As concerns about climate change burrow deeper into the mainstream of the finance world, a Carnegie Mellon University professor says one way the Federal Reserve can take up the challenge is by adopting a “green interest rate.”
In a paper released in June, Nick Muller notes that environmental harm comes with economic costs.
“Pollution damage — whether we're talking about air pollution or greenhouse gases or other things — affects [economic] growth through things like premature mortality and health costs [as well as] property damage,” Muller said.
His paper argues that the Fed could help to manage such impacts by adding environmental stability to its formula for calculating interest rates. Today, the Fed’s “dual mandate” consists of maximizing employment while keeping inflation in check.
If it were to prioritize the environment, too, Muller said, interest rates would also reflect expectations about the government’s approach to environmental policy: The cost of borrowing would go up if policymakers show signs they will implement pollution controls, and fall if such protections are not anticipated.
The idea is that higher rates would encourage saving, and delay consumption, until economic activity pollutes less. But if there are fewer environmental regulations on the horizon, lower rates would shift spending to the present.
“If the economy is getting rapidly dirtier per dollar of consumption,” Muller said, “we want more consumption in the present when the economy is relatively cleaner than we want in the future as it's getting dirtier and dirtier.”
Attempts to enact comprehensive climate legislation have gained no traction in a deeply divided Congress. So, Muller said, a green interest rate offers an alternate route.
“We likely face a challenging couple of decades coming up globally as the world gets warmer, and as we hopefully concurrently decarbonize,” Muller said. “And if our usual policy tools … to do abatement in the context of greenhouse gas emissions … are not at our disposal, we need to get creative.”
The Biden administration is trying a number of new approaches. In May, the President signed an executive order to prepare federal agencies to incorporate climate risks and other environmental, social and governance (ESG) issues into financial regulation.
The U.S. Securities and Exchange Commission had already begun to pursue its plan to create ESG disclosure rules for public and other regulated companies, and federal Treasury officials expect eventually to require banks to maintain cash reserves to absorb potential losses related to climate change.
‘No direct accountability’
Republican Pennsylvania Sen. Pat Toomey, the ranking member of the Senate Banking Committee, is a vocal critic of such strategies.
“In a democratic society and a republic,” he said, lawmakers, not financial regulators, should “deal with the big challenges that require a societal response.”
“If the American people don't like what Congress is doing or not doing, the American people can fire Congress,” Toomey said. “The American people can't fire the Fed — there is no direct accountability on the part of the Fed.”
But despite expressing doubts about how Muller’s green interest rate would work in practice, Tom Sanzillo, director of financial analysis for the Institute for Energy Economics and Financial Analysis, said he’s “sympathetic with the theory … that the economy has to be so substantially realigned that only a macroeconomic tool like an interest rate can help move the amounts of capital that need to be moved in the appropriate direction.
“The climate-change argument is an argument that is going to require leadership at all levels of our economy and society and government,” Sanzillo said.
In his paper, Muller estimates that his proposed green interest rate would have been 0.5% higher on average than actual U.S. interest rates over the last 60 years, thanks in part to the passage of the Clean Air Act in 1970.
Muller calculates that the green interest rate would have reduced pollution-related health costs by as much as 3% annually. Currently, those costs amount to about 5% of U.S. GDP, or about a trillion dollars, according to previous research completed by Muller.
But Sanzillo noted that a higher green interest rate that applies economy-wide could have “some unintended consequences.”
For example, if it were to become more expensive to finance a car or if businesses were forced to raise prices to cover their own loan costs, working-class communities could be especially hurt, he said.
Sanzillo also wondered what share of green interest rate proceeds banks would get to pocket, and whether an across-the-board change in how interest rates are calculated could stymie investment in environmentally-beneficial activities such as renewable energy development.
Muller acknowledged this potential effect on “especially capital-intensive” ventures. But, he said, “Policymakers [outside the Fed] could entertain interest-rate subsidies for renewables to encourage investment,” as already occurs or has been proposed.
On the Fed’s radar
But Muller’s model for a green interest rate doesn’t account for the cleaner technologies that such investments could bring about, said Institute for Energy Research senior economist David Kreutzer, who favors a free-market approach to climate adaptation.
“The problem is, [Muller’s green interest rate] really has nothing to do with changing anything other than some slight modification in how much we work now versus how much we work later, and as a consequence, how much we consume now versus how much we consume later,” Kreutzer said.
Kreutzer doubted that the idea of a green interest rate will catch on at the Fed.
“Saying we want to raise interest rates somewhat because we want people to produce a little bit less, which means they're going to work a little bit less and earn a little bit less is a bit cavalier,” Kreutzer said. “I just can't imagine the Federal Reserve saying we need to reduce employment now because the air is getting cleaner.”
Regardless, Kreutzer doubts that government agencies can “actually fine-tune” market conditions based on emissions projections that extend decades into the future.
Sanzillo, of the Institute for Energy Economics and Financial Analysis, noted that the Bush Administration encountered this problem with a loan program for coal-fired power plants. As the threat of climate change became more apparent, the federal Rural Utilities Service sought to adjust interest rates to reflect the environmental costs of coal-fired generation.
But, Sanzillo said, “The federal government couldn't determine what would be an honest and prudent interest rate … if [it were to take] into account the carbon risk of the projects,” and it ultimately abandoned the program in 2008.
Circumstances have changed since then, Muller countered, with regulators across the federal government prioritizing climate change. The Fed itself now considers climate risks such as rising sea levels and more severe weather events in assessing the resilience of the U.S. financial system, Muller noted.
“I'm confident that this set of issues is very much on the radar screen of the Fed here and central banks in many parts of the world,” he said.
