A Sustainable Future: Emanuel Moench, Deutsche Bundesbank, on Central Banks and the Climate Crisis

How will climate change affect central bank policymaking? Emanuel Moench, Head of Research at the Deutsche Bundesbank, joins A Sustainable Future.

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What is the case for central banks to include climate change within their mandates? Listen to Jason Mitchell discuss with Emanuel Moench, Head of Research at the Deutsche Bundesbank, the intersection of climate change and monetary policy and what central banks are doing to integrate climate risk in their macroeconomic models.

Recording date: 10 November 2021

Emanuel Moench

Commissioner Emanuel Moench is the Head of Research at Deutsche Bundesbank, Professor of Economics at Goethe University Frankfurt and co-chair of the recent ECB Strategy Review Occasional Paper: Climate change and monetary policy in the euro area. Prior to joining the Bundesbank, Emanuel was a Research Officer at the Federal Reserve Bank of New York. His research focuses on the intersection of macroeconomics and finance and has been published in the Journal of Finance, the Journal of Financial Economics, the Review of Financial Studies, and the Journal of Monetary Economics among others. Emanuel received the Journal of Finance’s Amundi Smith Breeden First Prize in 2015 and the European Economic Association's Young Economist Award in 2008.

 

Episode Transcript

Note: This transcription was generated using a combination of speech recognition software and human transcribers and may contain errors. As a part of this process, this transcript has also been edited for clarity.

Jason Mitchell:

Welcome to the podcast Emanuel Mönch. It's great to have you here and thanks so much for taking the time.

Emanuel Mönch:

Thanks so much for having me, Jason. It's great to be with you.

Jason Mitchell:

Today. Great. That's good to hear. So Emanuel, we have a lot to talk about, but I'd like to begin with some scene setting, given your experience at the Bundesbank and your work with the ECB. What's the case for including climate change within central bank mandates and how have you seen the support for this evolve? Even over the last several years, I'm thinking about, for instance, even the subtle shift in language from places like the US Fed.

Emanuel Mönch:

You know, central banks typically have pretty well-defined mandates that are given to them by lawmakers. Many central banks in developed economies are primarily required to deliver price stability. That's their primary mandate. The ECB is a good example for such a central bank. Its primary objective defined in the European treaties is to deliver price stability. European treaties also say that the ECB or rather the European system of central banks shall support the general economic policies of the European Union, but without prejudice to the price stability objective. So there's a clear ranking in the mandates with the price stability being the primary mandate in the case of the ECB. Now you mentioned the Fed and like other central banks, the Fed like other central banks, has a more prominently defined second mandate. The Federal Reserve Act in fact requires the Fed to balance the goal of price stability with full employment.

Emanuel Mönch:

Now I'm not aware of any major central bank, which has an explicit legal mandate to include climate change in its policy framework. But the Bank of England, since recently, maybe a possible exception where in March of this year, 2021 Chancellor Sunak required the Bank of England to also support the transition to net zero by 2050, but even without explicitly mandating to address climate change or support the low carbon transition, most central banks recognise now that climate change the policies addressing it will have a strong impact on the macro economic aggregates that they are required to establish such as inflation and employment. And they also understand that climate change and the net zero transition will affect financial markets, which are key for the monetary transmission. And moreover they will affect financial institutions, which central banks often supervise and the broader financial system for which they have a macroprudential mandate.

Emanuel Mönch:

So essentially all areas in which central banks are active. All of these areas will be impacted by climate change and climate policies. At the same time, you know, central bankers often are careful not to get drawn into contentious policy debates because this could potentially undermine central bank independence, which is very key for their ability to deliver on their mandates, primarily mandate price stability, most importantly. And so I think this explains rather cautious approach that we've seen by central banks communicating about climate change, what it may mean for their policies and some central banks in recent years have adjusted their stance with respect to those issues. And I think the Fed is one of them, but even though they often communicate carefully about climate change, I think in the background, many central banks have been very active trying to understand the implications of climate change for their work. You know, they have organised themselves for example, the network for the greening of the financial system, where they collaborate in a host of issues related to climate change and the broader financial system.

