Climate change and green finance: The role of central Banks

Dalia M. Ibrahiema, Rehab R. Esilyb,c, and Rasha Sameha, a Faculty of Economics and Political Science, Cairo University, Giza,
Egypt; b Faculty of Commerce, Damietta University, Damietta, Egypt; and c School of Economics and Management, Beijing University
of Technology, Beijing, China
© 2023 Elsevier Inc. All rights reserved.

Introduction 2
The importance of the central bank’s role in addressing climate issues 2
The impact of climate change on financial and monetary instability 2
The impact of climate change on price instability 3
The main green instruments of central banks in tackling climate issues 3
Green micro-prudential regulation 3
Green macro-prudential regulation 3
Green financial market development 4
International experiences of central banks in tackling climate issues 4
Federal Reserve System (Fed) 4
Climate risk assessment 4
Green banking rules 4
Green investments 4
European Central Bank (ECB) 5
Climate risk assessment 5
Green bond purchases 5
Green monetary policy 5
Bank of England (BoE) 5
Climate stress testing 5
Green bond purchases 5
Green banking regulations 5
Research on climate change 5
Bank of Japan (BoJ) 5
Climate risk assessment 5
Green banking regulations 6
Green investments 6
Challenges in implementing sustainable central banking practices in underdeveloped and emerging nations 6
Sustainable central banking approaches for underdeveloped and emerging nations 6
Challenges related to sustainable central banking approaches for underdeveloped and emerging nations 6
Underdeveloped financial infrastructure 7
Data quality issues 7
Restricted accessibility of funds 7
Inconsistency of regulatory framework 7
Conclusion and policy recommendations 7
References 8

Key points
• Central banks can play a critical role in promoting green finance.
• Various green tools can be used.
• Several successful initiatives by central banks in promoting sustainable finance exist.

Abstract

Central banks play a critical role in promoting the transition to a neutral-carbon economy by providing guidance, setting
standards, and incentivizing financial institutions to invest in sustainable projects. Thus, this chapter aims at discussing the
role of central banks in promoting green finance. Various green policy tools (micro green prudential regulation, macro green

Reference Collection in Social Sciences https://doi.org/10.1016/B978-0-44-313776-1.00122-7 1

2 Climate change and green finance: The role of central Banks

prudential regulation and green financial market development) to support sustainable finance are analyzed, and interna-
tional experiences of central banks in tackling climate issues and challenges in implementing sustainable central banking
practices in underdeveloped and emerging nations are summarized. The chapter concludes by recommending policies to
enhance the role of central banks in tackling climate change hazards by promoting sustainable finance. By offering direction,
establishing standards, and encouraging financial institutions to invest in sustainable initiatives, central banks may play
a significant role in advancing green finance. Financial incentives (subsidies and tax benefits) can be offered to small and
medium enterprises (SMEs) so they will make investments in green financial products and projects. Moreover, long-term
financing can be provided by financial institutions, especially green bond markets, which can be used to channel local
savings and access foreign lending and portfolio investments.

Introduction

Central banks all across the world are now very concerned about climate change. Due to their responsibility to uphold financial
stability and manage inflation, central banks have a part to play in combating climate change which may jeopardize financial secu-
rity and economic expansion. After the Paris Agreement was signed, central banks have been sought to tackle environmental chal-
lenges like climate change. A network of central banks called the Network of Central Banks and Supervisors for Greening the
Financial System (NGFS), which was founded in 2017, is starting to research ways to mitigate climate change vulnerabilities and
advance the shift to a green economy (Chen et al., 2021).
Overall, central banks are becoming more aware of the significance of including climate change in their operations and policies.
Central banks might help ensure financial system stability and ease transitioning to a low-carbon economy by adopting actions to
reduce climate-related risks and encourage sustainable finance.
Thus, this chapter aims to assess central banks’ role in tackling climate change issues, highlighting some international experi-
ences to reach the most important lessons learned and suggest crucial policy recommendations concerning the role of central banks
in combating climate change issues. The chapter will be divided into six sections; section “The importance of the central bank’s
role in addressing climate issues” will analyze the importance of the central bank’s role in addressing climate issues. Discussing
the main green instruments in tackling climate change will be the target of section “The main green instruments of central banks in
tackling climate issues”. Important lessons learned from international experiences and challenges related to sustainable central
banking approaches for underdeveloped and emerging nations will be discussed in sections “International experiences of central
banks in tackling climate issues” and “Challenges in implementing sustainable central banking practices in underdeveloped
and emerging nations”, respectively. Finally, policy recommendations will be suggested in section “Conclusion and policy
recommendations”.

