Given the climate and cost of living crisis, the Bank of England’s policy toolkit needs an urgent update. To achieve monetary and financial stability and broader ecologically and democratically defined goals, multiple interest rates across the economy may be required individually. With much of macroeconomic demand management reliant on a blunt single-rate tool, green targeted credit policy interventions will allow banks to better meet their price and financial stability goals and help better reflect environmental sustainability and The transition to net interest rates has zero importance, as the UK government has recently mandated.
Despite important policy reforms following the 2008 Global Financial Crisis (GFC), these reforms have not addressed the banking sector’s tendency to inappropriately allocate credit. With much of the money going to real estate and financial sector assets, UK bank lending is not well suited to support the real economy and important strategic investments. After the global financial crisis and before the pandemic, only 2% to 5% of bank lending went to small and medium enterprises (SMEs), which account for 60% of UK private sector employment and 40% of gross domestic product (GDP) from these businesses from SMEs. Changing only a single blunt rate instrument can be a very inefficient way of affecting real activity and aggregate demand, making it difficult for banks to achieve their price stability goals.
At the same time, the allocation of credit in the banking and financial sectors is fundamentally out of touch with the low-carbon transition. The UK approach focused on mimicking the disclosures of the Task Force on Climate-related Financial Disclosures (TCFD) and failed to effectively alter the flow of credit. The Bank’s policy tools are not currently designed to help achieve green transition goals or mitigate systemic sources of climate-related monetary and financial instability. British banks have poured more than £277bn ($364bn) into fossil fuel projects since the Paris Agreement was signed in 2015, and Barclays is the dirtiest bank in Europe. Meanwhile, estimates from the Office for Budget Responsibility (OBR) suggest that private sector investment must exceed £30bn (2019 prices) in additional green investment over the next three years – a 10% increase over current private sector investment levels. In response to the challenge of the green investment gap, UK private sector investment grew by around 0% in the three years prior to the pandemic. The pace and scale of filling the private sector green investment gap will require the Bank to provide transformational financial incentives. In fact, failure to curb dirty financial flows and fill the green investment gap will exacerbate climate-related financial risks and lead to sharp price corrections. Therefore, taking action is entirely within the monetary and financial stability remit of the bank.
Given the changing macroeconomic situation, the Bank’s key policy tools may also need to be reactivated. Soaring energy costs (especially fossil gas) and other supply-side bottlenecks are the main drivers of rising inflation. Simply raising the key policy rate will do little to stop external and supply-induced price increases. Conversely, higher interest rates could disincentivize new green investments that have very high up-front costs and therefore face higher financing costs, compared to fossil fuel alternatives with relatively lower up-front costs. In this case, a rate hike could strengthen the UK’s carbon lock-in and its reliance on volatile fossil fuel pricing. To reduce the risk of future price shocks driven by fossil fuels, as well as mitigate climate-related transition risks, monetary policy can be adjusted to accelerate green investments, such as energy efficiency and renewable power generation. A targeted credit policy framework that keeps interest rates on green investments low but allows higher rates for other economic activities would help introduce more appropriate price dynamics.
In fact, the Bank hardly ever reinvents the wheel. Historically, targeted credit policy intervention by central banks has been the norm, not the exception.These policies played an important role in supporting economic and industrial policy from 1945 to 1973 ‘The “Golden Age” of the West, and the recent rapid development that has helped East Asian countries. Over the past decade, the bank has started temporarily providing cheap credit to businesses and households across the UK in the form of the Term Financing Scheme (TFS). We recommend that the Bank, with the support of the Ministry of Finance, simply green the TFS, make it permanent and scale up. More recently, the Bank of Japan and the People’s Bank of China have spearheaded green credit policy measures with refinancing operations to provide cheap credit to banks and loans for sustainable investments. While fiscal policy must lead the green transition, and more intrusive credit policies are not a green panacea, emulating their Asian counterparts will help the Bank achieve its key price and financial stability goals and ensure it does so to reflect Environmental Sustainability and the Importance of the Transition to Net Zero.
