Governor Erkki Liikanen
High-level Seminar of the EMEAP and the Euro Area
Banca d'Italia, Rome
Climate change and its implications for central banks
1 General
Climate change has fast become a major challenge of our time. It is beginning to have a serious impact on our environment and economic development.
As such, climate change is not something new: since the dawn of time the earth has experienced both hot and cold ages and rainy and dry phases. What is new, however, is that the present period of climate change is mainly the result of the human impact on our environment.
The scientific community still holds various opinions about the causes of climate change. But there is a growing convergence of views on two issues:
First, we know that the earth is warming. Moreover, global warming appears to be progressing faster than previously thought.
Second, we know that the atmosphere is getting more humid as higher temperatures lead to more evaporation from both the land and the oceans. Moreover, observations and modelling confirm that rain is tending to come in fewer and more intense events, with longer dry spells in between. These two factors together imply that droughts, floods and storms become more frequent and more intense.
For the economy, an important factor that is broadly agreed on, is a permanent increase in the price of energy.
Actually, the real price of energy never was as cheap as we may have thought. The price of energy has been low because we have not priced in the cost of the negative externality from the use of fossil fuels and have sent the bill to future generations. From now on, the price of energy will necessarily be higher, as more of it will be produced from alternative sources of energy, and the prices of fossil fuels will rise due to environmental taxes and more stringent pollution control regulations.
2 Economic impacts of climate change
Climate change affects economic development in at least three different ways. A lot of attention has been devoted to the wealth impacts of climate change: the destruction of physical wealth and productive capital as a consequence of drought, floods and storms. In addition to the destruction of physical capital, climate change also undermines the productive capacity of the economy by making it harder to access natural resources. The most striking example of this is access to water, which has become a serious problem in many countries facing the spread of drought and desertification. On the other hand, there is a growing need for new infrastructure investments due to these changes.
In addition to its wealth impacts, climate change can also have a significant negative impact on economic growth through increased uncertainty, and hence higher risk premia.
The increased uncertainty is not due solely to the direct dramatic shocks of climate change (storms, increased fluctuations in weather conditions, etc). There is also uncertainty over how consumers and economic policy will respond to changes in climate (changing patterns of consumption, taxation, emission controls, etc).
It is possible that the present high prices of oil and other energy sources already include a climate change-related risk premium. It reflects uncertainty over how climate change will affect the availability of different sources of energy and the sort of policy measures that will be directed at their supply and pricing as a consequence of climate change.
Thus, the real message of climate change is that it signals a lowering in the potential growth rate of the world economy. Man-made climate change is a symptom of the world economy testing the limits of material growth. Certainly, this can be partly compensated for by structural change, ie by increasing the share of immaterial goods and services in world GDP.
This is already taking place, especially in the technologically advanced countries, but no country, not even the poorest, can any longer aspire to the so-called “extensive” growth. Despite the possibilities for structural change, the inevitable effect of higher energy prices and of emission control policies is to slow the growth of the world economy to some extent.
3 Emissions trading
Tradable emission quotas are a market-based way to speed up structural adjustment, to lower and hopefully sustainable levels of pollution. The idea behind the scheme is that, in principle, such market-based methods should minimize the negative growth impact of reducing pollution.
The development of emissions trading has increased the role of the financial markets considerably in the practical implementation of economic policy measures designed to moderate climate change. During the last four years, trading in carbon dioxide emission quotas has become one of the fastest-growing financial market segments, with large investment banks and a whole range of smaller institutions competing to enter it.
According to estimates by the World Bank, the value of emissions trading rose to approximately 64 billion dollars last year (twice as much as in 2006). By far the largest emissions trading mechanism, in terms of both participants and number of trades, is the European Union Emission Trading Scheme for greenhouse gases. Its value rose to around 50 billion dollars last year. The biggest market development in 2007 and 2008 was the emergence of the secondary market for carbon contracts.
The future of the emissions trading will depend on political decisions: how new countries adopt emissions trading, and how tightly they set their national emissions limits and targets. However, the market is likely to develop rapidly. The boldest estimates suggest that emissions trading could reach 1,000 billion dollars within the space of ten years, making it the world's largest commodity market.
This new growth segment of financial markets adds to the already challenging complexity of markets. Consequently, regulators must pay attention to the financial and legal risks faced by market participants in this important area.
