Executive Summary
- Central banking faces novel threats from climate change to its core mandates of price and financial stability. Both physical risks (extreme weather) and transition risks (carbon policy shifts) can shock inflation, asset prices and credit. For example, the Bank of England finds that house price declines in UK flood-prone areas could be on average 6.5 times larger than in median-risk areas.
- In response, many central banks are incorporating climate into their frameworks. Over 145 institutions across 90+ countries have joined the NGFS network to share best practices. Central banks now use scenario analysis and stress tests (e.g. ECB/ESRB climate stress tests) to quantify impacts on banks and markets.
- Action varies by country. Studies show central banks’ climate measures tend to reflect domestic politics: active in Europe and China, cautious elsewhere. US and UK banks report “significant data and modeling challenges” (e.g. lack of detailed climate exposure data) when attempting climate stress tests.
- Tariff and portfolio “greening” measures have limited effect. An ECB analysis finds even extreme “green QE” would cut emissions only about a quarter as much as a modest carbon tax. Central banks emphasize risk assessment rather than price-setting for climate.
- Recommendations: Clarify mandates (embed climate in financial stability goals), require regular climate stress tests and disclosures, improve data collection (TCFD alignment), and coordinate closely with fiscal policy on climate. International forums (NGFS, FSB) should harmonize approaches. Central banks should support, not substitute for, government climate policy.
Introduction
Climate change introduces dual risks to economies. Physical risks – storms, floods, droughts – can damage infrastructure, disrupt supply chains, and spark inflationary shocks. Transition risks – from carbon pricing, regulation or market shifts – can devalue assets and strain borrowers in fossil-fuel industries. As one analysis notes, “climate change – through both physical impacts and … economies transitioning to net zero – poses financial risks in both the short and long term”. Both channels can feed into price instability and financial strain. Indeed, the IMF observes that “climate change could impact price and financial stability, which are at the core of a central bank’s mandate”.
Central banks traditionally focus on inflation and systemic risk. But soaring disaster losses and looming transition shocks have forced their attention. The Bank of England states that “climate change affects our world, our economy and our financial system,” necessitating new risk assessments across monetary policy and supervision. The Reserve Bank of New Zealand has explicitly adopted a climate strategy to “identify, understand and manage climate-related risks to its financial system”.
Meanwhile, 145 central banks and regulators (100% of global systemically important banks and ~80% of large insurers) now participate in the Network for Greening the Financial System (NGFS). This report examines how central banks perceive and respond to climate risks worldwide, and what policies can strengthen monetary and financial stability under climate change.
Climate Risks to Core Mandates
Central banks’ main tasks – price stability and financial stability – can both be undermined by climate change. Physical shocks (e.g. a heatwave) can disrupt commodity markets, causing inflation spikes. Transition policies (e.g. a sudden carbon tax) could raise costs for carbon-intensive sectors, slowing growth and altering inflation dynamics. For instance, a Bank of England study finds that UK regions with extreme flood risk could see mortgage losses many times larger than average.
On financial stability, climate forces can sharply revalue assets. In a recent ECB/ESRB climate stress test under the EU’s “Fit for 55” climate package, even moderate transition shocks produced first-round losses equivalent to 5–7% of loan exposures across banks, insurers and funds. In a more severe scenario (transition shocks plus macro stress), first-round losses rose to 11–22% of exposures. These figures – while not system-ending – indicate that climate-driven shocks can materially impair balance sheets if unmanaged. Conversely, indirect risks (e.g. debt-servicing capacity or sovereign revenue loss from disasters) can feed back into banking risk.
Monetary policy faces dilemmas: a climate-induced supply shock (say, crop failures) might force a rate hike to contain inflation just as the economy slows. Central banks must thus incorporate climate scenarios into forecasts and reaction functions. This necessitates extending macro models to include environmental factors. For example, the Bank of England’s climate “Banking Book Stress Test” (BCBS) now includes scenarios for high carbon prices and extreme weather to assess impacts on mortgage portfolios and corporate debt.
Central Banking: Tools and Data
To manage climate risks, central banks are using new tools and disclosures. A common approach is scenario analysis/stress testing. The NGFS provides standardized climate scenarios (e.g. orderly transition, delayed policy, current policies) that banks and supervisors can adopt. Many jurisdictions now require or conduct climate stress tests. For example, the European Commission and central banks ran coordinated stress tests of dozens of banks and insurers under “Fit-for-55” and “Slow Transition” scenarios. In the U.S., the Federal Reserve piloted a climate scenario exercise in 2023 with the six largest banks.
These exercises reveal gaps. Fed staff report that participating banks encountered “significant data and modeling challenges” – such as lack of granular data on property characteristics, insurance coverage, and firms’ climate plans. They also struggled to trace indirect or chronic risks (e.g. local economic disruptions, sea level rise) into credit metrics. Without detailed climate-annotated data, stress-testing outputs remain imprecise. Central banks are therefore pushing for better data: examples include requiring corporate climate disclosures (TCFD-aligned reporting), developing climate risk metrics for sovereigns, and mapping high-risk zones (e.g. flood maps) against financial assets.