Jason Mitchell:

That's a really good description of the primary objectives. Like you said, price stability in the case of the Euro system and the ECB, full employment from a US perspective, if you could pull back the curtain a little bit, I mean, how would you describe or characterise the allowance that political willingness within the Euro system to more ambitiously integrate climate risk factors within those central bank mandates, to what degree has climate risk begun influencing, even in the abstract sense that primary price stability mandate discussion, not just that secondary general economic policy mandate discussion.

Emanuel Mönch:

As I just mentioned, European treaties involve a secondary mandate for the Euro system, which is to support the general economic policies of the union, but without prejudice to the primary stability mandate. So it's a subordinate secondary mandate, some policymakers in the Euro area and treat the secondary mandate as an obligation for the ECB to act on climate change. But others are rather skeptical of the stance. They argued going down that route of actively pursuing climate policies would open the door for further politicisation of monetary policy, which ultimately could put at risk the independence of the central bank. And thus again, undermine its ability to deliver on its primary price stability mandate. The Euro system recently completed a strategic review of its monetary policy framework. And, with it announced a climate action plan, the ECB governing council in announcing this climate action plan, I think was very careful not to invoke the secondary mandate instead that highlighted the importance of climate change for its monetary policy framework and its operations primarily on the basis of climate related financial risks. So really via the primary objective. And so specifically the Euro system recognised that financial risks can emanate both from physical risks due to extreme weather events, but also from risks associated with the transition to a low carbon emission economy. So transitions and both need to be taken into account when managing its own portfolios, but importantly also need to be taken into account by the institutions it supervises and by the broader financial system for which it has a macro credential responsibility.

Jason Mitchell:

Can I ask when it comes to this comprehensive action plan that you just spoke about, how do you think about designing measures that remain consistent with that price stability objective?

Emanuel Mönch:

You know, it's true that physical climate risks such as extreme weather events, such as droughts, floods, storms, wildfires that we typically think of when we think about climate change, you know, those are expected to materialise mainly medium to longer horizon. So typically beyond the horizon that central banks focus on who have a mandate to stabilise inflation and they took the plea look at sort of the business cycle frequency, but you know, there's also examples already now where extreme weather events affect price stability in Europe. Also in 2018, we had an extremely hot and dry summer in Germany where I live, this led to extremely low water levels at the river Rhine, which is a major freight route. And in turn, this led to fuel shortages and spiking of fuel prices in Germany and some neighbouring countries. So we have already seen, and we are continuing to see extreme weather winds that affect price stability even now today, more generally there's research that shows that extreme weather events have an impact on inflation, but the direction of the impact is not always clear. It's not always positive or negative because most of these events have both a supply and demand type effect on the economy. And that makes it particularly difficult for central banks to respond to these shocks.

Jason Mitchell:

I'd like to actually go back to the horizon problem that you mentioned, obviously alluding to the Mark Carney horizons, how do you see central banks reconciling short-term price, stability horizons with that longer-term climate horizon central banks typically look out and economic cycle while climate risk modeling requires at the very least a 30 year plus outlook.

Emanuel Mönch:

In general, we expect these physical climate risks to only affect price stability in the medium to longer term. But we already know now that unmitigated climate change will increase the frequency, the magnitude and persistence of climate related shocks in the future. And that will potentially make it hard for central banks to deliver on the price stability mandate in the future. But extreme weather events are not the only risk to price stability that emerge from climate change, climate mitigation and add a patient policies, also affect prices. Even in the short run, you know, take Germany again. As an example this year, the government introduced a carbon tax of 25 euros per ton of CO2 on certain fuels are primarily used for transport and heating. And this tax is already contributing to the increase of fuel and heating prices, which are a current topic of discussion here in Germany. So we know that, uh, even transition policies, transition risks, affect price stability in the short run. And we also know that such taxes need to increase quite rapidly to achieve climate goals that were pledged by governments. So even the near term climate transition risks will have an impact on prices and does implicitly affect central bank policies. And so I think it's not just a long horizon phenomenon. It's really something that we need to deal with in the year now.

Jason Mitchell:

Yeah. It's such a fascinating point, I guess I'm wondering, how do you think about the potential conflict that addressing climate change may at first be inflationary, think about the need to move to newer, initially more expensive energy sources and in particular under invest in older brown fossil fuel energy sources, should central banks hike in those situations, should they hike rates in response to that despite the potential that it may unanchor inflation expectations? I think we're living through a really interesting example now where we've had a lot of capacity building in renewables. We've had significant, and this is one of the takeaways that I took away from COP26 last week, but five to eight years of underinvestment in fossil fuels, wellheads typically lose 6% productivity per annum. So you're talking about 30 plus percent at the very least to as much as 50% lower productivity from your traditional energy sources, which is to some degree kind of shaping the degree of price volatility that we're starting to see in energy markets over the last couple of months.