The importance of the central bank’s role in addressing climate issues

Although some claim that governments alone should handle the issue of climate change because it is outside the purview of central
banks, several detrimental climate change effects have a direct impact on the financial system, making it a prudential risk that should
be discussed by the regulators of financial institutions (Durrani et al., 2020). Although the main duty of the majority of central
banks is to maintain inflation at a safe level, which is frequently stated in the mandate as the single or main goal of monetary policy,
but also, sustaining financial stability has historically been the other major goal for central banks, after maintaining steady and low
inflation.
Supporting broader aims of economic policy, such as sustainable growth or, in certain situations, maximum employment, is
a further (typically secondary) objective of central banking. How these basic goals are impacted by climate change and other envi-
ronmental threats provides a compelling case for central banks to consider environmental implications when implementing mone-
tary policy in fulfillment of their key goals (Durrani et al., 2020). Thus, it is reasonable for central banks to tackle climate change to
mitigate its impact on price instability and financial instability.

The impact of climate change on financial and monetary instability

Liability, transitional, and physical hazards brought on by climate change can substantially impact the long-term reliability of the
monetary system. By interfering with economic activity and raising the possibility of financial losses, these hazards have the poten-
tial to have an impact on the financial system. Here are some instances of how financial instability brought on by climate change
include:
Liability risks: Enterprises that fail to adapt to the effects of global warming or contribute to it may be held legally liable. Addi-
tionally, businesses may run the danger of damaging their brand and their financial accomplishments if it is believed that they are
not doing enough to combat the threat of climate change (Carney, 2015; Bolton et al., 2020).
Transitional risks: Market dynamics and prices for securities may change significantly when nations and enterprises move toward
a carbon-neutral economy. For instance, when the globe shifts to cleaner energy sources, investments in conventional energy sources
may become stranded securities. Investors who own these securities could suffer monetary losses as a result of this. On the other
 Climate change and green finance: The role of central Banks 3

hand, investments in carbon-neutral technologies and sources of green energy may become more lucrative, causing a reallocation of
money (Liu et al., 2021; Ohtaki, 2023).
Physical risks: natural disasters like drought, flooding, and hurricanes could become more prevalent and serious as a result of the
warming climate. These occurrences may result in tangible asset destruction, supply chain disruptions, and revenue losses. As
a result, businesses and financiers may incur greater expenditures or losses, which may affect their capacity to maintain financial
security. Additionally, it may be difficult for the insurance sector to cover risks associated with the environment, which could result
in increased insurance premiums or a reduction in coverage (Liu et al., 2021).
These dangers could substantially impact the stability of the financial instruments. For instance, if many companies and finan-
ciers are exposed to risk related to climate change, the financial system may experience a systemic shock. The functioning of the
financial sector may be disrupted by the mispricing of assets that results from climate-related hazards (Bolton et al., 2020).
Numerous institutions have taken action to manage such hazards after realizing the potentially detrimental effects of the changing
climate on monetary stability. For instance, to come up with recommendations for disclosing hazards associated with climate
change, the Financial Stability Board (FSB) established the Task Force on Climate-related Financial Disclosures (TCFD) in 2015
(Bolton et al., 2020).

