Monday 9 December 2019

One policy instrument for each target, and every agency in its place

My column in today's Fairfax papers argues that central banks really don't have any business playing in climate change policy. It isn't that climate change isn't important; it's rather that central banks have one big job - two if they're also responsible for prudential regulation. 

A snip:
In October, the Reserve Bank's general manager for governance, strategy and corporate relations highlighted the bank's growing focus on climate change. As part of the same press release, governor Adrian Orr noted the bank's role in "greening the financial system" and managing environment and climate-related risks.

Some of this makes sense as part of the Reserve Bank's role in prudential regulation. If a bank's capital stock includes a lot of farm mortgages that would be underwater with a change in emissions policy, then those risks should be considered when weighing that bank's overall position.

Of course, there are policy risks across many different sectors - just think about how Trump's tweets can affect different portfolios.

But the Reserve Bank seems to wish to go further than that, noting the importance of integrating sustainability factors into portfolio management, and recently purchasing US$100 million of green bonds. The current remit of the Monetary Policy Committee includes a preamble noting the government's economic objective of moving towards a low-carbon economy.

And there we start worrying about whether the instruments are suited to the targets, and whether the bank may be over-reaching.

Getting policy around climate change right is incredibly important. But it is not a job to which a central bank is well suited. We would not ask the Reserve Bank to help ensure that vaccination rates are high enough to prevent outbreaks of contagious disease, and we should raise an eyebrow if it started volunteering to do the job. It is a job better suited to others. And climate change policy is better left with the Climate Change Commission. The Emissions Trading Scheme is the best instrument for mitigating New Zealand's emissions.

If prudential regulation reaches beyond considering climate change risk as one of many factors affecting the soundness of a portfolio, to instead start nudging companies into changing their practices around climate risk, we start getting into Tinbergen's problem. Making prudential regulation more about climate change makes it less about the soundness and efficiency of the financial system. We then risk doing poorly for both.

This weakening of focus on core central banking business is hardly unique to New Zealand. Traditionally, central banks have sought to be sectorally neutral in their market operations: if a reserve bank must purchase bonds as part of monetary policy, it tries to do so without skewing the pitch in favour of one sector or issuer or another.

If pitch-skewing is appropriate, that is for democratically accountable parliaments to decide rather than central banks. But Christine Lagarde, the recently appointed president of the European Central Bank, is reviewing whether its bond portfolio should shift from market neutrality to preferring green investments.

These kinds of policies do not just violate Tinbergen's warnings. They also risk the independence of monetary policy if parliaments object to reserve banks taking actions going beyond monetary policy and normal prudential regulation.

And there are dangers too if markets come to expect that central banks might not pursue purely monetary goals in any crisis requiring quantitative easing.
This stuff shouldn't be hard, and it shouldn't be part of the RBNZ's remit.

Make sure that the ETS is working properly. Have a binding cap. Share the burden of getting the cap down to where it needs to be through a declining allocation to grandparented emitters and crown buyback and retirement of emission permits. Keep an eye on the ETS prices to make sure that they don't run ahead of prices in places that also take this stuff seriously. And set a regime, in concert with the OECD, for running carbon-equivalent tariffs for imports from places without a carbon price, and for exemptions of carbon charges on exports to places where the product would compete with products without a carbon charge.

None of that needs a greening or re-jigging of the financial system. It all works better if the financial system is working well, but that's about it.

Reserve Bank independence depends on strong cross-party consensus that the matters over which the Bank is independent are matters that require that independence, and that the Bank isn't straying from its wheelhouse.

Meanwhile, Rod Oram argues that ACC and other government investment funds should divest themselves of anything relating to oil, but with broader implications of course.
ACC’s role, though, goes far beyond a fiduciary responsibility. By being less than world class in its investment policies and practices on carbon, it is exacerbating climate change. That in turn only adds to our health burdens which ACC is meant to help alleviate.
I suppose that sort of thing sends a moral signal and stuff, but it just doesn't make much sense. If you want folks to use less stuff that generates GHG emissions, put a price on GHG emissions.

Imagine that there are two companies on the stock market, a dirty one and a clean one. There's no carbon tax. Ex ante, expected returns to investment in both stocks must be equivalent or funds would shift from one to the other until they were equivalent.

Then, the great awokening happens and a large investor decides it doesn't want to invest in the dirty one anymore. So it sells off its shares and uses the funds to buy shares in the clean company. If the large investor is large, then that action starts pushing down the share price in dirty and increasing the share price in clean. But there's no carbon tax - remember. The expected return on dirty starts going up - nothing in the fundamentals has changed. Investors who just care about return on investment will sell their shares in clean at over-the-mark prices to buy the bargain dirty stocks.

If the large investor is not large enough to buy up all the shares in clean, then we just wind up with the large investor owning nothing but clean, and other investors holding more dirty in their portfolios.

If it is large enough to buy up all those shares and still have cash left over, then things start getting more interesting. It can signal a desire to put more capital into clean, so clean can fund its next project which it otherwise couldn't have funded because the return on that project was (expectationally) lower than the going rate. So the large investor can start reducing the cost of capital for clean, but only at the expense of lower returns for its investors. So it cannot simultaneously be true that the clean investor both affects the real world, and earns expectationally higher returns on its investment.

So the ethical investing push does nothing unless it winds up having those investors forgo returns.

But putting a price on carbon would reduce the return to investing in dirty and increase the return to investing in clean.

And if we wind up in a spot where the government's various funds are pursuing investments based on the ethical views of those funds' directors rather than based on what makes most sense given their risk appetite and time horizons, then again we get into messes. There is risk of these things turning into government slush funds. Bright lines on this stuff are valuable - the funds should be pursuing the strongest possible returns rather than seeking to achieve other objectives.

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