Emanuel Mönch:

Yeah, this is a very good question. And as you mentioned, this is one question that's relevant right now in light of inflation rates that are quite a bit above the ECB's 2% target here, but that's also true in other currency areas and other economies. And as I just mentioned, these price increases are partially driven by carbon taxes. Although here in Europe, the impact on the currently high inflation rates are often the carbon tax is relatively small. Other factors are likely much more important. Now, I won't give a recommendation as to what the ECB governing council should do right now, but let me say this to assess the role of climate change or climate policies such as carbon taxes for inflation dynamics and thus for monetary policy it's important to understand that ECB like most central banks explicitly defines price stability for the medium term. Therefore the governing council really can see through short-term temporary fluctuations and inflation, as long as they don't lead to persistently higher inflation expectations, which themselves may of course then feed into higher future inflation. So to the extent of climate change and transition policies lead to persistently higher inflation rates, not just in some sectors, but across the board and also feed into higher inflation expectations, central banks may need to react in principle. They can see through short-term temporary fluctuations in inflation that may partially be driven by by transition policies.

Jason Mitchell:

That makes sense. So, I mean, I guess the key word would be if it's persistent and I mean, what we're talking about is sort of inflationary pressures or phenomenons that are temporal that are kind of phenomenons of capacity building and would not be persistent.

Emanuel Mönch:

I think that's right. So you really need to disentangle the temporary cyclical, uh, from the longer term trend factors, a sort of understanding of what the inflation dynamics are and then react to those primarily, which are deemed to be more persistent long-term.

Jason Mitchell:

One of the things I find really interesting are even within the Euro system, the individual kind of national reactions to climate change. So we've had the Banque's defaults announced earlier this year that they would exit coal and limit exposure to oil and gas in a shift to greener investments. Back in 2019, the Riksbank announced that they would no longer invest in assets from issuers with large carbon footprints regardless of yields. And in fact, they then went on to divest from some bonds out of Australia and Canada. The ECB is, I remember last year as well, it's sort of pointed to transitioning from brown to green bonds in a shift around its asset purchase program, you know, with so many different central banks within Euro system acting, not in concert, sort of in their own individual way. How do you think about the unintended consequences to financial stability of all the central banks de-risking in different manners?

Emanuel Mönch:

That's a very good question. First off. I mean, the ECB has announced I'm transitioning from brown to green bonds in its non-monetary policy portfolios. And then as part of its action plan announced that we'll look into how to potentially modify its asset purchase programs, the monetary asset purchase programs with regards to climate change. And this definitely plans to take into account climate related financial risks in its own portfolios. And as you rightly mentioned, other central banks have announced similar efforts or have even announced concrete steps to reduce carbon exposures of their portfolios, like the Banque de France, the Riksbank that you mentioned, and then principles such actions may contribute to a reallocation and hence a repricing of climate related risks. That's of course already underway in the marketplace. This reallocation and repricing is not, not just driven by central banks. It's driven by investors understanding that climate risks are major risks that they need to be aware of and position themselves for.

Emanuel Mönch:

So central banks doing something similar may contribute to this reallocation and repricing, but you know, these steps will be taken by a central banks will be taken a little by little and they will be implemented over the medium term. And I really don't have any doubt that they will be carefully designed and communicated to prevent a sharp and sudden repricing that could resolve in financial stability concerns. Central banks are really very careful communicators. And so I have no doubt that these announcements will be communicated carefully and these steps will be designed carefully so that no financial stability concerns around.

Jason Mitchell:

Is there a larger discussion within the Euro system about how to harmonise actions like these?

Emanuel Mönch:

In the case of the non-monetary portfolios, there was a high level task force in the Euro system that basically brought together all your areas, central banks, and they all have non-monetary portfolios, for example, to fund their pension plans for the employees, et cetera. And so there was harmonised basically approach discussed to deal with climate change in these non-monetary portfolios. And of course a monetary policy operations are discussed and assigned for the Euro area as a whole has little if any idiosyncratic or central bank specific components to these among three policy operations. So those are of course organized by construction. If you will.

