The climate emergency requires central banks, along with many other actors, to adopt new methods.
Central banks can be important partners in working out solutions to environmental problems. It could also be argued that, at times, central banks should not be limited to following what elected governments decide because elected governments too often do not plan for the long term, only for the next election as ex-Bank of England governor Mark Carney emphasized in his “tragedy of the horizon” speech.
The challenge is to find mechanisms that allow central banks to act with the long term in mind. A “climate bailout” tool could be just the thing, allowing central banks to assume a very constructive role in the net-zero transition while at the same time meeting their core objectives of financial and price stability better than at present.
The global energy transition from a fossil fuel-based energy system to a fully renewable one is the most important challenge of our times. Colleagues from the Institut Rousseau have suggested that constructive central bank responses fall into two categories: first, stopping the flow of money to fossil fuels and second, winding down fossil assets.
Most thinking on central banks and climate change has so far revolved around the first step. But climate science indicates a need to reduce the burning of fossil fuels at great speed: by around 8% (as much as during the Covid pandemic) year after year until the age of fossil fuels is over. That speed can only be achieved through bold measures.
Ending financing of fossil fuels is perhaps the hardest step to take, because it means overcoming a century or more of economic ideology. But winding down assets is where the most substantial body of work needs to be done but cannot be put off any longer – it’s the frog that must be eaten.
The climate emergency requires central banks, along with many other actors, to adopt new methods. A climate bailout tool would be a useful addition.
Numerous financial proposals have been put forward to address this challenge: coal asset transition (CAT) mechanisms, just energy transition partnerships, full divestment, the one-for-one rule, green interest rates and green quantitative easing – all of these have their own limitations and advantages.
The climate emergency requires central banks, along with many other actors, to adopt new methods. A climate bailout tool would be a useful addition.
The tool, outlined in a paper by myself and Matthias Kroll of the World Future Council, is a central bank-backed mechanism allowing owners to sell their fossil fuel assets if they build renewable energy with the money they receive.
Central banks will hold the fossil fuel assets on their balance sheets until society has found ways to use them more sustainably. This will not include burning material representing millions of years of “saved” solar energy, but may feature long-lived materials based on hydrocarbons which are well-designed and can stay in a circular economy in the long term, generating value not once but many times over.
A bailout for the climate
The climate bailout proposes to use a mechanism that has already been tested in responding to the banking and Covid crises. Both were successfully overcome by providing resources that did not exist before and went way beyond the leeways on government budgets.
In a climate bailout, this exercise would be repeated and fossil fuel assets would be “bought out”, but with a requirement to invest the proceeds in additional renewable energy infrastructure or energy efficiency measures. Linking buyout with investment requirements in this way will stabilize the energy sector and avoid power shortages as fossil fuels are wound down.
The total price tag of the fossil fuel infrastructure to be retired and reserves to be absorbed is substantial: it has been quantified at US$12tn. As colleagues have pointed out, buying up the bulk of the US oil and gas industry would take about half of what it cost the country to invade Iraq, one of the most expensive wars in recent history at US$2tn. In the EU, banks had half a trillion in fossil fuel assets on their balance sheets in 2019.
For the European Central Bank, the scale of the proposed climate bailout is dwarfed by asset purchase programs launched in response to the financial crisis and Covid-19.
Buying up the bulk of the US oil and gas industry would take about half of what it cost the country to invade Iraq.
While government budgets cannot cope with such magnitudes, they are not unknown to central banks: resources in the trillions were quickly mobilized by central banks to respond to the banking crisis and to the Covid pandemic. The climate bailout can be compared in size to these previous programs, only in this case it would serve to build the energy system of the future.
Digesting the frog
Of course there are some challenges to be overcome, both intellectual and operational ones. Maybe the biggest challenge is an intellectual hurdle: central banks will need to “eat the frog” of stranded assets, which are quite naturally going to lose value in the fossil fuel endgame. The question of negative equity for central banks is a touchy issue to put it mildly, although in practice it has occurred time and again.
As mentioned, the size of stranded assets on a global scale is huge, and commonly quantified in trillions. However, the “frog” of stranded fossil fuel assets is dwarfed by the looming economic damages of climate change. Can taking big losses now be justified to avoid even bigger losses in the future? Definitely, and especially if it is compatible with other key objectives such as financial and price stability. In any case, the scale of both issues – stranded assets and climate damages – leaves no doubt that central banks must and will be involved somehow in addressing them. The key question is how.
A system to “digest” the eaten frog will have to be designed. Existing experience with asset management companies (so called “bad banks”) will be needed. Proper mechanisms will have to be defined, for example discounts in buying prices over time to encourage early adopters, and a way to include climate liabilities in these prices which markets don’t price in today but will have to be dealt with. Multilateral development banks with their know-how in the energy sector could play an important role on the implementing side. In fact, some are already experimenting with facilitating a faster exit from fossil fuels (see the Asian Development Bank’s own CAT mechanism).
Unlocking a swift energy transformation
Of course, there are also benefits. A climate bailout would be useful from a central bank perspective in at least two major ways: Firstly, it could greatly reduce the key financial stability risks posed by stranded assets. Secondly, it would make economies less dependent on volatile fossil fuels: from a financial systems perspective, wind and sun are much less volatile than oil, gas and coal. It would allow active management of fossilflation risks, making the disappear altogether in the medium term. And it would also reduce climateflation, the effect of extreme weather on prices. The key benefit from a central bank’s perspective could thus be towards meeting its price stability mandate.
Can taking big losses now be justified to avoid even bigger losses in the future?
A recent analysis by the Banque de France looked at short-term transition scenarios, and the results could be taken as a tentative nod in the direction of a climate bailout: the biggest risk that harms GDP is the one related to stranded assets while public investment is the policy that achieves the biggest positive impact. The climate bailout combines these two, with public investment baked in through private actors backed by central banks.
A climate bailout would also turn those holding back the energy transformation today into advocates for favorable conditions for renewable energies, because they would necessarily own renewable assets after participating in the mechanism. From a societal perspective, it could help unlock a swift energy system transformation that is currently held back by vested fossil fuel interests. That alone would be a significant contribution towards helping humanity shift course from its current destructive track.
Let’s be realistic: fossil fuels will end. There will be those that helped bring about this change and those who will be caught out, still backing high-carbon energy sources when reasonable alternatives exist. By supporting a swift transition, central banks can guarantee financial stability in the long term and, while they do so, contribute a key piece of the energy transformation puzzle that nobody has so far managed to fit in.
Rebuilding an energy system seems to be unrelated to financial stability at best, or a risky undertaking at worst. But in fact, when speaking of “transition risks” we might have it the wrong way around: not transitioning may be the bigger hazard and transitioning faster could provide greater financial and price stability. The climate bailout tool could be just the answer we’re looking for.