The impact of climate change on price instability

Climate change can significantly impact price instability in various industries, including agriculture, the global supply chain, and
energy. Extreme weather events including extreme flooding, drought, and severe heat waves can be brought on by climate change.
These occurrences can have an impact on crop yields and food production, which can cause price volatility (Zhai and Zhuang, 2012;
Koch and Wall, 2023). Also, global supply networks may be impacted by climate change, which may have an impact on product and
service prices. Severe weather, for instance, might interfere with modes of transport, disrupt or spoil commodities, and raise
consumer prices (Pankratz and Schiller, 2022).
By altering the supply and demand of various energy sources, climate change can have a variety of effects on energy costs. As
nations strive to meet their emission reduction targets, climate change is anticipated to increase demand for sources of clean energy
like solar, wind, and geothermal power, which could result in a decrease in the total expense of green energy technologies due to
economies of scale and technological advancements (International Energy Agency (IEA), 2020), nevertheless, energy prices may be
impacted by climate change, particularly in areas that depend on hydroelectric or other forms of clean energy, as climate-related
hazards may lead to a decline in a hydroelectric generation which raises the cost of energy.
The hazards related to climate change and the risk imposed on the financial system and price stability make the role of the central
bank in tackling climate issues a crucial one.

The main green instruments of central banks in tackling climate issues

Central banks have a range of green instruments that they can use to tackle climate issues. They can be summarized as follows.

Green micro-prudential regulation

The system of regulations that tries to protect the stability and security of specific financial organizations is known as micro-
prudential regulation. In the context of green finance, micro-prudential regulation can be used by central banks to assist in transi-
tioning to a carbon-free economy and help in reducing the risks related to the climate crisis (Dikau et al., 2018).
Central banks can implement micro-prudential regulation for green finance by incorporating environmental risks into their
supervisory and regulatory frameworks. This may entail determining how exposed financial institutions are to climate-related risks,
such as physical hazards (e.g., damage from adverse weather occurrences) and transition risks (e.g., the cost of moving to a carbon-
neutral economy). Additionally, financial institutions may be required by central banks to report their vulnerability to hazards asso-
ciated with climate change and to create plans for reducing those hazards.
In addition, central banks can use micro-prudential regulation to encourage financial institutions to invest in green finance. For
example, they can introduce preferential capital treatment for green investments or require financial institutions to hold a certain
percentage of their assets in green investments. Overall, micro-prudential regulation for green finance can contribute to ensuring
that the financial system maintains its resilience and integrity in the midst of changing climates (Bolton et al., 2020; European
Central Bank, 2020).

Green macro-prudential regulation

The employment of macro-prudential standards to manage systemic hazards associated with environmental issues, such as climate
variability, is referred to as “green macro-prudential regulation”. These measures seek to maintain the security of the financial system
while accelerating the shift to a greener economy.
4 Climate change and green finance: The role of central Banks

The need of the banks to report their exposure to hazards associated with climate change is an illustration of green macro-
prudential regulation. This can aid in investors’ comprehending the potential and hazards related to certain investments, as well
as motivate banks to take steps to mitigate these risks (Dikau et al., 2018; Coelho and Restoy, 2023).

Green financial market development

Establishing and advancing financial markets that enable financial investments in low-carbon, green initiatives, and enterprises is
referred to as “green financial market development”. These markets offer a variety of financial products, such as green bonds and
green loans, that aims to promote ecological sustainability and halt the rise of climate change.
Green bonds are financial instruments employed to finance green projects, such as developing clean energy sources or construct-
ing energy-efficient structures. These kinds of initiatives are often approved by external organizations to confirm their environmental
credentials (International Monetary Fund, 2019). While green loans are used to fund ecologically friendly projects like building
energy-efficiency renovations or renewable energy projects. To encourage borrowers to invest in environmentally friendly initiatives,
green loans might offer lower interest rates as well as longer repayment terms than traditional loans (Spinaci, 2021).

International experiences of central banks in tackling climate issues

Globally, central banks are gradually beginning to comprehend how crucial it is to address climate-related hazards to maintain
monetary stability as shown in Fig. 1. Here are a few instances of central banks’ efforts to address the issue of climate change on
a global scale.

Federal Reserve System (Fed)

The Fed has been tackling climate-related issues. Following are several global examples of the FED’s missions and experiences (Daly
et al., 2021; Robins, 2023).

