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April 14, 2021, 9:06 a.m. EDT

How the Fed could give a green light to environmentally sustainable investments

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By Megan Greene

BOSTON ( Project Syndicate )—The Federal Reserve has made a number of climate-related  announcements  in recent months, joining the Network for Greening the Financial System in December and then  establishing  a new Supervision Climate Committee in February. Yet while these are important first steps, the Fed should do more to address climate change, which in turn can help it meet its mandate.

Although President Joe Biden has made clear that climate considerations will influence all of his administration’s fiscal decision-making, this does not take the central bank off the hook. But the Fed, concerned about its independence, is wary about deploying the unconventional tools needed to bring monetary policy-making onto the same page.

The Fed has already gone well beyond manipulating the overnight bank lending rate (the benchmark for borrowers and savers across the economy) and waded deep into unconventional waters, such as when it started buying assets in response to the COVID-19 pandemic. It says it does not want to pick winners and losers, but it already does: anyone holding assets that the central bank buys ends up a winner.

Opinion: Central banks don’t have to pick winners and losers to fight climate change

Legal constraints

True, even if the Fed were willing to incorporate climate change fully into its monetary policy, its actions would remain legally constrained. The central bank can buy U.S. government obligations directly only in open-market operations or through quantitative-easing (QE) programs. To support a particular asset class—such as green investments—directly, it would have to receive authorization from the Department of the Treasury to invoke  Section 13.3  of the Federal Reserve Act.

News: Government can leverage private spending to fight climate change, says Yellen

But the Fed can get around these constraints by encouraging private banks to channel their lending in a certain direction. The Fed charges banks for direct loans through its discount window, and this discount rate is currently set above the federal-funds rate. As a result, any bank that borrows through this window must pay a premium, inviting suspicions that it would only do so if it were in trouble. But this needn’t be the case. In the 1970s and 1980s, the discount rate was  below  the federal-funds rate, and the Fed could effectively subsidize banks that borrowed through the discount window by cutting the discount rate deeply into negative territory.

To encourage green investment, then, the Fed could stipulate that funds borrowed at the discount window at a preferential rate must be used for a climate-aligned purpose. And by maintaining a positive bank lending rate, it could ensure that the introduction of negative rates does not penalize savers or banks.

More on the Fed: Fed’s pursuit of climate-change disclosure is ‘imperfect’ but developing, Brainard says

Targeted lending

There is already a precedent for such targeted lending. After the global financial crisis, the Bank of England launched its Funding for Lending Scheme to encourage real-estate investment, and then  redeployed  this mechanism for targeted lending to small and medium-size enterprises during the pandemic.

Similarly, in April 2020, the European Central Bank  introduced  targeted longer-term refinancing operations in which banks generating new loans to the real economy borrowed at an interest rate below the main deposit rate. And in October, the Bank of Israel introduced its own separate interest rate for targeted lending.

But how can the Fed identify “green investments” when that concept remains so vaguely defined? For starters, it should offer targeted lending for two asset classes that it already supports: real estate (by securities purchases through QE) and autos (by lending to a special purpose vehicle that purchases auto loans through the Term Asset-Backed Securities Loan Facility).

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According to the Environmental Protection Agency, residential and commercial real estate account for roughly  one-third  of U.S. greenhouse-gas (GHG) emissions, and transportation accounts for around 28%. By encouraging the greening of these assets, the Fed could significantly affect the United States’ contribution to climate-change mitigation.

Moreover, the Fed does not have to reinvent the wheel to determine which properties or autos qualify as green. Both  Fannie Mae  and  Freddie   Mac  offer green loans and green certifications for single and multifamily homes. The Fed and the Federal Housing Finance Agency—Fannie and Freddie’s regulator—thus could come together to determine the best standards to use, and the FHFA could then become the screener for green properties.

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