The implementation and tightening of emission quotas will, if done on a world scale, limit the demand for fossil fuels and thereby slow down the rise in their prices. However, they also raise the user-prices of fossil fuels and emission-intensive goods relative to prices of other goods and services. While this is an intended consequence, it also creates a challenge for central banks. For example, if it leads to a sustained wedge between the headline and core inflation rates, central banks focusing on core inflation may have great difficulties in firmly anchoring inflation expectations.
4 Observed and perceived inflation
The recent IMF issues paper points out that a sustained increase in food and energy prices could open a persistent gap between headline and core inflation. Furthermore, increases in energy and food prices may create a gap between measured and perceived inflation. Modern behavioural economics postulates that consumers' inflation perceptions are influenced more by experiences with frequently purchased products, such as gasoline and food prices. Moreover, the theory claims that price increases influence inflation perceptions more than price decreases. These two factors imply that perceived inflation may turn out to be substantially higher than measured inflation at times of specific price shocks.
The euro cash changeover is an often cited episode in which this phenomenon was important, and a significant gap emerged between measured and perceived inflation. It is worrisome that, in the euro area, a similar gap emerged in 2007 when fuel and food price inflation started to accelerate. From a monetary policy point of view, the increase in perceived inflation during the euro cash changeover was much easier to manage than in the present case, as the cash changeover was a one-off event and global deflationary forces then reduced price pressures.
The wedge between measured and perceived inflation further strengthens the argument that central banks need to be careful to avoid second-round effects from persistent relative price changes. This is a challenge to monetary policy and to communication. The central banks need to monitor this closely.
5 Exchange rate flexibility
As suggested in the background paper by the IMF staff, central banks would benefit from improved understanding of the role of monetary and exchange rate regimes in an economy's adjustment to climate change.
Standard arguments would imply that exchange rate flexibility helps an economy to adjust to real shocks. Faced by adverse consequences of climate change (windstorms, long-lasting draught etc.), depreciation of the currency in a flexible rate regime can increase the domestic price of exports, helping to offset the effects of an adverse shock. Higher price levels can also reduce real wages, hastening the adjustment process. Conversely, in the case of a positive real shock, currency appreciation offsets the upward pressure on domestic prices.
Even more important than the direct price effect on imports and exports is the fact that a flexible exchange rate gives the monetary authority room to manoeuvre, to offset the effects of the shock via the appropriate interest rate policy. In a fixed exchange rate regime, a commodity exporter facing rising export prices must accumulate reserves in order to maintain the exchange rate peg, which fuels monetary expansion and price increases in the domestic economy. If climate change renders commodity prices even more volatile than before, exchange rate flexibility may become more important in the context of adjustment to climate change.
6 The role of policy measures
Climate change and energy price increases have shaken the global balance of supply and demand for food. The world is waiting for food production to expand in response to higher prices. If this does not happen, the imbalance between supply and demand may get worse, hurting the world’s poor, who will be able to afford even less food than before.
A number of emerging market and developing countries have been facing growing public dissatisfaction about the rise in domestic food prices. Some governments in the food exporting countries have responded by implementing administrative measures aimed at stabilizing food prices domestically. These measures include the introduction or extension of price subsidies and price controls, increases in export tariffs and restrictions or complete export bans for certain foodstuffs.
The introduction of export tariffs or export restrictions is worrisome because these can further restrain global supplies of those items. By prolonging the global state of excess demand, this has raised international food prices and, consequently, put further pressure on monetary policy to counteract the rise in foodstuff prices, to prevent second-round effects.
7 Climate change and investment
The long-term risks to the environment are increasingly reflected in the financial markets. At the same time questions have been raised about how the financial markets could help to combat climate change and help societies to adjust.
Climate change also touches the financial markets in many other ways. The long-term risks of environmental factors and living conditions affect the creditworthiness of economic agents and market prices. After all, the prices of financial assets and contracts should account for the expected economic trends and related risks. For example, the review period for the pricing of insurance contracts, shares and long-term liabilities is so long that long-term environmental risks, too, are becoming a highly significant factor.
The basic function of the financial markets is to channel finance from savers to investors. The pricing and allocation of funds on the market depend on the expected yields and risks of investment. The gathering pace of climate change has focused attention on the need to direct energy investments increasingly into renewable sources of energy such as solar, bio and wind power.
For investors, however, the early phase of renewable energy production involves considerable risks. Production facilities are often small in comparison to those using traditional energy sources. At the same time, the technology is often new, and, although it is developing rapidly, there is a lack of long-term experience of its use. Another significant risk for the investor derives from the fact that the profitability of renewable energy sources is highly dependent on the price of traditional energy sources, such as oil.