Jason Mitchell:

I like to actually stay on this issue around green bonds, green bonds are accounting for a increasingly meaningful portion of the ECBs portfolios and to play devil's advocate for a second, is this some form of mission creep that diverges from market neutrality? Or would you say it's within its mandate to help create and I guess provide liquidity to the green bond market?

Emanuel Mönch:

No, I want to not comment in detail about asset purchase programs that are currently conducted by the Euro system. What I can say is that except for some restrictions given, for example, by the individual central banks, capital keys or restrictions on credit ratings that we impose on ourselves and other considerations, the Euro system seeks to ensure that its purchases adhere to the principle of marketing neturality. Now, what does that mean market neutrality? It means that the ECB seeks to minimise the effect of its purchases on the relative prices of the securities advice in practice this mainly involves buying securities according to their shares in the bond market. Again, some restrictions imposed by capital and other considerations. And of course also applying due diligence criteria.

Jason Mitchell:

How do you weigh the trade-offs in particular around proposals for central bank action relating to green QE or green quantitative easing. I asked because I can't help, but think of [inaudible] argument in the future of money is his latest book. And again, admittedly, he's not talking about climate change and climate risk and allocation and that perspective, but he makes a point that a central bank should ideally stay out of areas in which the private sector can provide services satisfactorily and where competition can produce innovations and efficiency gains.

Emanuel Mönch:

You know, my personal opinion on proposals such as green QE is that there's a number of downsides to this type of policy. You know, they're difficult to justify on the basis of the price stability objective because they risk further politicisation of central bank policies, which as, as we discussed earlier, have clear implications for a central bank independence. I also think that the likely effects of such programs on the prices of green versus brown bonds are rather small. And of course any, each program may need to be unwound when priceability considerations require the central bank to do so. So we'll by construction, if you will be no permanent positive on the missions and even worse in certain situations, if the central bank really has to unwind such programs, it may even be potential negative effects. So in sum I'm personally rather skeptical that explicitly green asset purchase programs represent an effective way for central banks to contribute to the fight against climate change. But other tools may be more effective for example, requirements regarding climate disclosures on the issuers of financial assets for purchase programs, but also for eligibility as collateral in the standard monetary policy refinancing operations. I think such requirements will likely speed up the transition to a low carbon economy as the increased transparency of climate exposures. So I think this is a much more powerful tool that central banks have at their disposal.

Jason Mitchell:

I'd like to change lanes a little bit and talk about the ECB and the fact that they will be conducting a stress test on climate related risks. Next year in 2022, with banks expected to speak to how their balance sheets will evolve over a 30 year forward basis, reflecting the climate transition and in particular stranded asset risks. So it's a big ask. It's pretty ambitious as they did post the global financial crisis stress tests tend to provide a more systematic way of understanding the effects of the complex and interrelated exposure within the financial system. How do you see climate stress tests revealing a higher risk premium, let's say in a manner that the markets may not yet have recognised or acknowledged?

Emanuel Mönch:

That's a very good question. You know, I'm not an expert on stress testing, but I think in a similar vein as, as the first stress tests that were conducted by the fed and other central banks in the wake of the great financial crisis, climate stress tests will require banks to more systematically think about the exposures they have on their balance sheets, to the different types of climate risks, physical and in the transition. So I think the very first step in this process will be to improve the collection of available data on carbon exposures of the loans and the other assets that banks have on the balance sheets. So as a consequence, I think the primary goal of such stress tests will be to help banks to fill the data gaps that they have. And by the way, not just banks have faced these data gaps we do to a central banks and supervisors, and then any other institutions do investors do so filling data, it gets, I think is a, it's a key component of the stress test.

Emanuel Mönch:

In addition, I think stress has, should also involve a more systematic analytical assessment of climate risk exposures and past experiences such as the S Cap in the US the first set of stress test after the great financial crisis. I think these past stress test experiences have shown that such regulatory stresses may induce strong improvements in banks own internal risk management frameworks, which ultimately make them less prone to certain in this case climate risks and helps stabilise the commission system in this really important structural transition that we're in right now. Your question, the risk premium, you know, whether it's that stress test will give rise to a higher risk premium, I think is very difficult to tell at this point, generally speaking to the extent that such tests increase transparency about exposures, and if these exposures have previously been under appreciated by investors, then I wouldn't rule out some market reactions to the stress test results. Importantly, however, let me say that the head of the ECB supervisory arm has recently said that the climate stress test results will not immediately trigger any changes in capital requirements for the stress test, the banks. So any potential market reaction would be driven by a reappraisal of climate risk exposures and not by regulatory requirements ensuing from those exposures.

