Economic policy and climate change: Current practices and challenges for the ECB

Climate change is a global challenge and demands an active climate policy combining private and public agents as well as different policy instruments. Central Banks have been called to take action, but there is still a controversy if climate mitigation should be a monetary policy mandate. Conventional economic models, such as those incorporating the Taylor Rule, do not account for climate challenges. However, there is a mounting consensus that climate change might affect monetary policy effectiveness. In practice, Central Banks are already mobilized, actively implementing a climate agenda. For instance, the European Central Bank has explicitly emphasized its concern with climate threats and has already implemented climate risk measurement tools, along with enhanced management of fossil fuel asset portfolios. To study the impact of CB climate-related tool on the real economy, we present a stylized business cycle model aimed at capturing the interactions over the cycle between CO_2 emissions, output, as well as green and brown investment. We simulate the effect of higher interest rates as well as of a reduction in green capital requirements. We find that higher interest rates might delay the shift towards green investment, while reducing green capital requirements can accelerate the transition. Accelerating the transition can protect economies from climate risks. However, side effects such as financial risks and inflation should be taken into account for policy-decision making.