Beyond risk analysis, some central banks have debated more active measures. Proposals like “green quantitative easing” (QE) – limiting bond purchases to green assets – have been studied. An ECB working paper simulated extreme cases (reallocating 10% of GDP in assets to renewable energy) and found surprisingly small effects: such green QE reduced emissions only about one-quarter as much as a modest carbon tax.
This suggests central banks’ direct influence on climate outcomes via portfolio adjustments is limited compared to fiscal or market policies. Thus most central banks remain wary of straying into allocative policy. They instead focus on ensuring that their own operations (e.g. collateral frameworks) do not undermine climate goals. For instance, the ECB and BoE have begun to tighten haircuts on higher-carbon collateral, and both now publish their own emission footprints.
Finally, climate is being factored into traditional tools. Collateral frameworks may be adjusted to reflect transition risk premiums. Macroprudential policy (capital buffers) may be recalibrated if climate losses become material. Central banks like Sweden’s Riksbank and the Philippines BSP have started calculating a climate “risk weighted” lending sector index. In foreign exchange and reserve management, some central banks (e.g. Denmark’s, a few reserve managers) are considering shifting reserves into greener assets.
Political and Legal Constraints
Crucially, central banks act within political and legal constraints. A recent study finds that central banks’ climate actions correlate strongly with national climate policies rather than purely economic exposures. In other words, central banks tend to reinforce their government’s climate agenda. The Fed has conducted climate research but awaits clear Congressional authority (as “climate” is not in its mandate), while the ECB and Bank of England operate under mandates that allow broad financial stability and some mandate for environmental risk.
Legal frameworks can enable or limit action. The IMF highlights that central banks must ensure any climate-related interventions fit within their remits. In the U.S., for instance, federal law explicitly forbids factoring environmental policy into monetary policy. In Europe, courts have so far upheld some climate-related bond criteria (e.g. German Constitutional Court allowed ECB’s public sector purchase program to target environmental objectives). This legal context means some central banks can more readily “tilt” lending or reserves toward green, while others focus only on risk assessment.
Another factor is legitimacy and independence. Central bankers recognize that overt climate activism (e.g. lobbying for carbon taxes) could overstep their authority. Most emphasize that their role is to manage financial risk, not set climate targets. The consensus emerging is that climate should be considered a risk factor – akin to cyber risk or sectoral risk – and treated with the same toolkit (stress tests, disclosure, macroprudential buffers).
Policy Recommendations
- Embed climate in mandates: Governments should explicitly empower central banks to consider climate risk within their financial stability mandate. Legal reforms or supervisory guidelines can clarify this scope. A clear mandate reduces tension over “mission creep” and allows central banks to act decisively on climate-related supervision.
- Regular climate stress testing: Make climate risk assessment routine. Banking and insurance regulators should require periodic climate stress tests and scenario reporting. Coordination (through NGFS, Basel Committee) is needed to align scenarios and model assumptions. Climate stress tests should feed back into capital requirements and risk management expectations.
- Data and disclosures: Strengthen climate-related disclosures for both firms and banks. Central banks can mandate standardized reporting (building on IFRS S1/S2 or TCFD) to fill data gaps. Initiatives to quantify the carbon footprint of financial assets (similar to Task Force on Climate-Related Financial Disclosures) should be supported.
- Incorporate climate in monetary frameworks: While maintaining market neutrality, central banks can incorporate climate factors into forecasting and policy reaction curves. For example, explicitly modeling the inflationary path under carbon pricing or analyzing credit growth in energy-intensive sectors. Communicating how climate shocks fit into policy deliberations will improve transparency.
- Coordination with fiscal and climate policy: Monetary policy alone cannot achieve decarbonization. Central banks should work closely with governments so that, for example, predictable carbon pricing is communicated in policy guidance, or banks’ green financing initiatives complement public investments. International cooperation (NGFS, FSB, IMF) should harmonize approaches to prevent regulatory arbitrage.
- Promote green finance stability: Central banks can encourage financial markets to fund sustainable projects through collateral and asset purchase rules. For instance, giving preference (via lower haircuts) to green bonds or permitting a wider set of green assets as collateral. They can also develop green bond indexes for reserve management. However, such measures should be carefully calibrated to avoid market distortions.
- Develop capacity: Invest in training central bank staff on climate economics and data analysis. Collaborate with academic and international research institutes to improve climate risk models. Establish dedicated units (as many already have) to stay abreast of climate-finance developments.
- Monitor systemic links: As crypto and digital finance grow (see below), central banks should watch for climate implications (e.g. Bitcoin mining’s energy use) but focus primarily on financial risks.
- Global leadership: Continue high-level dialogue through multilateral forums. The NGFS’s 145 members illustrate consensus on climate as a core concern. Altogether, these steps will help central banks fulfill their stability mandates in a warming world, complementing – not replacing – broader climate policy.