Jason Mitchell:

I'd like to touch on the fact that you co-chaired the recent ECB strategy review, occasional paper, it's called occasional it's in fact, quite long, it's 200 pages, almost climate change in monetary policy in the Euro area. It's a fascinating, fascinating piece. I'd love for you to talk about it. I've got a lot of questions, but maybe we start out by, could you characterise the findings and recommendations, I think broadly, and to what degree does it ultimately, or does it try to rationalise central bank oversight of climate risk is financial risk.

Emanuel Mönch:

You know, the work stream was intended to collect and summarise the current state of knowledge on climate change and its implication for monetary policy with a focus on the Euro area and us central bank economists like, actually most other mainstream economists had sort of ignored the issue of climate change in our work. And so really there's a lot of catching up to do by not only ECB economists, but economists more broadly around the globe and in most central banks. And the starting point for our work was the recognition that climate change will really be a key driving force of the economic conditions that we will face and the future generations will face. And so of course these economic conditions will ultimately affect monetary policy in various different ways. And so what we did is to really with a large team of 50/60 experts from across the system, many of which only started to work on climate change.

Emanuel Mönch:

Recently, some have started to look into these issues already a few years ago together, we looked at the available academic literature and also our own internal analysis to discuss essentially the variety of different ways, how climate change could affect monetary policy today in the future. I don't want to summarise all findings here, but let me highlight a few climate change. Clearly we concluded for the fact that policy space that will be available to central banks in the future, as it further reduced the natural real rate interest, many refer to as our star. That's the rate of which saving and investment are in equilibrium in the long run or the supply and demand for funds are in equilibrium in the long. And this equilibrium rate of interest could be reduced by climate change because funds might need to be diverted away from innovation and productive activities to say reconstruction after natural disasters or to add a patient and protection against future natural disasters.

Emanuel Mönch:

So climate change in that particular way will likely reduce the policy space available to central banks in the future. Now, another reason we discussed for why policy space could be lower in the futures that high uncertainty that may be implied by climate change and transition policies may actually go hand in hand with an increased precautionary savings motive by households. And so this would also put downward pressure on, on this equilibrium rate of interest and hence reduce policy space available. There's a number of other potential sort of channels through which obviously space could be effected by climate change. So I think there's really a variety of potential channels through which climate change put downward pressure on rates of interest and enhance policy space for central banks. Democratic trends might be accelerated by climate change, for example, that could also put some pressure downward pressure, but you know, there's also potential positive effects of climate change for our stock.

Emanuel Mönch:

For example, technological advances that are related to climate change abatement could have positive spillovers for broader productivity trends and hence put upward pressure on those equilibrium interest rates. And so in some, what we concluded in the workstream report was that the net effect of climate change on policy space on equilibrium, real interest rates is really unclear. Ex-ante depends on all these different channels. And it's very hard at this point to quantify how important each of those will be. But from what we know now, based on existing work, it's not unlikely that it will, in sum further compress equilibrium rates of interest, the climate change will further compress equilibrium rates of interest. And that this means that central banks may have less policy space available in the future to smooth inflation. And the business side.

Jason Mitchell:

We've talked about different policy, transmission channels. Obviously we've covered interest rates. I'm wondering if you could touch on credit asset pricing and expectations. I thought was interesting as well.

Emanuel Mönch:

Yeah, so there's a number of traditional channels through which monetary policy affects prices and the real economy as the classical interest rate channel. There's a credit channel of one-two policy. There's an asset price channel of monetary policy and expectations channel. All of these could potentially be affected by climate change, the interest rate channel, which is sort of the most natural that comes to mind when thinking about how central bank policies affect inflation and real activity, the interest rate channel could be muted by climate change. Because again, these increased precautionary savings that I mentioned triggered potentially by uncertainty arising from climate change and transition policies, they may reduce the interest rate sensitivity of consumption in the credit channel might be affected negatively because climate change may affect negatively the balance sheet of households firms and as a result banks. So banks may reduce lending and not respond as strongly to policy rate changes as they used to.

