Central banks are at the centre of a climate-induced economic transition

The transition will have an impact on monetary policy and financial regulation decisions in multiple ways:

Inflation targeting: Energy price trends driven by fossil fuels and renewable energy price and cost developments. 
Macro financial stability shocks: Some countries and economic factors will benefit from the transition, whilst others will experience risk of secular decline and stranded assets. 
Employment and economic growth: Sectoral impact of the transition might be of crucial interest for monetary policy decisions. 
Volatile prices in other sectors: Sectors such as food and agriculture will be affected by physical impacts of climate change.
Global trade glows: Changes to global trade flows, especially related to the oil industry, will have widespread macro financial consequences if not managed effectively.
Green financing: Central banks might have to consider climate and environmental objectives, and the overall transition of the financial system to a net zero economy. 

Growing interest in climate scenario analysis

Sustainable transition policy frameworks require a thorough understanding of how the transition will take place, and how different climate scenarios will work out. Climate scenarios can show how the economy reacts to various climate pathways, and how a country’s sectors will be impacted.

The associated risks can be substantial, which central banks must consider now rather than later in their decisions.

Fiscal and monetary policies need to be aligned, along with other regulatory interventions (including sectoral regulations in energy, manufacturing, transportation, and banking).

The Bank of England has confirmed its inaugural climate stress testing to take place in June 2021. The Bank of Canada is working on improving country-specific climate scenario modelling towards the end of 2021. And the green central banking group, the Network for Greening the Financial System (NGFS) is amplifying its work across global jurisdictions.

How we can help central banks prepare for the sustainable transition

Cambridge Econometric’s E3ME model is one of the world’s leading macro-econometric models used for climate scenario analysis. E3ME is widely used by organisations and institutions operating at a global, regional, and local level to assess climate scenarios, which is based primarily on empirical evidence rather than assumptions on optimisation.

Cambridge Econometrics helps central banks understand how climate risk will affect their policy mandates, financial portfolio, and macro financial stability, tailored to each country’s economic structure:

• The climate scenarios developed comply with central bank expectations for climate stress tests
• Cambridge Econometrics offers localized economic scenario analysis, tailored to the national energy and climate plans (as opposed to the global aggregate coverage by the NGFS)

3 key elements of E3ME

1. Detailed coverage of the economy

In E3ME all the socio-economic and environmental consequences of a net-zero scenario can be assessed, including CO2 emissions, GDP growth, employment implications and investment requirements. The linkages in the model between sectors and regions allow us to consider the indirect impacts of each abatement technology or policy option. The indirect economic impacts on GDP or employment are often as significant as the direct impacts.

2. Future technology innovations are included 

E3ME has detailed technological modules for realistic modelling of renewable energy uptake and because it does not assume the economy is at equilibrium, we can calculate the impacts of climate policy, including stranded assets. Detailed economic sectoral structure of the model with Future Technology Transformation (FTT) modules allows for a thorough modelling of the transition impacts.

3. Scenarios are NGFS aligned 

Our scenarios are in line with NGFS requirements, such as: assessing physical and transitional effects in case of different climate policies, assessing a scenario in line with the Paris agreement, containing information about key macroeconomic variables and sectoral vulnerabilities on long-term horizons, while our scenario outputs are disaggregated to regional and sectoral levels. The range of possible scenarios is wide, we can model the impact of orderly or disorderly transitions, partial or full compliance with the Paris Agreement, or the impact of accelerated versus delayed policy actions.

These characteristics make the E3ME-based climate scenario analysis a perfect tool for central banks to support the design of new monetary policy strategies.

One recent example of a central bank taking steps to better understand the impact of the transition and climate change is Magyar Nemzeti Bank, the central bank of Hungary

We recently completed a Climate Impact Analysis project with the central bank of Hungary to provide inputs for the bank’s climate stress testing.

The objective was to calculate the impacts of climate-related scenarios with varying levels of global climate action for the Hungarian economy. This project looked at the differences of transition and physical risks of:

1. Scenario 1 –  clean energy transition scenario to reach the global warming target set by policy makers in Paris in 2015
2. Scenario 2 – a climate-uninformed, warmer world continuing with only today’s policies

Looking ahead 

With the transition already starting to take place, central banks need to act now, both as a financial regulator and a monetary policy authority, in response to the challenges posed by climate change. Climate scenario analysis is an essential tool for central banks in understanding the impact of the climate induced economic transition on financial stability.