For these reasons it is understandable that the public sector has a considerable role to play in financing renewable-based energy production, particularly in the area of product development. This situation is, however, rapidly changing. Recent years have seen rapid growth in investment in renewable energy, and we have now reached a level of critical mass such that private investors have also 'discovered' this new sector.
The United Nations Environment Programme (UNEP) has estimated that worldwide investment in renewable energy last year topped 117 billion dollars, an increase of 41 % over 2006 and a 400 % increase from 2004. This has been accompanied by a substantial diversification in the forms of financing this investment. Alongside traditional government support of investment and product development, there has arisen a diverse range of forms of private finance. Of these, the most rapidly growing in recent years have been private capital investment and equity investment – either directly or via the stock exchange – in companies generating energy from renewable sources.
8 Monetary policy responses
As the complexity and length of the transmission process make it impossible for monetary policy to offset unanticipated shocks to the price level (eg changes in commodity prices), some short-term volatility in inflation is unavoidable. For this reason, the ECB's monetary policy has a medium-term orientation, in order to avoid introducing unnecessary volatility into the real economy. Similar reasoning also implies that the central bank should not react to temporary increases in the price level, induced for instance by higher commodity prices, unless they are reflected in inflation expectations and generate second-round effects in other costs and prices.
As discussed above, there are many reasons to believe that this time we are experiencing a longer lasting increase in real commodity and food prices. As food and energy represent on average 30 percent of the consumption basket in the euro area, this implies that headline inflation will stay above the ECB's inflation target for an extended period. This is exactly what has happened recently. How should monetary policy respond to such a permanent shock in relative prices?
According to its strategy, the ECB is committed to keep the rate of price increase below but close to 2 percent over the medium term. Given the weight of food and energy in the consumption basket in the euro area, inflation in other goods and service prices would have to be pushed substantially below 2 per cent to compensate for accelerated price increases in food and energy products.
The situation today is even more challenging for monetary policy, when global disinflationary effects stemming from emerging market competition in the non-energy industrial goods sector have come to an end as inflation in emerging countries has picked up. What other options could be considered? As the financial market is still in turmoil and leading economic indicators for the euro area have turned lower, some commentators have claimed that the ECB should put more weight on the output (or unemployment) gap in its monetary policy strategy.
Careful research by Athanasios Orphanides and others has clearly shown the risks of such an approach, which relies on overambitious stabilization targets and an overoptimistic view of our understanding of the state of the economy. This research demonstrates that if policy-makers mistakenly adopt policies which presume that we know how close we are to the production potential of the economy, we are prone to induce instability in both inflation and economic activity.
The experience from the 1960s and 1970s, when the industrial world simultaneously faced an increase in inflation and stagnation of economic activity, strongly supports this conclusion. That adverse outcome resulted from a failure to see how much the energy crisis of the 1970s had in fact reduced the productive potential of the industrial countries. For some time, monetary policy in many countries was aimed at maintaining levels of activity which turned out to be unsustainable.
Another option which is sometimes suggested is an upward revision in the inflation target to accommodate higher imported inflation, which cannot be controlled by the central bank. Or that we should, in principle, consider an even more elaborate inflation target which would be periodically revised - upwards or downwards - based on the rate of inflation in imported goods.
In both cases, monetary policy could easily compromise one of its main goals – to firmly anchor inflation expectations. An upward shift in the inflation target would immediately raise inflation expectations and, moreover, markets would add an extra premium into inflation expectations to hedge against a similar move in the future. A shifting inflation target would hardly provide an anchor for expectations, as the market would always be guessing on the next change in the target.
In all, the alternatives are clearly inferior to the established strategy of the ECB, to maintain inflation rates below but close to 2 percent over the medium term. The strength of this strategy is that it provides a clear and fixed anchor for inflation expectations which is robust to short-run and even longer run shocks to the economy.
Furthermore, this strategy provides a clear yardstick for the central bank to ascertain what policy stance is needed today to maintain price stability in the future. If the assessment indicates that inflation will not return to the target without action in the medium term, the central bank must ultimately act.
Given the large and persistent external price shock which the euro area is facing today, one cannot assume that monetary policy could somehow help our economies to evade the inevitable. Economies must in fact face the increased energy bill, the cost of adjusting to a cleaner and more sustainable structure of production. This cost is real and must be paid whatever monetary policy is followed. Even with monetary policy being responsible for keeping economic activity within the bounds of what is possible, the energy bill or the environmental bill are not caused by monetary policy. And experience shows that if inflation is allowed to creep up and this induces an upward shift in inflation expectations, it will be costly to bring it down later.