Suggest
1. Reuse the Bank of England’s existing Term Financing Scheme (TFS) to create a permanent green TFS. TFS provides cheap money to banks at or near bank rates to lend to households and businesses under certain conditions. Central banks could build on this monetary innovation by offering zero or negative real interest rates for green activity, while keeping their key policy rates in positive territory. For example, the Ministry of Finance and the Department of Business, Energy and Industrial Strategy (BEIS), which represent elected governments, could recommend that the Bank first target energy efficiency retrofits, clean energy activities, electric vehicles and charging stations; and reducing borrowing costs for households and SMEs. Once the UK Green Taxonomy has been implemented, the Green TFS can also be used for a range of other green-defined activities.
2. The existing TFS should be decarbonized starting from the most harmful sectors to ensure that the Bank does not implicitly subsidize banks to lend to fossil fuel and carbon-intensive activities. This means that banks should not be allowed to provide dirty collateral for cheap financing, nor should they be allowed to lend for dirty activities. The Bank can identify polluting assets and apply science-based exclusions based on the framework it has developed for greening the corporate bond purchase program.
3. TFS is conditional on banks demonstrating that they are expanding lending to businesses and households. The lower financing costs of Green TFS require additional conditions:
One. Banks must demonstrate that they are expanding their lending to desired industries and activities. For example, for retrofit loans, an Energy Performance Certificate (EPC) rating can be used to assess improvements in energy efficiency.
b. Banks must demonstrate that they are passing on the minimum rate cut to customers (such as following the precedent set by the coronavirus rebound loan scheme).
4. Set bank lending metrics and targets to align the UK financial sector with Paris. Although the Bank’s financial stability and monetary policy terms of reference have been updated to address climate change, there are no indicators or targets to hold the Bank accountable for a green financial system. The Green TFS can be specifically calibrated to meet the annual quantitative targets for green finance flows, specifically to fill the green finance gap.
5. Extend TFS to UK state-owned investment banks – UK Infrastructure Bank and UK Business Bank. These banks can: i) on-lender to UK alternative banking sectors that may not currently be able to use TFS (i.e. credit unions, community development financial institutions (CDFIs), building societies), and/or 2) lend directly to transition activities and small businesses .
To illustrate how Green TFS performs in practice, we provide an example of how Green TFS can be used for building retrofits while helping the Bank better achieve its monetary, financial stability, and secondary green mandates.
While awaiting the green taxonomy, financing improvements for building EPCs could be used as green criteria for bank lending. The Ministry of Finance or BEIS can advise the Bank to extend eligibility to other verifiable green investments such as solar panels, domestic wind turbines and heat pumps.
The interest rate on green credit lines provided by TFS to banks can be set at 0%, or in all cases lower than the bank rate, to ensure a lower cost of green credit. Refinancing rates may be negative (echoing the European Central Bank (ECB)), provided commercial lenders pass on pre-determined minimum rate discounts to retrofit borrowers – for example, 0% to households and businesses loan. To push interest rates on retrofit loans towards zero, a combination of negative interest rates charged to banks under the Green TFS and partial loan guarantees from the Treasury Department (similar to the Pandemic Program) could be used.
A household borrowing £10,000 at 0% for six years will save £1,980 on total repayments compared to borrowing at the current (as of February 2022) private unsecured loan rate of 6.14%. Also, a 0% lending rate to borrowers means negative real interest rates (after inflation). Assuming inflation follows the Bank’s May 2022 forecast, a household that borrows £10,000 under a scheme starting in 2023 will end up paying £730 less in real terms than initially borrowed over an illustrative six-year period.
If green TFS funds are offered at negative interest rates, banks and Treasury should agree on a new framework for managing bank balance sheets, considering using it in the long run to support social goals while maintaining currency stability.
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