What Is Green Credit Guidance?

Central banks are a key institutional locus of state involvement in the management and maintenance of private economic activity. They are crucial to the workings of private credit creation and allocation. As such, they have direct and indirect powers to shape the allocation of credit, which in turn affects real capital and infrastructure investment. Decarbonisation is an issue of investment and divestment in the real economy — where financing conditions play an operative role in investment and divestment decision-making. Therefore, shaping the financing conditions of decarbonisation related investments and divestments is crucial for creating the economic conditions for decarbonisation.  

More broadly, investment and divestment patterns shape price stability. Inflation is best thought of as the frictions that are sparked by unharmonised shifts in the composition of supply and demand in the real economy, which lead to distributional and coordination struggles. Therefore, proactive management of investment in critical sectors, such as electricity, is a key vector for supporting price stability. Central banks have historically supported price stability and the balance of payments by curbing credit allocation to certain sectors to manage the allocation of demand, real resources and currency in the real economy.^[1] Central banks have historically, in the case of, for instance, the ECB, and presently, in the case of the People’s Bank of China (PBoC), used their credit steering powers to support national industrial policies.  

Green credit guidance refers to a set of regulatory or policy-driven measures by which central banks or financial regulators can encourage or mandate private financial institutions to increase credit flows towards sectors critical to decarbonisation, such as renewable energy and attendant supply chains. Central banks may also directly allocate credit.  Many G20 central banks have begun to implement green credit guidance policies. Most notably, the People’s Bank of China has directly facilitated large-scale green investment through the Carbon Emission Reduction Facility (CERF) which has supported state-owned enterprises and private companies in China expand investment.

Green Credit Guidance mechanisms include:

• Quantitative targets for green lending:
  
  • Central banks can mandate that financial institutions meet lending quotas for targeted sectors.
• Preferential capital requirements for green loans:
  
  • Central banks regularly impose capital requirements on financial institutions. These requirements make financial institutions hold a certain level of capital relative to their assets and risk profile. This is meant to prevent bank failures by mandating a capital buffer to absorb potential loses. Higher capital requirements tighten lending. Central banks can therefore give preferential capital requirements for decarbonisation related lending, which serves as an inducement to provide credit. Similarly, central banks can penalise lending to fossil fuel related sectors by increasing capital requirements.
• Adjusted collateral frameworks favouring green assets:
  
  • Central bank collateral frameworks play a powerful role in contemporary financial systems, where non-bank financial institutions use financial assets as collateral in the process of shadow-money creation. Traditional banks create money by extending blocks of credit to businesses in the form of loans. Non-bank financial institutions can extend credit and create money used within the financial system by trading financial assets. A classic example of this is a “repo transaction”: a financial actor sells an asset to a counterparty and agrees to repurchase the asset from them later often at a slightly higher price; this transaction furnishes the original seller of the asset with credit and the buyer with a form of interest. This transaction is dependent on the value and liquidity of the asset being traded.
  • Central banks often provide liquidity support to actors in the financial system in exchange for collateral assets. Therefore, inclusion or exclusion of assets from central bank collateral frameworks which govern what assets they will accept as collateral has an effect on the liquidity and value of assets and the financing conditions for real economy actors.  
    
    • Central banks can guide credit to decarbonisation activity by shaping their collateral frameworks to prefer green assets and exclude carbon related assets.
• Green bond purchase programmes under central bank balance sheets:
  
  • Central banks purchase bonds as part of their open market operations, with the aim of injecting liquidity and to backstop particular markets. For example, through quantitative easing, central banks purchased primarily government bonds to provide financial market liquidity, lower interest rates and stimulate real economy investment. As with collateral framework policies, the bond purchase programmes of central banks play a powerful role in contemporary market-based financial systems, as their purchases affect the liquidity of certain assets which shapes the ability of financial actors to use such assets to extend credit in the process of shadow money creation. Central banks can directly purchase bonds related to decarbonisation activity and exclude that of carbon intensive activities.
• Direct credit allocation:
  
  • The policies listed so far are indirect tools. Central banks also have the direct capacity to create money and allocate credit to financial institutions or real economy actors (both public and private).).

Why is Green Credit Guidance an Important Tool?

