Member of the Board Tuomas Välimäki
A monetary policy approach to Green Growth
Green Growth Forum
Lahti and online, 14 September 2021
Presentation slides (pdf)

A monetary policy approach to Green Growth

It is a pleasure to be here today in Lahti, this year’s European Green Capital, to give a talk on issues related to Green Growth and Climate Change. I would like to thank Erkki Liikanen, the Chair of this session, as well as the organizers for this excellent conference. You have been able to put up an excellent programme, even though the pandemic still continues to complicate arrangements of these kinds of events.

Earlier this morning, Sirpa Pietikäinen clarified for us the essence of climate-related taxonomy and standards, and emphasized their role for green growth. Philipp Hildebrand illustrated for us how sustainable investment strategies should be implemented, and how Environmental, Social and Governance related risks are best managed by large investors.  I will now take you through the green growth and climate change from a central banker’s perspective.

[Slide 2] The Climate Change report by the Intergovernmental Panel on Climate Change, IPCC, painted a gloomy picture in front of us last month. In qualitative terms, the main messages were similar to those in the 2013 report. Yet, it seems we have even less time, and the new report now gives us more precise estimates of the developments and also a more detailed regional assessment. As laid out in the report, the latest evidence and scientific understanding on the progress of the climate crisis urges us to take swift actions against global warming.

The consensus among climate experts seems to be emerging with more accurate estimates on how climate change is affecting biodiversity, crops and weather patterns, to name just a few of the adverse outcomes. And this will impact us all in many respects: the way we build infrastructure and housing, how we plan future investments as well as how the financial market participants look at risks and opportunities.

The potential consequences of a late response to the developments are much more dramatic than we thought possible a few years ago.

[Slide 3] The responsibility for the main economic policy actions against the climate change clearly rests with the governments. They have the most suitable and effective instruments to this end: taxation, subsidies, and the right to impose restrictions and obligations.

However, we all have a responsibility for global issues like climate change. Global warming impacts us all; so everyone should contribute to meeting the challenge. None of us should be playing blame games here; we should all be seeking for solutions.

There are still differing views on the role of central banks when it comes to climate matters, but attitudes seem to be evolving rapidly. A growing number of central banks are openly participating on this frontier and announcing policies that take climate change into account in their actions.

Based on our mandate, our response to climate change can take several avenues, depending on our different roles as monetary policy-maker, guardian of financial stability as well as a real money investor. 

When it comes to monetary policy we, Suomen Pankki – the Bank of Finland, are part of the Eurosystem. That is, the actions taken by the ECB are also our actions. The emphasis on climate considerations in monetary policy have substantially increased in recent years. Most notably, aspects related to climate change were formally included in the ECB strategy review concluded this July. I’ll return to this in a minute.

Concerning the management of our foreign reserves and euro-denominated investment policies, we at the Bank of Finland have tried to be early movers on climate-related issues among our peer institutions. This has meant designing our responsible investment policy, adopting the UN-backed Principles for Responsible Investment as the second central bank in the world, and most recently, setting of a comprehensive climate target for our own investments. As a matter of fact, we are today announcing a carbon neutrality target for all our investments, and, to my knowledge, we are the first central bank to do so.

[Slide 4] Climate change in central banking

Let me spend a minute on motivating climate change as an issue for the monetary policy maker.

Climate change affects the macroeconomy. This includes impacts on employment, investments, productivity, interest rates and prices.

Like most modern central banks, our primary objective is to maintain price stability. A phenomenon that affects productivity, level of uncertainty in the economy and pricing of risk by the financial markets, is likely to impact equilibrium real rate of interest, prices and wages; hence, it clearly falls under the remits of our primary mandate. That is, climate change will feed directly into our policy activities.

Furthermore, our Statute states that if and when we (the Eurosystem) can, without prejudice to price stability, support other general economic policy goals set by the European Union, we should seek to do so. As we heard from Sirpa Pietikäinen earlier this morning, climate policies have clearly been given high priority by the European policymakers. The European Green Deal published in December 2019 set the target of climate neutrality in the EU by the year 2050, and this objective was confirmed this summer by the European Council in adopting the European climate law.

