ECB must step in to tackle fossil- and climate-flation

Faced with record inflation driven by high energy prices, the European Central Bank (ECB) has raised its interest rates to 1.25%, and further hikes are expected in the coming months. Yet, this risks derailing investments in renewable energies and building renovation needed to tackle the crisis at its root, writes Rens van Tilburg.

Rens van Tilburg is an economist and director of the Sustainable Finance Lab at Utrecht University.

With Saudi Arabia following in Russia’s footsteps to squeeze global supplies of oil and gas, “fossilflation” – inflation driven by our dependence on fossil fuels – has reared its ugly head.

While economies around the world are reeling from the price shock, nowhere have the costs of energy gone up as much as in Europe, dependent as it is on the coal, oil and (especially) gas from Russia. Gas prices in Europe are now eight times higher than the ten-year average, with fears over supply shortages for the coming winters threatening further economic disruption.

Inflation in Europe is already at 10%. The European Central Bank (ECB) has increased its interest rates by a record margin of 0.75 percentage points to 1.25%, with further hikes expected as it attempts to quell inflation and restore price stability. The US Federal Reserve and Bank of England have likewise ramped up rates. The threat of a global recession looms.

Yet rising interest rates risk derailing the investments in renewable energies and building renovation that are actually the best protection against two of the drivers of the current inflation: climate change and fossil fuel prices. Perversely, this means central banks’ higher rates could also contribute to higher inflation.

Renewable energies have become much cheaper over recent years. They are now among the cheapest source of energy when looked at over the whole life cycle, with operating expenses close to zero, unlike fossil fuels. They, however, do require higher initial investment costs. Because of this, higher costs of capital have a much larger impact on the price of renewables than on the price of fossil energy. An increase in the cost of capital that would make the cost of gas-fired electricity rise by 8% would increase the cost of electricity from renewable sources by 47% to 60%.

For the EU, this means its climate programmes, such as the ‘Green Deal’, ‘Fit for 55’ and RepowerEU packages aimed at accelerating the energy transition and rapidly reducing greenhouse emissions, are in peril.

So how can the ECB tackle fossil- and climate-flation, and is it within their mandate to do so?

To achieve this, the ECB must turn its asset purchase programme and collateral framework green. This summer, the ECB stated an ambition to do just this. However, the first steps it has announced fall far from this ambition as it will only very lightly shift from fossil to green assets. Instead, the ECB should start by selling the bonds of the most fossil-intensive companies while at the same time doubling down on purchasing the bonds of the green frontrunners.

Taking these steps would be a departure from previous bond-buying rounds, which were heavily weighted towards fossil fuel-intensive sectors at the expense of green energy. Research from the LSE Grantham Institute showed that the ECB’s corporate bond portfolio was twice as fossil intensive as the overall economy. In contrast, renewable energy companies were not represented at all. This meant the ECB was effectively giving a tailwind to the largest polluters by lowering their capital cost while the EU was gearing up to accelerate the energy transition with its wide-ranging ‘Green Deal’ and ‘Fit for 55’ packages.

But more importantly, given banks’ dominant role in the Eurozone economy, the ECB needs to green its refinancing operations. By retooling its Targeted Longer-Term Refinancing Operations (TLTROs) programme to be focused on sustainability objectives, the ECB could incentivise commercial banks to lend more money for green investment while making green borrowing cheaper for households and businesses.

As such, a green TLRO programme can be much smaller than the current programme and would also effectively contribute to the desired monetary tightening. This would boost the energy transition and help propel the European Commission’s Renovation Wave Strategy, slashing the emissions generated by building energy use and helping wean the EU off volatile and expensive fossil fuels.

This, admittedly, is a challenge to convention. Recent consensus has been that central bank decision-making should be independent of politics, purely serving the goal of price stability. Economic textbooks championing free market thinking have taught this generation of decision makers that are focusing on keeping inflation around the 2% target means other goals like full employment and economic progress will be best served.

Yet while price stability is the primary mandate of the ECB, the EU treaty clearly stipulates that the ECB is obliged to support the economic policies of the Union if it is possible to do so without hurting price stability.

Central banks stepping in to set the economy’s direction is nothing new. These institutions have a long and rich history of helping their societies rise to the occasion by making what is necessary financeable.

For example, one of the oldest central banks, the Bank of England, was founded in 1694 to help fund the Nine Years War with France (1688–1697). Monetary financing was also used by the American colonists in their war of independence of 1775-1783 through the so-called Continentals, zero-coupon bonds. President Roosevelt’s New Deal was partially financed by the Federal Reserve through the Reconstruction Finance Corporation.

More recently, we have seen central banks worldwide doing everything they can to prevent the Covid pandemic from turning into a full-blown economic crisis, echoing the vigour we saw after the 2008 subprime mortgage crisis and during the Eurozone crisis of 2012.

The ECB wouldn’t be alone in taking steps to green its operations – there are plenty of global precedents. In China and Japan, banks can now access cheap refinancing from their central bank for green lending, and in the UK, the Bank of England has tilted its asset purchase programme towards the less fossil-intensive bonds.

Climate change is as clear and a present danger as any historically faced by central banks. Accelerating the energy transition is the most effective way to prevent further price destabilisation from both climate change and our dependence on volatile fossil fuels, and provides a clear win-win. The ECB should grasp the opportunity to shield the Eurozone from further climateflation and fossilflation.