Failure to Tackle Climate Change Suppresses Rates, ECB Study Says

(Bloomberg) -- Slow progress in reducing carbon emissions risks putting pressure on central banks to keep interest rates low, according to a European Central Bank working paper.

“Climate risk reduces the natural rate of interest,” researchers Ghassane Benmir, Ivan Jaccard, and Gauthier Vermandel wrote in a study published Tuesday. “The reason is that households become more risk averse when firms fail to internalize the damage caused by their emissions.”

Uncertainty, in turn, increases precautionary savings, lowering overall demand in the economy.

The authors of the paper concluded that a carbon tax for companies determined by the market price of emissions would be helpful in countering risk aversion and allow natural interest rates to rise. That would provide central banks with more policy space and decrease the likelihood of hitting the effective lower bound.

The ECB is currently conducting a review of how challenges such as climate change affect policy. Interest rates in the euro area have been negative for more than six years, and while officials including President Christine Lagarde insist they can drop further if needed, they’ve relied on other tools to support the economy.

The paper comes as Europe ramps up its ambitions to slash emissions in the region and become climate-neutral by mid-century. While the 27-nation European Union already has a binding target to cut greenhouse gases by at least 40% by 2030 from 1990 levels and runs the world’s biggest carbon market, the European Commission last month proposed cutting emissions by at least 55% in the same period.

The EU’s carbon price has roughly quadrupled over the past three years and climbed above 30 euros ($35) a ton last month. It is forecast to go even higher as Europe advances its climate goals.

The cost of polluting in the EU will need to triple to encourage emitters to use hydrogen instead of fossil fuels, according to a report by BNP Paribas Asset Management. For the bloc to meet its 2050 goal, emitters in the transport, buildings and manufacturing sectors will have to shift from fossil fuels to clean hydrogen, which would need carbon prices at around 79 euros a ton, the research said.

The ECB’s paper also suggested using the carbon tax to “cool down” the economy during periods of booms and to stimulate it in recessions. The “optimal environmental policy is procyclical,” the authors said.

The effectiveness of such a policy depends on how efficient technologies such as carbon capture are for lowering emissions, they said. If firms cannot circumvent the tax by reducing emissions, their only choice will be to cut production.

“Improving the existing emission abatement technology should come first,” the researchers said. “Once available, an efficient technology would help to mitigate the side effects of the tax, thereby maximizing the welfare gains from the policy.”

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