Emanuel Mönch:

So the credit channel of monetary policy might be hampered by climate change. We also discussed, and you mentioned asset markets, credit markets. I mean, climate change is likely reflected in higher risk premia in certain asset markets due to a heightened volatility of certain asset prices and exposures to new sources of undiversified risks as new or newly understood sources of undiversifiable risks. So you mentioned stranded assets, so that's one such risks. So as a result, I think the asset price channel of monetary policy is very likely also to be affected now, how exactly, and what ways, how quantitatively important this effect will be, is really difficult to tell at this point, because we're lacking data, but for sure there's a variety of reasons why climate change might impact monetary policy transmission in the future. And probably already does today. To some extent they don't all go in the same direction, but I think on balance, we concluded the monetary policy transmission is likely to be negatively affected by climate change and transition policies. So life of central bankers, as you will, is unlikely to become any easier with climate change.

Jason Mitchell:

Let's talk about some of the gaps that the ECB paper identifies. The first one is around this idea of climate economy modeling. How do you reconcile climate specific models that represent the economy in over simplified ways versus macro economic models used by central banks that generally do not include climate factors because of, as we talked about the horizon problem, how do you consider physical and transition risks in the transition to a net zero economy?

Emanuel Mönch:

You know, this gap that you mentioned between the sort of traditional climate economy model and the monetary policy focused models that we use in central banks, this is a really important gap. And it's an important area for research at the intersection of economics, finance and climate science. You know, the workforce model that climate economists use to compare the economic costs and benefits of climate policies. For example, carbon taxes, these types of models are called integrated assessment models. And they typically have a very simplistic economic structure. And so most of the transmission channels that have shown to be relevant, modern macroeconomic analysis. And then some of which I mentioned just before most of these transmission channels are missing from these models, they're already quite complicated in and of themselves. Now, central bank economists typically use their workforce macroeconomic models, so-called dynamic stochastic general equilibrium models, and they have these transmission channels built in, but they typically do not feature any climate related variables or transmissions to climate or from climate to the economy.

Emanuel Mönch:

And so there's really strong demand for bridging these two types of models. And there's a lot of ongoing research already that tries to do so, but it'll, it'll take some time. Now in the meantime, what we concluded in the workstream was that satellite approaches maybe a good starting point, right? Climate related scenarios, we can obtain from such integrated assessment models would be used as inputs in more advanced structural models of the economy, which may then also take into account for example, sectoral interdependencies, which may be important. Another approach that we discussed is to use existing structural and semi structure models and feed them with paths of macroeconomic shocks that are designed to mimic certain climates in the areas that we obtained from these integrated assessment models. So there's basically different ways to get started now, but ultimately we really need to bridge the gap between these two types of models of climate economists and central bank economists have been using over the past years.

Jason Mitchell:

To what degree does the new Area Wide Model, the in AWM model that the ECB paper alludes to. Can you talk about that to what degree does that reveal how climate change could minimize the effects of a monetary policy?

Emanuel Mönch:

I mean the new area-wide model was not designed to feature climate change yet in the workstream, colleagues from the ECB and other central banks used it to study the implications of climate change for Montreal policy under different climate scenarios. And this was done in a way, I just outlined before: you use the structural or semi structural model and you feed it with paths of macroeconomic shocks that designed to mimic certain climate scenarios doing. So the main finding was that standard demand shocks, which central banks try to accommodate, by easing policy, are likely to have a larger and more persistent impact on the economy on inflation and the output gap under scenarios where monetary policy space, and also fiscal space by the way, are constrained by climate change. So the simulations show that when the size, the frequency and the persistence of certain supply and demand shocks increase through the climate change, and it will be much more difficult for the central bank to establish inflation. And that's especially true. Coming back to a discussion we had earlier, if the natural rate of interest is also pushed down due to climate change. So basically while these models haven't been designed yet to feature climate change, we can really use them to study monetary policy in the future in scenarios under which climate change affects a certain chalk profiles, but also certain variables that are important for monetary policies, such as the natural rate of interest.

Jason Mitchell:

The second gap that I'd like to address coming out of the ECB papers, the obvious question, which is around data. So where, with your central banker hat on, where are the data gaps and how do you think we close them?

