Why central bankers should worry about climate change

Jackson Hole, Frankfurt, Washington and New York are the most frequented cities by central bankers. Kyoto, Montreal, Copenhagen and Doha have been the headquarters of some of the most important environmental conferences over the past 20 years; different contexts, historically distant from each other. After last week’s agreement, Paris may be remembered as the meeting place that put climate change on the agenda of central banks.

A change of attitude, beyond Kyoto’s limits

Last week, representatives of 196 countries gathered in the French capital for COP21 and reached the world’s most significant agreement to address climate change since the issue first emerged as a major political priority decades ago. Expectations were very high, despite previous results. The first Conference of Parties, in Berlin in 1995, was a complete fiasco; the most recent conference, which took place last year in Lima, ended in deadlock. The most well-known conference is still Kyoto, thanks to the protocol signed in December 1997 by more than 180 countries, which entered into force in 2005 with the ratification of the signatories who together accounted for more than 55% of global greenhouse gas emissions. However, there were many limits to that agreement. China and India were not covered by the obligations, and the United States, which at the time accounted for more than one-third of global emissions, did not ratify it.

It remains to be seen if the Paris agreement will be implemented but the mood has changed and the outcome of COP12 is a consequence of this. It is time for industrialized and emerging countries to start working together. Last September, the agreement between Barack Obama and Xi Jinping in regard to the fight against global warming was a good sign. So was the recent public commitment of 79 multinational companies to reduce emissions and energy consumption. Over the past few years, a sense of urgency and awareness on this subject has increased. The attitude of central bankers has also shifted.

The global warming that freezes the financial world

This was confirmed in a speech by Mark Carney, the governor of the Bank of England, where he pointed out the costs, current and future, caused by climate change. Although talking about global warming, his speech sent chills through the audience. Since 1980, climate-related events have tripled and insurance losses, net of inflation, have increased five-fold, reaching $50 billion a year.

The consequences go far beyond the insurance industry and affect global financial stability more widely, a priority issue for central banks. There are three risks involved. A physical risk, concerning insurance compensations for damage caused by floods and storms, especially in agriculture and trade. A liability risk, related to the possible future demand for compensation by damaged parties against the alleged perpetrators, primarily companies from the mining and oil sectors. Lastly, there is a risk of transition, namely the economic adjustment towards a more sustainable model. These three factors could undermine the current economic equilibrium and create instability in financial markets.

Instability in the macroeconomic sector and adjustment costs

The concept of adjustment in relation to climate change is central. In the absence of agreements and joint decisions for sustainable growth, the risk is that climate change will cause a substantial increase in macroeconomic instability. A growth rate that fluctuates significantly from year to year in a very unpredictable way would put central banks in a tough position.

If, instead, the adjustment is planned with a certain degree of cooperation between countries, the transition could become more gradual over a period of time, more predictable and would probably create new opportunities for growth and employment, through the development of new technologies and renewable energy sources. However, even in this case there would a certain degree of instability, as is usual when changing the productive structures of an economic system.

Volatility of agricultural prices and challenges for monetary policy

One sector particularly sensitive to climate change is agriculture. More droughts, floods and frost could exacerbate price volatility, which we’ve already been seeing in recent years. In addition, changes in rainfall and average temperatures affect productivity and the geographical distribution of crops in the long term.

Furthermore, increases of CO₂ and temperatures favour the development and spread of new parasites and pathogens, at the present time responsible for about 30% of the loss of agricultural production. The livestock sector is also negatively affected.

This volatility makes it more difficult to adopt an adequate monetary policy and to predict the impact on the economy. Moreover, the increase of agricultural products can significantly affect the cost of living in developing countries, where the proportion of income spent on food consumption is very high.

Energy prices and inflation: the tough position of central banks

Energy is another sector that is very sensitive to climate change. In fact, a serious implementation of an international agreement on reducing global warming would trigger an increase in fossil fuel prices. This would directly interfere with the primary objective of central banks: price stability. We still have a vivid memory of what happened during the 1970s, when two oil crises caused a sharp rise in inflation in advanced economies.

Today, however, many of these economies have a different structure, and are less dependent on fossil fuels. In fact, between 1999 and 2000, oil prices, which almost doubled, produced only a marginal inflationary increase.

In any case, the role of central banks remains complex. On the one hand, they should not oppose an increase in energy costs, so as to avoid undermining climate policies aimed at making economies more sustainable. On the other hand, they cannot let their guard down on general price levels. Rising energy costs could in fact generate salary tensions with the objective of maintaining a stable purchasing power, triggering an inflationary spiral.

A joint decision for a greener economy may enable us to better manage the timing of an economic adjustment, minimizing uncertainty and volatility, opening up new paths for growth. However, the transition will not be without difficulties and decisions on monetary policy in any case remain very intricate. Even if an agreement was found to slow global warming, the “temperature” in central banks remains very high.

This article, in a slightly different version, was published in Italian on AffarInternazionali

Authors: Marco Magnani teaches Monetary and Financial Economics at LUISS in Rome and is non-resident fellow of IAI – Institute for International Affairs. As Senior Fellow at the Harvard Kennedy School he has published Sette Anni di Vacche Sobrie (UTET) and Creating Economic Growth (PalgraveMamillan). Gilda Giordani is a graduate student in International Relations at LUISS with strong interest in energy and climate change topics.

Image: A four-wheel drive vehicle drives through flooded streets in Wraysbury in southern England, January 13, 2014. REUTERS/Toby Melville