Climate risk assessment

The Fed has been analyzing the financial system’s exposure to climate-related hazards. The Central Banks and Supervisors Network
for Greening the Financial System (NGFS), a coalition of central banks and regulators working to advance the shift to a sustainable
economy, welcomed the Fed as a member in March 2021. The Fed published a report on the effects of climate change on the finan-
cial system in June 2021. This report identified a number of risks, including transition and physical threats (such as the impact of
policy changes on carbon-intensive industries). Physical hazards include damage to property and infrastructure from severe weather
events.

Green banking rules

The Fed is also thinking about how to include environmental concerns in its regulatory framework. The Federal Reserve (Fed)
released a request for information (RFI) in April 2021 regarding how it can include risks associated with climate change in its regu-
latory and supervisory framework. A wide range of topics were covered by the RFI, including the kinds of climate-related risks that
should be taken into account, the kinds of data that would be required, and the potential impact on financial institutions.

Green investments
The Fed has been looking into several strategies to encourage green investments. In 2020, the Fed increased the scope of its Main
Street Lending Program to include loans to charitable groups that offered services to underserved areas, including those pertaining
to renewable energy and clean energy sources. Although it has not yet made any official plans, the Fed has been thinking about how
to take climate change into account when buying assets.

Fig. 1 Measures taken by central banks regarding climate change.

 Climate change and green finance: The role of central Banks 5

European Central Bank (ECB)

ECB has been dedicated to tackling climate challenges in its own operations as well as in its authority as a central bank. Following
are several global examples of the ECB’s missions and experiences (McConnell et al., 2022; Aloui et al., 2023; Beukers et al., 2023).

Climate risk assessment

The ECB has been analyzing the threats to the financial system posed by climate change. The European Central Bank (ECB) carried
out a climate risk assessment of its own operations in 2020 and discovered that it was exposed to a variety of climate risks, including
transition risks and physical hazards (such as investments in industries with high carbon footprints that might grow into stranded
resources in a carbon-free economy). The ECB’s continuous efforts to manage and reduce these risks will be guided by the results of
this evaluation.

Green bond purchases

Since 2016, the ECB’s asset purchase program has included the purchase of green bonds. The ECB claims that as of March 2021, it
had acquired green bonds worth more than V60 billion (European Central Bank, 2021). This has encouraged businesses to issue
additional green bonds and supported the market for them.

Green monetary policy

The prospect of “green monetary policy”dusing monetary policy tools to facilitate the shift to an emission-free economydhas also
been investigated by the ECB. One suggestion to encourage banks to invest in green initiatives is to modify the collateral qualifying
requirements for ECB loans. Another suggestion is to incorporate environmental standards into the ECB’s corporate bond
purchasing program.

Bank of England (BoE)

BoE has led central banks’ initiatives to address climate challenges. Here are some foreign examples and experiences related to the
BoE’s work (Jung et al., 2021).

Climate stress testing

Since 2017, the BoE has run climate stress tests to evaluate how well-prepared the UK banking system is for hazards associated with
climate change. The impact on banks’ balance sheets and capital levels is evaluated through the use of several climatic scenarios in
the stress tests. The BoE’s supervisory and regulatory efforts have been guided by the outcomes of the stress tests.

Green bond purchases

As part of its asset purchase program, the BoE has also started buying green bonds. The BoE declared that it would boost its green
bond holdings to £20 billion in 2020 from the current level of £10 billion (Dafermos et al., 2022). The BoE has also been looking
into measures to boost the green bond market even more and lure in more issuers.

Green banking regulations

The BoE has encouraged banks to handle climate-related risks by using its regulatory authority. The BoE release guidelines on risk
management connected to climate change for banks and insurers. According to the rules, businesses must evaluate and declare their
exposure to climate hazards as well as create short-, medium-, and long-term risk management plans.

Research on climate change

To better understand the possible effects of climate change on the economy and financial system, the BoE has also been investing in
research on climate change. A framework for evaluating and disclosing climate-related risks and opportunities is being developed,
for instance, by the BoE’s Climate-Related Financial Disclosures (TCFD) research program.

Bank of Japan (BoJ)

Additionally, BoJ has been making efforts to address climate-related challenges. Here are some international examples of BoJ’s work
and experiences (Furukawa et al., 2020; Batten et al., 2020).

