Beyond carbon pricing: The role of banking and monetary policy in financing the transition to a low-carbon economy

- Carbon pricing may not be enough to fill the gap in low-carbon investment.
- This is due to a market failure in the process of credit creation and allocation.
- Macroprudential financial regulation can be used to facilitate green investment.
- The idea of easing reserve ratios for low-carbon lending is discussed.
- Green macroprudential policy is more likely to work in emerging economies.

It is widely acknowledged that introducing a price on carbon represents a crucial precondition for filling the current gap in low-carbon investment. However, as this paper argues, carbon pricing in itself may not be sufficient. This is due to the existence of market failures in the process of creation and allocation of credit that may lead commercial banks - the most important source of external finance for firms - not to respond as expected to price signals. Under certain economic conditions, banks would shy away from lending to low-carbon activities even in the presence of a carbon price. This possibility calls for the implementation of additional policies not based on prices. In particular, the paper discusses the potential role of monetary policies and macroprudential financial regulation: modifying the incentives and constraints that banks face when deciding their lending strategy - through, for instance, a differentiation of reserve requirements according to the destination of lending - may fruitfully expand credit creation directed towards low-carbon sectors. This seems to be especially feasible in emerging economies, where the central banking framework usually allows for a stronger public control on credit allocation and a wider range of monetary policy instruments than the sole interest rate.