[Slide 5] Price stability

As we exist to ensure price stability, price implications stemming from both climate change and policies addressing it, are the main driver of our interest in climate issues.

There are many ways in which climate change may impact prices. For example, an increase in the frequency of extreme weather events may raise insurance premia and other costs of preparedness, e.g. on construction sites. More frequent droughts and floods, as well as higher global average temperatures may increase food prices, for instance. Also, increasing price of carbon and the technological innovations needed for less carbon-intense production may add costs, at least initially. For example, producing cleaner steel costs currently up to 30% more than using traditional production techniques.[1] If and when these kinds of developments start feeding into the expectations of households and businesses, they may start impacting on the outlook for inflation, which consequently may call for a reaction from the monetary policy maker.

The transition to a low-carbon economy will also require policies that result in changes to relative prices to make low-emission alternatives more attractive than the more polluting ones. Environmental taxes, emissions trading and subsidies can bring about such changes. The impact of all climate-related changes on price stability will depend substantially on the smoothness of the transition. The earlier one starts addressing the climate change, the less abrupt policy changes will be called for.

Monetary policy is best suited for addressing demand shocks, as they tend to be associated with so called divine coincidence. That is, a positive demand shock increases both output and inflation, whereas a negative shock reduces them both. The monetary policy response is rather straight forward: when facing a negative demand shock, one counters it by providing the economy with more monetary policy stimulus. Similarly, in case of a positive demand shock that overheats the economy, tighter monetary policy is called for.

Things get more complicated when the economy faces a supply shock. In these cases, the output and inflation tend to move into opposite directions, and the policy maker needs to trade off between stabilizing inflation vs stabilizing output. In this case, the optimal monetary policy response is likely to be dependent on the duration of the shock.

Climate change is likely to increase the frequency of supply shocks – e.g. following extreme weather events. This impedes the making of monetary policy, as the central banks will be facing more challenging identification problems: is the shock we are facing mostly a demand or a supply shock, are its effects likely to be temporary, persistent or even permanent?   

[Slide 6] Equilibrium real rate

Let me now turn to the concept of equilibrium real interest rate, also known as the natural rate, i.e. the imputed interest rate that balances the economy at maximum output and constant inflation. At the central banks, we are also concerned about the risk that climate change could lower productivity, and that the increased uncertainty could reduce willingness to invest. This could cause a downward pressure on the equilibrium real interest rate.

Over the past few decades, we have evidenced a significant drop in the equilibrium real rate, following population aging and lower productivity growth in developed economies as well as increased global saving in emerging market countries including China. This has reduced considerably the leeway for interest rate policies to boost the economy and prices in severe downturns. We cannot simply push nominal interest rates heavily into negative territory, as otherwise the holding of cash would become profitable, mitigating incentives for the real investments that keep the economy going. So, the lower the equilibrium real rate of interest is, the less we can cut our policy rates and ease financing conditions before we hit the lower bound for the nominal rates.

This phenomenon, often called the effective lower bound in economics, was one of the key drivers behind the ECB’s recent strategy review. We would certainly dislike developments that would further narrow down our room for manoeuvre.

Yet, the jury is still out on the long-term impact on productivity growth of climate change and policies to address it. The shift to a low carbon economy is likely to call for massive investments in new carbon-free technology, which in turn could bring about new innovations with countering effects on productivity and the equilibrium rate.

Normally, we tend to think that investments and innovations improve productivity, better technologies drive out older, less productive technologies. However, with climate change policies, we may need a disruption that kills old industries that are polluting, even though they could otherwise at least in the short term, be more efficient than the new technologies. Instead of creative destruction, one would be closer to the phenomenon of destructive creation – which would still be a necessity for sustainability reasons. One indication of this phenomenon is the large subsidies that are often needed to make more environmentally friendly products more attractive to consumers (taxation of electric cars in Finland to give you an example).

We clearly need much more research to better understand all these interactions. The only thing that is certain, is that climate change and policies to address it will impact monetary policy in the future.

[Slide 7] Financial market stability

Now, I believe we all agree that a lot of investment is needed to change the structure of the economy towards lower carbon intensity. This calls for financing opportunities. So, a well-functioning financial market that prices risks correctly is a prerequisite for companies to receive sufficient funding for energy efficient investments in low carbon sectors as well as supporting green innovations in carbon-intensive sectors, i.e. simply managing Green Growth.

