Sarah Breeden, who is responsible for the supervision of the UK's banks, building societies and credit unions at the Bank of England.

The woman responsible for supervising UK banks has spoken of the need for banks to abandon the “doctrine of market neutrality” when making policy decisions. That’s because of the overriding need to align monetary policies with reaching net zero by 2050.

Sarah Breeden is responsible for the supervision of the UK’s banks, building societies and credit unions and has oversight of the Bank of England’s work enhancing the financial system’s resilience to climate change.

Three challenges lie ahead she says: “The first is the need to liaise with government policymakers on setting out the path to net zero. We must complement, amplify, and catalyse the process. 

“The second is that data and models are presently incomplete, and yet we need to act now, so much analysis is urgently needed. We need multiple scenarios looking decades ahead, that are coherent with all elements, modelled granularly from the bottom up.

“Finally, we need to work together internationally. If we do no more than focus on the financial system, that it supports the transition, then that is what we must do.”

Breeden added that the notorious mantra of “market neutrality” is “not an issue here”. 

This doctrine appears to be crumbling in the face of the need to transition the world economy to net zero. It was also questioned by Christine Lagarde, the president of the European Central Bank (ECB), last autumn.

The crucial role of central banks

With growing numbers of governments introducing targets and plans to achieve net-zero around the middle of this century, leading banks and investors are committing to align their portfolios with net-zero by 2050. 

One group of financial actors has so far been largely missing from this race to net-zero finance, however: the world’s central banks and financial supervisors. 

These major central banks are unique to every nation or region. They are responsible for overseeing its economic and monetary policies and ensuring the stability of the financial system. Unlike commercial and investment banks, these institutions aren’t market-based or competitive. 

Examples include the US Federal Reserve System, Bank of England and the Reserve Bank of Australia.

These central banks set the rules guiding the behaviour of all other financial bodies. They are supposed to prevent runs on banks and financial institutions.

The costs of climate change related disasters on banks threaten to be far deeper than their pockets.

But the costs of climate change related disasters threaten to be far deeper than their pockets. Recognising this existential threat, they are waking up to the fact that they are vital for reaching net-zero, and many are considering how to adapt.

Weaning Australia off coal

Central Banks, and a so-called Supervisors Network for Greening the Financial System, which includes the Reserve Bank of Australia, last year forecast that “coal use in the Asian region will be phased out sometime between 2040 and 2050 under scenarios that meet the Paris Agreement’s goals.”

If the Australian economy has to switch from coal and gas as major export industries, then banks need to stop underwriting them, and providing loans.

The reasons given are two-fold: recognising that net-zero as the best way of minimising the risks of climate change to stability of the financial system itself; and making sure that central bank and supervisory activities align with net-zero government policy.

A new report, Net Zero Central Banking: A New Phase in Greening the Financial System outlines the case for why central banks and supervisors need to act on net-zero and how they could start doing this. 

At the report’s launch last week, leading author Nick Robins, professor of sustainable finance at the London School of Economics’ Grantham Research Institute said that a major Capital realignment was under way. “Asset owners with $5 trillion assets and banks with $15 (A$19.61) trillion have committed to net zero already.

“For policy coherence central banks must ensure financial activities are consistent with net zero policy, especially in countries where there is an explicit mandate, such as the EU. If adopted this would provide clarity, predictability and integrity.”

Sunak tasks Bank of England with tackling climate change

The British chancellor Rishi Sunak has this month charged the Bank of England with a new remit to support a transition to net zero.

The Bank responded that it will provide more information on adjusting the Corporate Bond Purchase Scheme (which is meant to give adrenalin shots to the economy by lowering yields on corporate bonds and so reducing the cost of borrowing for companies) to account for the climate impacts of the issuers of the bonds it holds.

Sunak said its interest rate-setting monetary policy committee must now include a duty to support the government’s net zero carbon ambition alongside its longstanding responsibility to keep inflation in check.

The bank must also support the government’s strategy to “level up opportunity in all parts of the UK” and to “transition to an environmentally sustainable and resilient net zero economy”, according to the Treasury, which is also to issue a £15 (A$27) billion Green Gilt sovereign bond, and set up a £22 (A$39.61) billion National Infrastructure Bank based in Leeds, in the north of England.

How should banks respond to the climate crisis?

The new report has seven recommendations:

  1. Central banks and supervisors develop a net-zero roadmap including long-term expectations and near-term actions
  2. Prudential regulation to make net-zero a core element of supervisory practice, for example requiring all regulated financial institutions to submit net-zero transition plans, as well as addressing climate risks in regulatory
  3. Making forward-looking scenarios more consistent with a net-zero pathway to limiting warming to 1.5°C
  4. Make monetary policy consistently account for the impacts of climate change on macroeconomic outcomes and operationally align with net-zero
  5. Include a net-zero target for investment practices for central banks’ portfolios and publish a transition plan to achieve this
  6. Evaluate the implications of net-zero for jobs and livelihoods to bring about a just transition in all sectors and regions
  7. Incorporate net-zero into key international financial and regulatory frameworks and processes
Luiz Awazu Pereira da Silva, Deputy General Manager, Bank for International Settlement.

At the report’s launch, Luiz Awazu da Silva – ex-chief of the Brazilian central bank and its finance ministry and now deputy general manager, Bank for International Settlement, which is a bank owned by and for the central banks – said the “official sector is almost lagging behind everyone else. While the central banks are not ignorant of the risks, there’s unanimity of need but not of the how. Any approach has to take into account nonlinearity, and biodiversity.”

Climate risks don’t worsen linearly but can cause big shocks, as the pandemic shows.

The BIS recently published a book co-authored by da Silva, “The Green Swan“, calling for central banks to help coordinate measures to fight climate change.

“Even if central banks lead action to net zero, there’ll be a heavy cost to acquisitions and mergers, and it will hit the poor most,” he said. “So we need to have way to redistribute and to compensate the poor.”

The growth impact of good policies to fight climate change needs to be emphasised, he added. “This is about the perception. You need to show the policies are growth enhancing as well, and give incentives for all sources of renewable energy, with fiscal multipliers. 

“If you combine a good political economy and analysis of redistribution of these policies and of growth, then central banks, acting within their mandate, can do a lot to contribute.”

Market neutrality is dead

Ulrich Volz, reader in economics at SOAS University of London and founding director of the SOAS Centre for Sustainable Finance agreed with Sarah Breedon concerning the end of market neutrality. 

“We need to correct the carbon bias. Banks shouldn’t provide liquidity for sectors that have to shrink in the transition. They should demand credible net zero plans from them. Failing to take carbon risk into account can reverberate back in the future,” he said.

“The action and inaction of central banks will have profound impacts on the expectations and behaviours of financial markets. Central banks shape markets, which respond to signals from them, especially how they think about risk.”

Capitalism has always adapted to change in the face of numerous predictions of its demise in the past, most recently after the 2008 financial crash. 

Climate change is probably its biggest challenge yet, and if central banks’ high priests challenge the “invisible hand of the market”, it will be interesting to see how the hand responds.

David Thorpe is the author of ‘‘One Planet’ Cities: Sustaining Humanity within Planetary Limits and Director of the One Planet Centre Community Interest Company in the UK.