The European Central Bank faces a dilemma regarding how to respond to high energy prices, since raising interest rates would make the green transition more expensive. One way out would be to offer a green discount rate for investments in energy efficiency and renewables.

This article was written by Stanislas Jourdan and Rens Van Tilburg, and was first published as an op-ed on Energy Monitor.

Inflation hit a record high level in the Eurozone in 2022, caused largely by rising energy prices. As a consequence, a debate is mounting on whether the European Central Bank (ECB) should tighten its monetary policy. 

Many experts are arguing that the inflation pattern is temporary, and overreacting to it could be counterproductive, by shutting down the economic recovery even before it gets a chance to flourish again. Another key argument is that tightening monetary policy would do little towards the energy component of inflation, which is imported from tensions in the global energy market upon which the ECB’s monetary policy has little grasp on. From this view, the ECB’s best course for action is to wait for this temporary transitory inflation to go away.

However, in a speech last week, the German ECB economist Isabel Schnabel warned against the possibility that energy prices may continue to rise faster than we have predicted so far. ‘The combination of insufficient production capacity of renewable energies in the short run, subdued investments in fossil fuels and rising carbon prices means that we risk facing a possibly protracted transition period during which the energy bill will be rising.‘, Schnabel explains.

In the past, central banks have usually ignored energy shocks – for good reasons. However, Schnabel hints that this time could be different, wondering: ‘If energy inflation were to prove more persistent than currently anticipated under our baseline scenario, at what point could we no longer afford to look through such a shock?’

The traditional approach of monetary policy to fight inflation would be to make funding more expensive across the board, by raising interest rates. But here lies the problem: tightening monetary policy uniformly would also increase the cost of green investments, which are absolutely needed to complete any successful transition. Moreover, we know that renewable energy investments are more sensitive to the cost of capital than fossil fuel investments. So, in effect, raising interest rates would result in penalizing renewable energy more than fossil fuels. Such a contradiction would be difficult for the ECB to justify after it adopted an action plan to combat climate change last year. 

The ECB faces a big dilemma: how to pursue a price stability mandate without slowing down the green transition, the failure of which is a clear and present danger to financial stability itself?

Obviously, the easiest scenario for the ECB would be for governments and the EU to deliver on their commitment to complete the energy transition as quickly as possible. With an energy mix that is less dependent on fossil fuel imports, and with greater energy efficiency, the European economy and inflation would be less vulnerable to the geopolitical shocks that characterise energy markets. This strategy already pays off: we have seen that countries that have a larger share of renewable sources suffered less from the rising energy prices, as they paid a lower bill for importing gas.

But central banks can do more than just wishing governments and the EU will get the energy transition done soon enough. It starts by recognizing that the ECB can actually do something about energy prices – if it plays the long game. 

The ECB can directly support the transition by ensuring predictable favourable funding conditions for any spending or investment that contributes to increasing the supply of domestically generated renewable energy, or investment that reduces the consumption of fossil fuels energies.

In practice, the ECB should get on board with the so-called ‘dual rate’ policy, whereby it sets a different price signal to different actors, instead of a one-size-fits-all policy. For example, the ECB could offer a preferential ‘green discount rate’ through its TLTRO programme for banks, proportional to their portfolios of loans for energy-efficient home renovation or renewable energies. 

In parallel, the ECB could raise interest rates for other economic activities, and start reducing the volume of its corporate bond purchase programme, starting by selling the bonds of corporates linked or dependent on fossil fuel activities. 

For the ECB, not acting proactively in support of the EU green transition would only expose itself to a more difficult task of managing price stability under disorderly transition scenarios, with even more uncertainty and volatility in inflation patterns. Protecting itself from such complications clearly falls under the ECB’s primary and secondary mandates.


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