Central banks across the G20 have started raising interest rates to slow down economic activity and curb spiralling inflation caused by soaring energy prices. However, an unwelcome side-effect of central banks making borrowing more expensive is that this risks curtailing much-needed investment in clean energy, which currently faces a massive $3trn financing gap.

It is “critical” that central banks implement policies cognizant of the ecological as well as financial crisis, or risk climate breakdown and long-term price instability, argues non-profit Positive Money in a new report in late November. The report is its second annual assessment of G20 central banks’ approaches to green research and advocacy, monetary policy and financial regulation.

Positive Money argues that raising interest rates will do "little to address supply-side inflation caused by oil and gas price volatility", but could threaten capital-intensive green investments.

Clean energy is disproportionately impacted by higher interest rates because of its higher upfront costs. The average cost of building new power-generating capacity becomes higher for green versus brown technologies when interest rates rise above 2%, according to research from a Swiss think tank for the French government.

Green lending facilities

Central banks could update their policy toolkits to offer lower interest rates for green activities, suggest organisations like Positive Money and economic think tank the New Economics Foundation. There is a precedent for this kind of policy intervention, with Asian banks currently leading the way.

In 2021, for example, the People’s Bank of China (Pboc) rolled out its carbon emissions reduction facility, which allows the PBoC to offer low-interest loans to financial institutions that assist companies with cutting their carbon emissions.

On a smaller scale, in June 2021, the Bank of Japan announced a green lending facility that offers 0% interest loans with a maturity of one year (with the potential to renew until 2031) to financial institutions supporting projects that contribute to domestic climate action, selected on the basis of their past investment performance on climate-related bonds and loans as well as transition finance.  

Repurposing the UK’s Term Funding Scheme

As it currently stands, neither the European Central Bank (ECB) or any of its members, nor the UK’s Bank of England (BOE) has such a facility, despite ECB President Christine Lagarde expressing support for one, saying:  “Japan is doing it. China is doing it. Why wouldn’t we have an open mind about it?” at the virtual Green Swan banking conference this summer.

In a September 2022 report, NEF outlined a detailed proposition for how the UK could implement its own targeted green lending scheme by repurposing the BoE’s Term Funding Scheme (TFS).

The TFS was established in 2012 to encourage banks and building societies to lend more to households and businesses. Through it, the BoE provides low‑cost funding to participating institutions for a four‑year term. According to NEF, the BoE could "build on this monetary innovation" by making it permanent, and offering zero or negative real interest rates for green activities "while keeping its main policy rate in positive territory".

A pivotal moment for green lending policy

Lukasz Krebel, an economist at NEF, says there are “two opposing factors” at stake in relation to dealing with rising interest rates and its impact on green lending. On the one hand, the energy and climate crises mean there is an “even stronger case” for banks to “start doing something to reduce reliance on fossil fuels”.

However, at the same time, the “prevailing bank orthodoxy” is to reduce interest rates when inflation soars. In responding to the energy price (and inflation) crisis, banks could end up inadvertently pushing climate action down the agenda – even as such action offers a long-term solution to high and volatile fossil fuel prices.

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Krebel says there does appear to be some appetite for green policies; for example, in a November 2022 blog post, Lagarde acknowledges that fossil fuels pose a risk to price stability. However, Krebel concedes too there is no certainty such policies will be implemented.

“In the current energy crisis, central banks have started to become quite short-sighted,” says Nikki Eames, an economist and the lead author of Positive Money’s report. Bilateral interactions between the NGO and central banks reveal that their main priority is bringing down inflation by raising interest rates while protecting energy security, even if that means redirecting finance into fossil fuel assets, she says.

Positive Money’s position is that it is possible to “tackle both the energy [price] crisis and climate change together”.

The need to decarbonise

Green lending facilities are just one of several policy tools Positive Money suggests central banks could use to tackle the dual impacts of the global energy crisis and climate change.

While Asian banks may lead the pack on green lending facilities, Japan and China’s central banks score lower than their European counterparts overall because of their continued investment in fossil fuels. The Bank of Japan, for example, still purchases fossil fuel assets and allows them to be used as collateral by financial institutions.

As the table below shows, Positive Money’s scorecard allocates a maximum of 50 points for banks’ financial and monetary policies, and offers fewer points for ‘research and advocacy’ (10 points) and ‘leading by example’ (20 points). Banks can also be docked points for activities that hinder climate progress. As a result, the PBoC receives the same score (12 out of 50) for its monetary policy as the ECB despite the former having a green lending facility and the latter still in discussions over one, because of the PBoC’s support for the “green and efficient” use of coal. 

As the ECB scores higher than the PBoC on other metrics, such as ‘leading by example’ by tilting its corporate bond holdings towards a Paris Agreement-aligned pathway, it scores higher overall. 

With the PBoC falling from first place in 2021 to sixth place this year, thanks to its ‘extensive support for coal’, France’s central bank tops the list because it has aligned all of its non-monetary portfolios with 1.5°C and excluded fossil fuels.

Where European banks do better than other G20 central banks is in their attempts to decarbonise their asset purchase programmes. Although asset purchase policies are becoming less relevant in the context of quantitative tightening, Positive Money and NEF argue that banks should create frameworks to screen for environmentally harmful activities like fossil fuel expansion or those that contribute towards deforestation.

In this space the ECB is a leader, having pledged to tilt its corporate bond holdings onto a Paris-aligned pathway, by assessing corporate bond issuers on their emissions, carbon reduction targets and climate-related disclosures.

The BoE has not gone this far, although in late 2021 it did establish a framework for greening its Corporate Bond Purchase Scheme (CBPS), which has historically tilted heavily towards high-carbon sectors. This is in part an effect of the BoE’s supposed ‘market neutrality’, which results in its bond purchases representing the total amount of bonds issued by each UK sector.

As sectors with a high contribution to emissions are over-represented, in 2020 the BoE's CBPS was aligned with 3.5°C of warming by the end of the century, according to its own calculations.

Positive Money welcomes the BoE’s framework to green its CBPS as an ‘important commitment’ to excluding activities that are incompatible with the goal of net zero by 2050, but also says it falls short because it does not include an outright ban on investments in coal mining and firing, nor oil and gas; such investments remain eligible if companies demonstrate awareness of climate risks and set climate targets. For this reason, Positive Money argues that the framework is not aligned with the International Energy Agency’s net-zero roadmap, which foresees no financing for new fossil fuel projects beyond 2021.

More positively, almost all of the banks in Positive Money’s report score full marks for 'research and advocacy', meaning they have committed to addressing environmental risks and in many instances, particularly in Europe, adopted the principle of ‘double materiality’. This is where the bank accounts for how its activities impact the outside world, in addition to considering how climate change will impact its own activities. It now remains to be seen how far strong research and advocacy will translate into policy action.