Transition risk: how central banks can de-risk the transition

The climate crisis is no longer just an environmental issue – it also affects financial stability. As a result, de-risking the global energy transition has became a responsibility for central banks in the global north.

Bodies such as the Network for Greening the Financial System have issued multiple reports highlighting climate-related risks. As producers of global reserve currencies, central banks from richer countries have unique economic capabilities to support the financial response to the climate crisis. Yet despite a growing awareness of the risks, they have not fully leveraged their power to combat climate change.

To meet the accelerating pace of the climate emergency, central banks must go beyond recognising transition risk to understanding the risk posed by continued financial support for fossil extraction. Not only that, they must play an active role in driving solutions and de-risking the transition, by both facilitating the shift to renewables (particularly in the global south where a massive financial gap is holding back progress) and restricting financial support for fossil fuel expansion.

Central banks have demonstrated their ability to act swiftly in times of crisis. During the 2008 financial meltdown and the pandemic, they rolled out innovative measures to stabilise economies. The climate crisis demands a similar response. While the threat may seem less immediate, the long-term economic fallout of inaction will be devastating.

There are many options for central banks to de-risk the energy transition, and there are three in particular that should be prioritised.

1. Climate-TLTROs for long-term investment

Several suggestions for using a “green” variation of the existing targeted long-term refinancing operations (TLTROs) have been made during the last few years (including recently from the Sustainable Finance Lab). The climate-TLTROs proposed here mainly differ in their maturity.

Central banks can launch climate-TLTROs to provide ultra-long-term, very low-interest or (to a lesser extent) zero-interest loans to development finance institutions (DFIs) from both the global north and south, which should be earmarked for climate investments. DFIs can use the interest-free portion of these financial resources for grants and concessional lending, thereby enabling further climate investments.

As public development institutions, DFIs can execute this task more effectively than commercial banks because they are not obligated to maximise profits and can offer loans over much longer periods of time.

By offering financing for 100 years or more, central banks would effectively treat these loans as a permanent asset on their balance sheets. As the permanent part of the central bank’s balance sheet is no longer available for short-term monetary policy operations, care must be taken to ensure that its share of the overall balance sheet does not become so large that it hinders the exercise of normal monetary policy. However, this long-term approach reflects the multigenerational nature of the climate challenge and would signal a deep commitment to sustainability.

2. De-risking renewable energy investments in the global south

One of the major barriers to renewable energy projects, particularly in global south countries, is the lack of reliable risk assessments. Central banks can help by backing guarantees for renewable energy investments, reducing the perceived risk and unlocking private capital.

These guarantees, granted in partnership with DFIs, would transform renewable projects into low-risk investments. This would attract institutional investors, leading to lower interest rates and cheaper renewable energy, making it more affordable worldwide and in line with UN’s sustainable development goal of clean affordable energy for all.

3. Convertible climate bonds for a fossil-to-renewable energy transition

Many large companies are sitting on fossil fuel assets that may soon become stranded. Central banks could offer to buy convertible climate bonds from designated DFIs as a last exit strategy for fossil fuel companies.

The central bank should first determine an amount of these bonds to finance the last exit option. In the next step, the designated DFIs can offer to purchase potentially stranded fossil fuel assets if the selling companies will provide a precise investment plan to build new and additional renewable energies with the received money.

The DFI wold then purchase the fossil fuel assets from those companies, which provides the best offer in terms of saved fossil fuels, new renewable capacity and expected output of renewable energy per purchase. The (stranded) assets would then be bundled into new CCBs and sold to the central bank.

These investments must be new and additional, and not supplant other renewable energy investments. This would not only facilitate a smoother transition but also ensure fossil assets are removed from the energy system. A detailed proposal outlining how this could work has been published by myself and Kjell Kühne of the Leave It in the Ground Initiative.

Taking the long view over generations

The solutions proposed here illustrate that central banks can play a transformative role in de-risking the transition to a sustainable economy. In particular, climate-TLTROs highlight the importance of thinking long-term. By structuring these as multi-generational assets which sit on balance sheets for decades, central banks would acknowledge that the fight against climate change spans many lifetimes and requires bold, innovative action today to secure a livable future for tomorrow.

The three tools above are only intended to show what is feasible in principle. Of course, many monetary policy and legal issues remain to be clarified, but as soon as the political will is there to do so implementation should be possible.