Climate risk assessment

The BoJ has been analyzing the financial system’s exposure to climate-related hazards. The BoJ created a new department in 2020
with a focus on environmental and climate change problems. The department’s responsibilities include investigating how climate
change may affect the financial system and economy and creating strategies to mitigate associated risks.
6 Climate change and green finance: The role of central Banks

Green banking regulations

The BoJ is looking into how to make its regulatory framework takes climate change into account. The BoJ said in 2021 that it will
examine its corporate bond purchase program in order to take climate change into account when choosing eligible issuers.

Green investments
The BoJ has been looking into several strategies to encourage green investments. The BoJ declared that it would begin a loan
program in 2020 to assist banks in their efforts to fund climate change-related initiatives. The program offers banks money at
no interest as long as the money is used to fund initiatives that aid in reducing the effects of climate change or preparing for them.

Challenges in implementing sustainable central banking practices in underdeveloped and emerging nations

Due to their heightened susceptibility to the effects of climate change, developing nations are increasingly in need of green central
banking (UNDP, 2020), to reduce the hazards of climate change and boost sustainable development. Although there exist chal-
lenges when implementing green initiatives, still there are just a few instances of green finance initiatives that developing nations
have put in place.

Sustainable central banking approaches for underdeveloped and emerging nations

Emerging and developing countries realize that in order to ensure their future development and energy security, they must swiftly
transition their economies to one that promotes sustainable green growth. Thus, central banks have started to take a significant part
in tackling the threats posed by climate change and the demand for green investments in several underdeveloped and emerging
nations as reported in Table 1.

Challenges related to sustainable central banking approaches for underdeveloped and emerging nations
Emerging and developing countries struggle in particular to attract green and sustainable financing and in this regard, they face
several challenges, some of them can be summarized as follows.

Table 1 Summary of Sustainable central banking approaches for underdeveloped and emerging nations.

Nation Sustainable central banking approaches

Bangladesh • Established Climate Change Trust Fund in 2009 to support environmental projects (Millat et al., 2012)
• Commercial banks and non-bank financial institutions (NBFIs) are compelled to devote 5% of their entire credit portfolio to
green enterprises.
• Projects that are beneficial to the environment and society (E&S) have lower equity margin specifications (Dikau and Ryan-
Collins, 2017)
China • Under its re-lending policy, the People’s Bank of China (PBoC) created incentives for going green using two different
processes. Both green loans and green bonds, both of which offer preferential financing and interest rates, have been
permitted as collateral in its medium-term nature financing facility. Both have an AA rating.
• With the inclusion of the assessment of banks’ green performance in the macroprudential assessment (MPA) framework by
the PBoC, banks have more motivation to increase and document their green portfolios (Choi et al., 2020)
Brazil • The Sustainable Banking Network (SBN) was founded in 2012, and the Central Bank of Brazil (BCB), with the help of the
FiBraS project, joined the NGFS in the first quarter of 2020.
• With over USD 9 billion in green, transitional, and sustainable bonds issued on both the local and foreign markets, Brazil is
one of the major green markets in Latin America in 2020.
• BCB formally unveiled its expansive sustainability program in September 2020 after realizing that climate threats posed
a severe danger to the nation’s financial stability. The BCB seeks to develop a rural credit center, give “sustainable
liquidity” where financial institutions’ credit lines are supported by personal loans or securities, incorporate environmental
and social variables into the administration of its foreign reserve, and monitor climatic hazards through stress testing
(Matthias Knoch and Colin Van der Plasken, 2020)
India • In 2019, guidelines for the priority sectors lending program of the Reserve Bank of India (RBI) have been updated and include
renewable Energy (Dikau and Volz, 2020).
• The priority sector loans scheme of the RBI now includes loans to renewable energy companies; 40% of net commercial bank
credit must go to support priority industries (Dikau and Ryan-Collins, 2017).
• Since 2015, green bonds have been introduced to fund green energy (Dikau and Ryan-Collins, 2017).
 Climate change and green finance: The role of central Banks 7

Underdeveloped financial infrastructure

Underdeveloped financial infrastructure is clearly apparent when it comes to organizing massive projects, offering loans and insur-
ance, and other critical areas that enable both large and small enterprises and families to make investments and manage the risks
they encounter ((UNEP), 2016).

