustainable loans

The ECB says the next phase of greening has now begun. In addition to taking climate change more into account in economic models, the ECB is considering introducing sustainability requirements for the guarantees that banks give to the central bank when they borrow money. However, to do this, more data is needed: which loans are truly sustainable, and which are not? This data may become more available in the coming years, because listed and larger companies must provide more public information about their emissions and social impact under European CSRD rules.

The ECB continues to work on greening banknote production using only eco-cotton from 2027. The ECB wants to impose sustainability requirements when introducing the digital euro.

In its climate plans, the ECB did not mention the introduction of a “double interest rate” as a means of monetary policy. Now all banks pay the same interest if they deposit money with the central bank (currently 4 percent). By offering a lower interest rate to greener banks, this could make sustainable financing less expensive, supporters say. In response to a question from a journalist, Elderson agreed that there were good arguments for double interest rates. “We see that banks are already doing this themselves, offering discounts on sustainable loans. Governments are also offering more favorable lending terms through funds, for example. The ECB still sees a lot of challenges to the central bank’s dual interest rate, according to Elderson. “In defining what is green and in providing data to validate labels. But once progress is made on this matter, we will look into this matter again.”

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