Decarbonisation requires large-scale, directed investment

Decarbonisation is a problem of investment and economic coordination. It entails rapidly transforming global infrastructure stocks through twin programmes of investment and divestment, ensuring real asset by real asset that the new system is built and the old system is wound down. Such investment and divestment may defy conventional considerations of profitability. And importantly, investments and divestments must be carefully sequenced and coordinated to prevent breakdowns in the ongoing operation of critical infrastructure systems and production and consumption networks. Private investment is ill-suited to this task, as private markets will underinvest due to the liquidity preference (John Maynard Keynes’ term which captures the preference of private capital to refrain from fixed capital investments in the face of uncertainty). Moreover, renewables are highly sensitive to interest rates and other financing conditions. Therefore, green credit guidance can be a critical tool to support a positive financing environment alongside other key policies to drive investment in decarbonisation activity.

Conventional monetary policy is less effective in climate contexts

Decarbonisation and building socioeconomic resilience to climate-induced supply shocks necessitate a new paradigm of public macroeconomic planning and inflation management. Current macrofinancial arrangements in the US, EU and UK are centred around central banks as the primary public macroeconomic planning authority and rely on their wielding of interest rate hikes in the face of inflation. This blunt tool aims to curb inflation by inducing macroeconomic contraction. In the context of decarbonisation, this will simply stunt the transition. Moreover, this paradigm is unable to drive or manage the inflationary structural changes in the composition of supply and demand that both decarbonisation and climate-induced supply shocks will entail.

Interest rate hikes as a tool for dissipating inflation address only the demand side and do so in aggregate, by inducing a macroeconomic contraction. A central bank will raise interest rates to cull demand for private credit and, with it, depress real economy investment, capacity utilisation, employment and macroeconomic growth. Although rate increases need not affect public investment for most developed countries, as their central banks can engage in monetary financing, they can rhetorically be used to support austerity. In this sense, the central bank currently serves as the primary public macroeconomic planning authority, setting limits to the level of investment, employment, output and macroeconomic activity broadly.

Green credit guidance allows for a more targeted approach to sectoral reallocation of supply and demand in the face of inflation, in comparison to central banks raising interest rates. This will be important to smooth the sectoral reallocations that decarbonisation entails. Furthermore, supply-side climate disruptions (e.g. energy price spikes, crop failures) pose a structural inflation risk because they affect supply of key goods and services. For example, climate destabilisation already threatens to make coffee more expensive.^[2] Likewise, climate change stands to affect generalised growth and financial stability. GCG can help build resilience by financing domestic renewable energy and resource-efficient infrastructure, which reduces long-term inflation volatility.

Overview of Green Credit Guidance in Transatlantic Context

United States (Federal Reserve)

In recent years, the Federal Reserve, has taken very minor steps in incorporating climate considerations into its operations, primarily through scenario analysis. However, it has not implemented any direct or indirect credit steering policies. Although President Trump’s administration is likely hostile to such a development, in general the Federal Reserve has wide institutional scope to develop its operations to support green investment. This should be a critical pillar of policy thinking and development looking beyond the duration of the current administration. Green credit guidance could complement programmes like the Inflation Reduction Act by supporting green industrial policy with monetary tools.

United Kingdom (Bank of England)

The Bank of England’s remit explicitly includes environmental sustainability, and it has already begun to integrate climate considerations into its asset purchases and stress testing. However, these are indirect tools. Implementing direct green credit guidance policies such as targets and credit provision would support the UK’s net zero strategy, green industrial policy goals and reduce energy-import-induced inflation.

Conclusion: Green Credit Guidance — A Critical Tool

Green credit guidance is pragmatic and essential to meet the most salient economic policy challenges we face today: decarbonisation and inflation management. It is a critical tool that central banks can yield to simultaneously support financial stability, price stability and decarbonisation goals in a period of global economic flux and reordering.

Developing green credit guidance policies and frameworks would expand the policy reach of central banks. This is an organic evolution as central banks have expanded their policy toolkits and remits in recent decades and will have to continue to do so in the face of the twinned challenge of decarbonisation and continuing to support economic stability in the face of locked in climate destabilisation. There is a suite of potential tools central banks could employ towards developing such a green credit guidance framework, of which direct credit allocation is the strongest. Failure to employ such tools and failure to build a robust green credit guidance policy framework would leave central banks vulnerable in the face of the economic turbulence and price frictions that we know will define the future of the economy they are mandated to govern and support. Building robust green credit guidance frameworks in the years ahead is the measure of pragmatic and responsible central banking practice.