The Case for Climate Objectives in Central Banks’ Targeted Refinancing Operations
Central banks are making increasing use of targeted refinancing operations to pursue their mandates. However, so far none of them, with a few exceptions in developing economies, has aligned its targeting with the objective of a transition to a low-carbon economy. This must change.
Refinancing operations are a core monetary policy tool to provide liquidity to credit institutions. Whereas traditionally such operations have all been short-term, many central banks extended their maturity in response to the last financial crisis. Crucially, several central banks also started targeting them by offering reduced rates for bank refinancing of loans to particular segments of the economy.
The Targeted Longer-Term Refinancing Operations (TLTROs) of the European Central Bank (ECB) are a case in point. They offer banks ECB refinancing at reduced rates for loans to non-financial firms as well as non-mortgage loans to households. The ECB introduced this instrument in 2014 (TLTRO I), followed by a second series in 2016 (TLTRO II) and a third one in 2019 (TLTRO III). Moreover, in response to the COVID-19 crisis, it modified the conditions of TLTRO III and further reduced the applicable refinancing rate by 25 basis points.
The Bank of England (BoE) provides another illustration. In 2012, it introduced the Funding for Lending Scheme (FLS) to encourage bank lending to households and businesses by providing low-cost refinancing to participating institutions. Similarly, in 2016, it launched the Term Funding Scheme (TFS) to ensure the pass through of the August 2016 cut in the BoE rate to the interest rate faced by households and businesses. In March 2020, the BoE adopted the Term Funding Scheme with additional incentives for SMEs (TFSME) to support the economy in the post COVID-19 crisis and to particularly encourage bank lending to small and medium-sized enterprises (SMEs).
Further examples of targeted refinancing operations, including many with a particular focus on SMEs, abound. The Reserve Bank of Australia’s Term Funding Facility (TFF) provides one dollar of additional funding to banks for every dollar increase in credit outstanding to large businesses, and five dollars of additional funding for every dollar increase in credit outstanding to SMEs. The Paycheck Protection Program Liquidity Facility (PPPLF) launched by the US Federal Reserve (Fed) in April 2020 offers another illustration. The program is intended to bolster the effectiveness of the Small Business Administration’s Paycheck Protection Program (SBA PPP), with the Fed supplying liquidity to participating financial institutions through refinancing PPP loans to SMEs. Eligibility for the program is qualified by the SBA and its definition of the features of PPP loans in terms of scope, maturity, and interest rate.
The wide use of such targeting notwithstanding, none of the advanced economy central banks have so far aligned these measures with their strong emphasis on climate risks, nor with the objective of the transition to a low-carbon economy that many governments have set. This is striking.
Again, the ECB is a case in point. While using TLTROs since 2014 it is yet to explore the potential of this instrument to reflect its full mandate, including the responsibility to “support the general economic policies in the Union with a view to contributing to the achievement of the objectives of the Union”. A key goal of the EU is undoubtedly the transition to a low-carbon economy. Indeed, within the European Green Deal and in line with the Paris Agreement, the European 2050 long-term strategy sets the target for the EU to become climate neutral by 2050. Without prejudice to the objective of price stability, such a commitment at the political level should be reflected in ECB operations — including the targeting of its refinancing lines.
Introducing climate considerations into targeted refinancing operations
Accounting for climate objectives in the targeting of refinancing operations can conceptually take at least two different forms.
First, targeting can aim at refinancing loans that banks offer towards greening the economy. Such an approach can cover loans to a wide range of green activities or a more focused set of individual sectors. The proposal for Green TLTROs linked to the EU Taxonomy, with an initial pilot for energy efficient building renovations, that was highlighted in the European Parliament’s Monetary Dialogue with ECB President Lagarde last September, provides an illustration. Targeted refinancing for loans to renewable energy projects offers a further example.
Second, the introduction of sustainability considerations into targeted refinancing operations can also be based on the composition of the entire loan portfolio of banks. To this end, overall bank exposure to climate risk can be used as discriminating factor. Existing climate risk metrics offer the analytics to underpin such schemes. And here, for the wonky readers, is a model that further describes the dynamics.
Ensuring policy coherence
Such amendments to its targeting would allow the ECB to align its pursuit of price stability with a significant contribution towards the EU objectives in terms of emission reductions, renewable energy, and energy efficiency, as set in its 2030 climate & energy framework. Such targeting would also lend itself to a more gradual approach of further loosening or tightening monetary policy — with the former channeled through additional reductions in refinancing rates for specific green segments of the economy, and the latter implemented through an increase of refinancing rates for the entire economy except for targeted green activities.
After the financial crisis and more recently in response to the economic fallout from COVID-19, central banks have increasingly made use of targeted longer-term refinancing operations. Within these operations, clear decisions have been made about which segments or sectors benefit from favorable financing conditions, as in the case of SMEs. However, many central banks have failed to align these measures with their full mandate and with broader government objectives — in particular the transition to a low-carbon economy.
This lack of coherence between monetary policy and the broader goals of countries is alarming — even more so as decarbonizing the global economy requires all public institutions to work in the same direction. Sustainability is a core objective for governments around the world. Central banks should not act against this effort by disregarding sustainability in their operations. Their policies must be coherent with existing societal objectives.
Ensuring that their refinancing operations are targeted accordingly is a critical step in this direction.