By ensuring price stability, we can reduce uncertainty, maintain risk premia that would otherwise be higher, and thus facilitate financing conditions that support investment and good economic developments. To this end, we also need to promote financial stability.

Climate change may increase disruption to banks' operations. Climate change itself or the transition to a low carbon economy could hit certain regions and industries hard, causing collateral values to fall and credit losses for banks. Insurance companies, for their part, are likely to face new types of insurance risks.

It is important to understand the risks posed by climate change and the transition process. Central banks, and financial market supervisors in particular, can play a role in identifying and mitigating these risks. The ECB is currently conducting and developing climate stress tests in which these phenomena will be assessed using a large body of data.

Furthermore, global central banks and supervisors have organized themselves around an important climate network, the Network for Greening the Financial System, NGFS. It is one of the key forums where climate risk analysis methods are currently being developed. The Bank of Finland has been a member of the network almost since its establishment and we have also been active in its work related to identifying best practices in greening the central banks’ own portfolio management and disclosure.

[Slide 8] Transition to a low carbon economy and supporting green growth

In addition to taking care of price stability and contributing to financial stability, central banks may facilitate the funding of low carbon activities also more directly. Currently, investors are facing difficulties when assessing their investments’ environmental impacts. To address this, the EU has set up a sustainable financial rating system (taxonomy) that defines which economic activities are sustainable.

Investors need taxonomy, coherent data and disclosures. This is also crucial for central banks; we need to be able to base our policies on objective criteria against which we can assess data that is reliable and can be easily accessed.

Central banks can also fund less carbon-intensive activities directly as well as through banks and other financial institutions.

One can provide support to green growth via the monetary policy asset purchase programs that are currently being conducted by almost all major central banks. Yet, it is not unproblematic, monetary policy normally needs to remain market neutral and be based on objective criteria. That is, monetary policy makers normally try to avoid making price distortions to the market. However, as the climate change is associated with externalities that are not necessarily correctly priced, some people argue that policy makers should try to address the existing price distortion by direct purchases.

Furthermore, buying assets in line with market capitalization is not always seen climate neutral, as normally carbon-intense large industries are more relying on capital markets than e.g. less intense services sectors. Maybe we at the central banks need to consider soon whether market neutrality can be replaced by other types of market efficiency principles.

Yet, one needs to acknowledge that many central banks have already been investing significantly in green bonds. The Eurosystem has bought a considerable share of the market of green bonds under the Corporate Sector Purchase Programme. And we at the Bank of Finland have also allocated a significant portion of our investment portfolios to green assets including thematic asset holdings exceeding 500 million dollars.

As it comes to analytical capabilities, green growth also requires a great deal of information and understanding of climate change related issues. We at the central banks try to support green growth also by providing increasing number of high-quality research analysis on the impact of climate change and the transition to low carbon economy.

Issues related to climate change in the ECB strategy review - action plan with road map[2]

The outcome of the ECB’s monetary policy strategy review was published in July this year.  Whereas the main focus of the new strategy was on the definition of price stability and the ways and means the Eurosystem uses to achieve it, one of the key issues raised in the review related to climate change.

To emphasize the fact that price stability is the number one priority for the ECB, I need to recall that according to our primary objective we now aim at having annual inflation at 2% over the medium term. This target is symmetric, meaning negative and positive deviations of inflation from the target are equally undesirable.

Previously, our target was defined as inflation being close to, but below 2%, which was somewhat ambiguous and asymmetric. The new formulation should instead provide the markets and general public with a clear focal point at 2% for their inflation expectations. The more so as the ECB’s Governing Council indicated in its strategy statement that it will take the effect of the lower bound on interest rates into account going forward; i.e. when the economy is close to the lower bound for interest rates, forceful and persistent monetary policy measures are needed to avoid negative deviations from the inflation target becoming entrenched. This may imply inflation moderately and temporarily exceeding the medium-term target of 2%.

