Central Bank Collateral as an Instrument for Climate Mitigation

Central banks can provide vital support in the transition towards a climate-neutral economy because they are largely independent authorities of the monetary systems and therefore have unique capabilities and policy options unavailable to governments. This paper discusses potential green monetary policy instruments to identify the most appropriate ones to be used to support the transition process. We identify adding collateral "haircuts" based on assets’ carbon intensity to the central bank collateralised lending framework as the most promising conduit of green monetary policy. The impact of such an intervention is then formally explored by extending a general equilibrium transition model to include a simple banking sector with central bank lending facilities. We find that the instrument is effective in increasing carbon neutral investment while decreasing carbon intensive investment and emissions. Additionally, adjusting the collateral framework together with a carbon tax reduces the burden on governments which might allow for a less painful transition involving a lower carbon tax.