Fossilflation: ECB timidity on climate change impoverishes Europeans

New research from Reclaim Finance shows the bank cannot deliver on its core price stability mandate without tackling “fossilisation”

Climate change and fossil fuels are now inflation-driving forces that the European Central Bank (ECB) cannot fulfil its primary mandate without playing an active role in the low-carbon transition. The ECB’s lack of action could lead to historic financial turbulence as climate and fossil fuel shocks intensify, according to new research from Reclaim Finance.

Dependence on fossil fuels is at the heart of the current high European inflation, with natural gas prices pushing inflation to levels not seen since the early 80s. This is what ECB board member Isabel Schaber called “fossilflation” in a speech in March. As such, reducing energy use and increasing the provision of renewable energy is the most obvious way to control inflation.

However, the ECB, the main entity in charge of controlling inflation in Europe, has not enacted any measures that contribute to these objectives. Worse, it continues to support fossil fuel companies through asset purchases and their guarantee framework, while their only response to the inflation crisis (rising interest rates) could restrict the development of capital-intensive renewable energy projects.

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Therefore, Reclaim Finance argues that, in order to fulfil its core mandate, the bank must contribute to Europe’s clean energy transition by doing three things:

1. End support for fossil fuel companies by excluding them from asset purchases and guarantee frameworks

The ECB has a carbon bias: in 2020, the high-carbon sectors (manufacturing, electricity, gas, steam and air conditioning, and transport and storage) account for 61.8% of the outstanding balance of bonds accepted by the ECB as collateral, despite the fact that these sectors contribute less than 21% to euro area employment and only 24% to Gross Value Added. As of April 2020, the bank held bonds from 38 fossil fuel companies, including coal companies and companies involved in new fossil fuel projects.

This bias was likely exacerbated by its Pandemic Emergency Purchase Program (PEPP). From April 2020 to September 2021, the number of bonds of the five major European oil companies (Shell, TotalEnergies, OMV, Repsol and Eni) held by the ECB increased by 16.2%.

The bank plans to start tilting its corporate bond purchases toward “better climate performers” from October this year. But this will not go far enough. The ECB will not exclude any sector, including fossil fuel developers, from its purchases, while the criteria used to define climate performance are likely to have little impact on the volume of assets it buys from such companies. Moreover, it does not intend to apply this process to its guarantee framework.

2. Introduce a preferential “green interest rate” for loans related to energy efficiency renovations and renewable energy

There is nothing to oblige the ECB to have a uniform interest rate policy. In fact, when responding to the Covid-19 pandemic, the bank set a negative interest rate for banks that reached a certain lending threshold. It could use a similar process to funnel interest-free or lower-rate loans for renewable energy and building renovation projects. This would unlock massive green financing and help fight energy poverty, climate change and inflation at the same time.

3. Coordinate with the European Investment Bank (EIB) and the EU Commission to purchase climate bonds

The EIB and the EU Commission could issue “climate” or “just transition” bonds that would be bought by the ECB through its asset purchases.

This coordination, which would require a political agreement, could contribute significantly to closing the EU’s clean energy financing gap. Unlocked funds could be directed to green loans and existing EU funds and programmes, such as the Just Transition Mechanism, the Social Climate Fund or the Recovery and Resilience Facility.

The ECB’s timidity on climate change

The ECB’s reluctance to act more decisively on climate change and fossil fuels stems from its current interpretation of its price stability mandate, linked in particular to a ‘market neutrality’ approach prohibiting the use of sectoral or activity-specific policies, and its belief in the possibility of ‘green inflation’.

But, in the age of “fossilflation” and intensified climate disturbances, this is no longer sustainable. “To manage price volatility, the ECB must recognize that one sector is the overwhelming cause of that volatility,” said report author Paul Schreiber.

Rising interest rates combat inflation by suppressing demand throughout the economy. It does little to address the specific drivers of the current crisis (fossil fuel prices), but it has a negative impact on growth, employment, tax and social security revenues, and the cost of public debt. A more targeted response is needed, one that suppresses demand for high-carbon activity while stimulating the green economy.

Moreover, the bank appears to overestimate the potential for “green inflation.” In March, ECB board member Isabel Schnaber said: “As more and more industries shift to low-emission technologies, green inflation can be expected to exert upward pressure on the prices of a wide range of products.”

However, it is widely recognized that clean energy is cheap and safe and could significantly reduce energy costs and protect consumers against changes in energy prices. If a rapid increase in demand for critical minerals without increased supply could push up renewables prices during a transitional period, Reclaim Finance argues that this effect would be limited compared to the impact of fossil fuel prices. He stressed that there are solutions to ensure the adequate supply of key materials. For example, Europe’s largest metal producers found that 75 percent of the region’s clean energy metal requirements could be met through recycling.

The key to avoiding this transient inflation is early investment in a planned transition. On the contrary, as the governor of the Banque de France, François Villeroy de Galhau, said, “the longer the transition is delayed and disordered, the greater the risks of green inflation.”

Time to act

Some prominent figures at the ECB have, to some extent, acknowledged these arguments. Christine Lagarde has mentioned several times that climate must be considered in managing inflation. More specifically, in June 2021, Schnabel acknowledged that “the existence of climate externalities implies that we have to reconsider the notion of market neutrality”, while in March 2022 he noted that “green inflation has had a much smaller impact on prices and the final consumer than fossil inflation”.

However, these recognitions have yet to be translated into policy changes and concrete actions. Against the backdrop of Europe’s worst drought in 500 years and a growing cost-of-living crisis for its citizens, the bank cannot afford to delay action any longer.

The report’s author, Paul Schreiber, said: “The ECB cannot continue to support companies driving the climate and inflationary crises, nor can it continue to ignore the EU’s urgent need for transitional financing. Failure to act could violate the central bank’s mandate and lead to historic financial turbulence as the impacts of climate change and fossil fuel supply intensify.”

After raising interest rates on September 8, ECB President Christine Lagarde said: “I can’t reduce the price of energy. I cannot convince the big players in this world to reduce gas prices. I cannot reform the electricity market. And I’m very happy to see that the European Commission is considering measures in that direction because monetary policy is not going to reduce the price of energy.”

To which Schreiber replied: “The ECB cannot reduce the price of energy, but it is not powerless in this situation. It could and should use monetary policy to help reduce the impact of gas prices, in particular by creating a preferential credit line for loans related to energy efficiency, building refurbishment projects and renewable energy.”

Source: The Energy Newspaper