Emanuel Mönch:

There are a lot of data gaps for sure it's true that, um, historical climate data is available relatively easily. But as we discussed earlier, these only tell us so much about future realisations of physical risks that may be arising from climate change in the future. And that's why we use scenario analysis and climate modeling and understanding climate scenarios may affect monetary policy and future. We also discussed earlier that monetary policy typically operates a business cycle frequencies for which transition risks are are key. And so what's really crucial is to properly measure these transition risks. And for that, we need detailed, granular data on the carbon exposure. Some firms, sectors countries, these are being increasingly collected, but, you know, and I think you've discussed this also in prior issues of your podcast. The quality of those data is often not clear. The results differ across data vendors.

Emanuel Mönch:

Much of the available data is imputed using a variety of sources and models. And so really that's a data gap that needs to be filled, not just for central bank purposes, but also for other purposes. In addition, I think there's different initial and methodological issues that we need to deal with, which are associated with climate change. And that's really a question of disclosures. And I think these issues that are open, they need to be solved very quickly so that we, as central bankers can improve our understanding of the transition risks and how they impact financial markets, individual firms, and monetary policy. And of course, rating agencies play a key role in this context. And I think we also need to improve our understanding of what these agencies do to incorporate climate change into their ratings and need to have discussions with them about how this is done. As we also rely on ratings very much, for example, in our collateral framework, but central banks can also contribute to filling these gaps on exposures. How can they do so? Well, I mentioned earlier the disclosure requirements and central banks can impose on issuers of financial assets, which the central banks accept as collateral or that they even purchase in the marketplace and asset purchase problems. So central banks themselves may actually play a crucial catalytic role for the improved climate related disclosures and think they understand this well now.

Jason Mitchell:

The question, and I've got an interest in this, but given that you've done a good deal of academic research around risk premia, and I'm wondering because this is an issue or a topic that continues to come up in a great podcast with Cam Harvey, in a most recent one with Abraham Lioui, obviously both academics. And I'm kind of wondering your views around the existence of this risk premium. It feels much easier to define in a green context, talk about greeniums particularly around sort of spreads in the green bond market relative to non green bonds. How do you think about this? The reason I ask this is that I often find that what's purported to be an ESG premium or a climate premium is often little more than other common risk factors, sort of amalgamated into some sloppy factor.

Emanuel Mönch:

You know, that's a great question. And, um, as an economist interest in asset pricing, I am very interested in this question, although I haven't really worked on it myself yet, but conceptually, I mean, to the extent that physical and transition risks that emanate from climate change represent undiversified source of risk for investors, you know, there should be a premium for bearing such risks, but of course there may also be potential positive returns for certain firms or industries that may banish it from climate change or the net zero transition. So yes, I think conceptually these premiums should exist and they can be either positive. So investors requiring a premium to bear these risks, or they can be negative investors willing to pay a premium to hold assets that will likely do well in certain future states of the world. And I guess it boils down to measuring these risks properly.

Emanuel Mönch:

And that's challenging as these risks are clearly multifaceted. They involve physical risks as well as transition risks, physical and transition risks are themselves multifaceted as very different types of such risks. And so I think it's unlikely that you can really summarize all of these risks in one simple factor. Maybe the carbon exposure of a firm's revenues is a good starting point, but it's certainly not the only factor I would think conceptually that would measure climate risks. Some exposures to climate risks, physical and transition are probably relatively well captured by other commonly used risk factors, such as quality and size, but without really being an expert in this field, I would doubt that these will be enough to really span the different dimensions of climate risks. And so I think clearly more research is needed to come up with risk factors that are good proxies for climate risks. And some of the recent work you have covered in past issues of your podcast. But I think there's really a lot more to be done on this.

Jason Mitchell:

So it's such an exciting area. So it's been fascinating to discuss how to think about the intersection of climate change and monetary policy, what central banks are doing to integrate climate risk into their macro economic models and why it's vital that we continue to examine how climate change may impact the financial system. So I'd really like to thank you for your time and insights. I'm Jason Mitchell, co-head responsible investment at Mann group here today with Emanuel Mönch, head of research at Deutsche Bundesbank, many thanks for joining us on a sustainable future. And I hope you'll join us on our next podcast episode. Thank you so much, Emanuel.

Emanuel Mönch:

Thank you so much, Jason, for having me and for this very interesting discussion.