Central banks and climate change: what can be done?

As extreme weather events become more frequent, central banks are focusing on how to mitigate the economic knock-on effects. Here, Shubha Samalia, ESG Macro Strategist, answers some questions about the why and how.

31 Jan 2025

It’s no secret that climate change, and associated extreme weather events, pose significant challenges to the global economy, whether through disrupting economic activity or inflation volatility. Compared with the 1970s, the annual number of natural disasters has increased fivefold, and inflation-adjusted economic losses have surged sevenfold. Without co-ordinated mitigation, these trends will continue to strain economic systems worldwide.

ESG Macro Strategist at NatWest, Shubha Samalia is intimately aware of the relationship between climate change and the economy, and here answers some questions about how monetary policy may need to adapt.

How do natural disasters influence economic stability and inflation?

Natural disasters disrupt economic stability by causing extensive damage to infrastructure, housing, and industries. For example, hurricanes in the US and heatwaves in Europe have led to billions of dollars in damages and significant loss of life. These events reduce GDP growth, increase inflation volatility, and pose challenges for policymakers. Supply chain disruptions, particularly in agriculture and energy sectors, often lead to elevated food and energy prices, disproportionately affecting emerging economies where agriculture is a primary economic driver.

The inherent long-term uncertainties and, in some cases, non-linear effects from climate change pose conditions that central banks might not be equipped to deal with, especially over the short-term. However, the risks of dismissing the consequences are high.

What role can central banks play in addressing climate risks and what’s in their armoury?

Incorporating climate risks is becoming increasingly significant for central banks to meet their mandates on price stability, financial stability and economic growth. Climate change affects potential output through impacts on labour, capital, and productivity but proactive climate considerations enable central banks to better manage these dynamics and support sustainable economic growth.

This includes:

Transition away from market neutrality to prioritise assets linked with sustainability benefits and exclude carbon-intensive industries.

Expand research on climate risks, associated physical risks and integrate findings into macroeconomic models and projections.

Mandate climate risk disclosures and stress tests for financial institutions.

Adjust monetary tools, such as asset purchase programs and collateral frameworks, to incentivise sustainable investments.

Promote international collaboration for consistent climate risk management.

What have major central banks done so far?

Among the three economic areas we focus on:

European Central Bank (ECB): The ECB has pioneered efforts to incorporate climate risks into its operations and monetary policy. It established a climate change centre in 2021 and introduced measures like climate stress testing and adjusting corporate bond holdings to favour environmentally sustainable issuers. By 2022, the ECB’s portfolio had reduced its carbon intensity by over 65%. Climate-related financial risks are now considered in review of collateral haircut schedules, and climate-related disclosures are expected to be part of its collateral framework from 2026. More recently, the Bank, through its Climate and Nature plan, is looking to address the physical impact of climate change alongside other focus areas.

Bank of England (BoE): The BoE has made moderate progress, such as greening its corporate bond purchase scheme and implementing collateral reforms for residential mortgages. However, its focus has waned recently. This is however expected to be reversed, with the new government last year and its net zero ambitions.

Federal Reserve (Fed): Even prior to the US withdrawal from the Paris Climate Agreement, the Fed’s approach was cautious, with the bank having said that addressing climate change is beyond its mandate. While acknowledging climate risks to financial stability, it has until now pursued modest measures, such as pilot stress tests for large financial institutions. How the withdrawal affects the Fed’s stance remains to be seen.

What challenges do central banks face in addressing climate risks?

Central banks encounter several challenges, including:

Data limitations: Reliable data on climate and associated physical risks and their economic implications is often scarce.

Uncertainty: The long-term, non-linear effects of climate change make it complex to assess impact and incorporate risks into policy formulation.

Resource constraints: The exercise of assessing and addressing climate-related impacts is long-drawn, complicated and resource extensive. Central banks need to be well supported by the governments in their jurisdiction.

Mandate constraints: Some central banks, like the Fed, perceive climate action as outside their core responsibilities.

Global divergence: Varied approaches among central banks, such as the ECB’s proactive stance versus the Fed’s caution, lead to inconsistent progress.

What is the outlook for central banks and climate risk management?

While progress varies, the growing global consensus on addressing climate risks is encouraging. Central banks like the ECB are setting high benchmarks, integrating climate considerations into operations. Others, like the BoE and Fed, have room for improvement. The journey ahead requires robust data systems, international co-operation and innovative policy tools to navigate the evolving challenges posed by climate change. But central banks are waking up to their role in mitigating climate change effects, and that must be welcomed.

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