The combination of higher inflation and the still too slow green transition creates a dilemma for the European Central Bank (ECB). Calls are mounting for the ECB to sacrifice public investments in the green economy for the sake of fighting inflation. Shutting down the sustainable recovery is an old school approach to monetary policy. The ECB needs to adopt instead a green interest rate approach, maintaining favourable funding conditions for any spend or investment that contributes to a successful energy transition.
Inflation hit a record in the eurozone in 2022, caused largely by rising energy prices. As a consequence, a debate is mounting on whether the ECB should tighten its monetary policy.
The ECB has to figure out how to pursue a price stability mandate without slowing down the green transition, the failure of which is a clear and present danger to financial stability itself. The traditional approach of using monetary policy to fight inflation is making funding more expensive across the board, including for the green investments that are essential to complete the transition to net zero.
There is, however, a way to overcome this apparent paradox. It starts by recognising that the ECB can actually do something about energy prices – if it plays the long game.
Many experts argue the inflation is temporary, and overreacting to it could be counterproductive, by shutting down the economic recovery before it really takes hold.
Another argument is that tightening monetary policy would do little against the energy component of inflation, which is imported from tensions in the global energy market upon which the ECB’s monetary policy has little grip. From this point of view, the ECB’s best course of action is to wait for this transitory inflation to go away.
There are plausible risks that energy prices remain higher than expected. Indeed, as flagged by the ECB’s Isabel Schnabel in a speech on 8 January 2022: “Potentially protracted supply and demand imbalances related to ‘transition fuels‘, such as gas, as well as the fact that carbon prices are likely to rise further, and to extend to more economic sectors, mean that the contribution of energy and electricity prices to consumer price inflation could be above – rather than below – its historical norm in the medium term.”
In the short run, the energy transition may indeed lead to elevated energy prices. Fighting climate change means adjusting relative prices and the cost of capital between carbon-intensive activities and low-carbon ones. However, countries with a larger share of renewables have also suffered less from higher energy prices. They paid less for gas imports, proving that the energy transition cuts both ways.
In the past, central banks usually ignored energy shocks – for good reasons. However this time could be different. “If energy inflation were to prove more persistent than currently anticipated under our baseline scenario, at what point could we no longer afford to look through such a shock?” Schnabel asked on 8 January.
The ECB can do more than just wish governments and the EU get the energy transition done. The bank can directly support them by ensuring predictable, favourable conditions for any spend or investment that contributes to increasing the supply of home-grown renewable energy, or investment that reduces the consumption of fossil energy.
The ECB should provide a clear signal that the cost of capital for clean investments will not be disproportionately affected by its efforts to keep inflation in check. This is absolutely critical, since renewable energy investments are more sensitive to cost of capital than fossil fuel investments.
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In practice, the ECB should embrace a so-called 'dual rate' policy, whereby it sets a different price signal for different actors, instead of a one-size-fits-all policy. The ECB could offer a preferential 'green discount rate' through its targeted longer-term refinancing operations programme for banks, which offers them longer-term loans at attractive rates. Application of the discount rate could be proportional to their loans to activities that contribute to the energy transition such as home renovation and renewable energies.
In parallel, the ECB could raise interest rates for other economic activities and start reducing the volume of its corporate bond purchase programme, first selling the bonds of corporates linked to or dependent on fossil fuels.
Not proactively supporting the EU's green transition would only expose the ECB to the more difficult task of managing price stability under disorderly transition scenarios, with even more uncertainty and volatility in inflation. In the face of climate change and the fundamental economic transition this requires, supporting developments that steer the ECB clear of such situations should now be its primary objective.