The new definition, symmetric 2% inflation, also allows somewhat more room for relative price changes in a world that is characterised by downward rigidities in nominal prices. Hence, our new definition for price stability should also smoothen out the way for the relative price changes needed for green transition.  

[Slide 9] Now, in the renewed strategy, the ECB also introduced an ambitious, yet a realistic action plan to incorporate climate considerations into the various parts of our monetary policy activities, including a timeframe to deliver these changes.

Issues related to climate change will in the future feed into our macroeconomic analysis. Furthermore, the monetary policy operational framework will be adjusted to take account of climate change in our risk assessments, collateral policies and in the future purchase programmes.

The action plan includes developing new macroeconomic models that will be based on theoretical and empirical analyses to monitor the implications of climate change (as well as the policies to address it) for the economy, the financial system and the transmission of monetary policy to the real economy, i.e. to the households and firms. Also, new risk indicators will be developed. These are to cover relevant green financial instruments and the carbon footprint of financial institutions, as well as their exposures to climate-related physical risks.

Climate-related disclosure will be required as a new eligibility criterion or as a basis for a differentiated treatment regarding collateral and asset purchases. The requirements are aimed at promoting more consistent disclosure practices on the markets.

Risk assessment capabilities such as climate stress tests and internal ratings to incorporate climate change risks will be boosted. We will start internal climate stress testing covering the balance sheet of the whole Eurosystem in 2022. Further to facilitate our risk management capabilities, the ECB is going to assess whether the credit rating agencies we use when assessing collateral eligibility for monetary policy operations, have disclosed the information necessary for us to understand how they incorporate climate change risks into their ratings.

[Slide 10] Road map

The 19 national central banks of the Eurosystem together with the ECB made a joint decision earlier this year, to report climate risks including the carbon footprints of our non-monetary policy portfolios. At this stage, the homogeneous reporting is to cover euro-denominated investments, although we, the Bank of Finland, have decided to report more extensively than the minimum requirement.

This decision to report comparable climate-related data across the Eurosystem may not sound like a significant move. But one of the main hurdles investors are pointing out is the lack of climate-related data. The issue lies with both the adequate coverage and the reliability of the data. Through this joint decision we are sending a clear signal. We are setting an example for market participants to improve climate reporting and climate data quality, while also highlighting the need for increased transparency.

The procurement for the Eurosystem wide common data provider is on-going. We expect the first results of our climate data to be published in 2022.  Actually, this reporting decision also covers some of our monetary policy portfolios, as the Corporate Sector Purchase Programme will be subject to the same treatment.

Implementation of the action plan

The list of strategy-related actions may sound very long, especially as the time frame is quite ambitious, with everything to be finalised and implemented by 2024. The roadmap tells how the three main milestones are planned to progress from reliable data to knowledge, and finally action.   

I would like to paraphrase what was said at the ECB press conference as ’meaning what we say and doing what we mean’ as a guidance on how the ECB is committed to implement the action plan in the given time frame.

[Slide 11] Bank of Finland climate targets

Let me now turn to the Bank of Finland approach to climate change related issues in our investments. Before talking concretely about our climate targets, it is important to understand why the Bank of Finland has assets that are not directly linked to monetary policy, often referred to as the non-monetary policy portfolios. [Slide 12] Whereas a large part of our balance sheet items, like monetary policy lending to the banks or the public sector asset purchases under the asset purchase programme, are directly related to monetary policy implementation, some other items are more independently managed by the Bank. The latter include foreign reserves and own investment assets, like the pension funds.

The Eurosystem national central banks are financially independent entities that also have several domestic policy responsibilities. Through its investment activities, the Bank of Finland secures the value of its financial assets and its ability to support the liquidity of the banking system, whenever necessary. [Slide 13] The objectives of the Bank of Finland's asset management are security, liquidity, return and now also responsibility. 

Whereas the allocation of monetary policy holdings in the Eurosystem stems directly from the monetary policy needs, the allocation and management of non-monetary policy assets are in the hands of each of the National Central Banks belonging to the system. Therefore, the way we take responsibility into account in our investment policy is in the hands of the Bank of Finland.