Data quality issues

These countries struggle with both the availability and the quality of data. Stakeholders struggle with a lack of forward-looking data
in terms of explicit emission reduction objectives and transition plans, as well as a lack of macro data and access restrictions to the
scant data that is accessible (Natalucci et al., 2022).

Restricted accessibility of funds

Underdeveloped and emerging nations need foreign capital flow in specific areas as water, energy transport and agriculture, and this
may make it challenging to obtain funding for green projects and programmes (UNEP, 2016; Natalucci et al., 2022).

Inconsistency of regulatory framework

The regulatory framework is a crucial component of green finance because it establishes rules, practices, and processes that financial
institutions must follow to invest in sustainable projects and efficiently manage environmental risks. However, there are a number
of issues with the green finance regulatory structure related to lack of consistency and limited regulatory expertise. As for lack of
consistency, the legal framework for green finance varies significantly between different nations and areas, and financial institutions
and investors who conduct business across different jurisdictions may become perplexed and uncertain as a result. While limited
regulatory expertise exists when some regulators might lack knowledge of sustainable investments’ unique risks and prospects as
well as experience in green finance, so, it may be challenging to create efficient regulatory frameworks that promote green finance
as a result (Natalucci et al., 2022; Rao, 2022).

Conclusion and policy recommendations

Green finance, often referred to as sustainable finance, describes financial operations that support the transition to a carbon-neutral
economy, lower greenhouse gas emissions, and encourage ecologically sustainable economic growth. By offering direction, estab-
lishing standards, and encouraging financial institutions to invest in sustainable initiatives, central banks may play a significant role
in advancing green finance. Although there are several successful initiatives by various central banks in promoting sustainable
finance but there exist several challenges especially in emerging and underdeveloped nations that need more effort to be eliminated
to address these challenges and here are some recommendations suggested:

• Financial inclusion or ensuring that the financial system serves the public including small and medium enterprises (SMEs) and
aids in the fight against poverty and economic exclusion, is the main force behind sustainable finance in several nations. This can
be achieved by enhancing the foundational effectiveness, reliability, and accessibility of the banking system, particularly for
SMEs (UNEP, 2016). Regulators must consider the costs of compliance with green finance regulations, particularly for smaller
financial institutions. This can be a significant barrier for some institutions, particularly those in developing countries. So
financial incentives can be offered to SMEs so they will make investments in green financial products and projects. Subsidies, tax
benefits, and low-interest loans are a few examples of this.
• Long-term financing can be provided by financial institutions, especially green bond markets, which can be used to channel
local savings and access foreign lending and portfolio investments.
• Countries are becoming more aware that without active engagement to promote financial system shifts, not just through market
innovations but also through voluntarily rules, public-private partnerships, and favorable policy, regulatory, and fiscal
measures, sustainable finance needs and opportunities will not be met effectively. So, working together with other stakeholders
can help promote green finance and provide a coordinated approach to sustainability. Central banks can work with other
stakeholders, including governments, regulators, and international organizations.
• Assessing the possible impact of environmental risks on the stability of the financial system and taking necessary action to
reduce them represent two actions that central banks should do. This may entail subjecting financial institutions to stress tests
against hazards associated with climate change and demanding disclosure of such hazards.
• Central banks can provide technical assistance and capacity building for financial institutions to develop expertise in green
finance. This can include training programs, workshops, and certifications.
• Central banks have to create a regulatory framework to support green financing. This may entail developing guidelines for the
disclosure of environmental hazards, setting green finance goals, and using regulation to encourage sustainable investment.
• In order to standardize data availability, at least for the largest corporations, efforts must be done. Improved information
management could aid in solving data quality issues by lowering borrowing costs, reducing maturity mismatches, and facili-
tating resource allocation that is effective (Natalucci et al., 2022).
8 Climate change and green finance: The role of central Banks

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