[Slide 14] We, the Bank of Finland, are one of the few central banks that have signed the UN-backed Principles for Responsible Investment. Signing these principles shows commitment not just to climate topics, but also to broader sustainability issues. The solid foundation can be seen in our public document on responsible investment principles and in our climate programme. We report climate impacts from our own direct activities, but also elements from the recommendations of the Task Force on Climate-Related Financial Disclosures, TCFD, in respect to our investment activities. We will continue to use these guidelines where relevant in the future, too.

[Slide 15] In addition to the climate programme relating to own activities, the Bank of Finland aims to achieve carbon neutrality in our own investments. According to the very recent decision, actually published right now in this speech, our target is to turn our investment portfolio to a carbon neutral one by 2050 at the latest. The target covers almost all of our own investment assets[3]. This means that we are not just targeting equities, corporate credit and real estate, but also government and government-related entities, in order to achieve carbon neutrality.

Due to the policy goals assigned to our investment portfolios, the holdings in them are very skewed towards government bonds. This comes especially from the high liquidity requirements we have for our foreign reserves. Therefore, we need to honour the pledges individual countries have made to reach carbon neutrality as the target for investments. This also hinders us from being even bolder with our target. When we talk about carbon neutrality in our target, we mean the broad definition also including other Kyoto protocol green-house gas emissions than just carbon dioxide[4].

Once we have set this over encompassing long-term carbon neutrality target, we are also set for pledging ourselves for interim targets that will guide our next steps more concretely. We do not have all the details for these interim targets in place just yet, but they are likely to include exclusion thresholds for fossil fuels and qualitative targets for supranational and externally managed investments as well as emission reduction targets for equity investments. More information on interim targets can be expected from us later this year.

[Slide 16] Concluding remarks

Finally, the central banks in general and the ECB in particular can best promote green growth by ensuring price stability and financial market stability. These are the key factors for balanced growth, and will also best support a controlled transition to a low-carbon economy.

In addition to this, the new measures listed in the ECB’s new strategy will be important ingredients in the quest for favourable financing conditions for investments and innovations that are needed for a cleaner earth.  We will put extra effort into projects that increase and improve climate data and their disclosures by all financial market participants.

The ECB's monetary policy strategy is implemented from a medium-term perspective, but climate change is a long-term issue. In the coming years, lessons will be learned from the climate related actions now decided and they will be re-evaluated in the next review of the strategy in 2025.

Also the Bank of Finland contributes to addressing climate change. The actions we take seek to reduce the transition and tail risks to which the climate crisis may expose our assets. This will ultimately improve the risk/return ratio of our investments. In concrete terms, addressing climate change implies financing less carbon-intence activities, which facilitates our quest for carbon neutrality by 2050 at the latest and being in line with the Paris Agreement.

We at the Bank of Finland will seek to be adaptive to climate-related issues in the future, too – we want to behave responsibly under all circumstances.

Thank you for your attention!


Thank you Principal Responsibility Specialist Anna Hyrske and Senior Economist Seija Parviainen for the background work for this speech!

List of links in the speech

BoF Blog (in Finnish): Ilmastonmuutos on kaikkien aikojen suurin markkinahäiriö 

ECB's website: The ECB’s monetary policy strategy statement 

ECB's website: The ECB’s Detailed roadmap of climate change-related actions 

ECB's Press release: ECB presents action plan to include climate change considerations in its monetary policy strategy 

Bof Bulletin: Recent economic crises have modified the Bank of Finland's market operations 

BoF's website: Bank of Finland’s Responsible Investment Principles 

BoF's Press release: Bank of Finland sets climate target for its investment portfolio – carbon neutrality to be achieved by 2050 at the latest


[1] According to various studies, producing cleaner steel is facing several bottle necks including the price and availability of green hydrogen, significant investments needed to retrofit existing steelmaking capacity and significant investments already made in conventional/traditional facilities rather than retrofits.   

[2] The new Strategy’s predecessor, the 2018 Action Plan (external link ), mainly focussed on growing green investments. ECB has designed a detailed roadmap for incorporating climate considerations across its monetary policy activities, including corportate bond purchases.

[3] Excluding gold holdings in the first phase.

[4] To begin with we will use Scope 1 and 2 emission levels, but we are confident that the calculation methodologies and coverage improves to add scope 3 emissions too.