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Biophysical Neutrality: The Ecological Limits of Central Banking

Writer: Vimarsh Padha
Vimarsh Padha
Aug 12
9 min read

Central banks have long treated their balance sheets as “neutral” toward markets - but not toward the planet. This piece examines whether energy and ecological limits now belong inside the monetary policy mandate, across advanced economies, emerging markets, and the international financial system



Historically, central banks have calibrated policy against abstract financial metrics, treating the physical environment as external to macroeconomic analysis. "Biophysical neutrality" argues this separation is no longer tenable. If ecological constraints increasingly destabilize inflation, credit risk, and asset valuations, a market-neutral monetary policy cannot safely ignore them.


With institutions from the Bank of England to the Reserve Bank of India already recognizing climate-related risks, the challenge is no longer ideological. The question now is whether these physical realities can be translated into precise, testable models that enhance how central banks assess financial stability and long-run growth.


1. From "Market Neutrality" to "Biophysical Neutrality"


The starting doctrinal fault line is the ECB’s long-held market neutrality principle - the idea that a central bank’s asset purchases and collateral frameworks should not tilt the allocation of capital, only replicate the market’s existing composition. Officials such as Benoît Cœuré have openly acknowledged that this meant the ECB was buying corporate bonds regardless of their carbon footprint because its framework required neutrality toward the existing market structure (Positive Money EU, 2018). Critics have argued that this stance is self-undermining: a central bank that simply mirrors a carbon-biased bond market is not neutral at all - it is reinforcing the very market pricing that has failed to internalise climate risk, which quietly politicises an institution that draws legitimacy from claiming to be apolitical (Thiemann et al., 2023).


Biophysical neutrality pushes this critique one layer deeper. It is not just that financial markets mis-price carbon; it is that GDP-based, credit-driven growth itself has a physical anchor: energy, materials, land, water, and the sinks that absorb waste - that price signals alone do not register in time. Biophysical economists working in the Hall–Klitgaard tradition frame this through Energy Return on Investment (EROI): every unit of monetary growth ultimately rests on a surplus of usable energy extracted at a cost lower than what it returns. Global average oil EROI is estimated to have fallen from roughly 100:1 in the 1930s to around 20:1 by the 2000s, and societies whose EROI falls below roughly 10:1 risk struggling to sustain the complexity of a modern economy (Hall & Klitgaard, 2018). If that decline continues as fossil reserves deplete and are progressively replaced by lower-EROI renewables and unconventional sources, then the “natural rate” of growth central banks implicitly assume when they set neutral interest rates may itself be falling, for physical, not merely demographic or productivity, reasons.


2. The Advanced-Economy Debate: From Stranded Assets to "Greenflation"


In advanced economies the debate has moved fastest through the financial stability channel. The BIS’s 2020 Green Swan report reframed climate change as a source of systemic risk unlike anything in the standard toolkit - events that are radically uncertain, involve non-linear chain reactions across sectors and countries, and cannot be anticipated by backward-looking risk models calibrated on historical data (Bank for International Settlements, 2020). Its authors warned that a disorderly transition could strand large volumes of fossil-fuel reserves, and that in extremis central banks would have little basis for rescuing holders of carbon-intensive assets, unlike in an ordinary banking crisis, because the underlying economic activity itself may no longer be viable (Bank for International Settlements, 2020).


The second advanced-economy front is price stability. Isabel Schnabel’s influential 2022 taxonomy split climate-related inflation into three channels: climateflation (supply shocks from droughts and extreme weather), fossilflation (volatility from continued dependence on oil and gas, sharpened by geopolitical shocks such as the war in Ukraine), and greenflation (rising prices of the metals, minerals and grid capacity needed for the energy transition itself) (Schnabel, 2022). This framing lets ECB officials treat the ecological transition as squarely a challenge to price stability rather than an issue outside the bank’s mandate - a rhetorical bridge from “neutral” central banking to active engagement, though one that stops short of asking whether the growth path itself is biophysically sustainable.


This has produced open institutional conflict. Bundesbank president Jens Weidmann argued explicitly that it was not the central bank’s job to correct market distortions caused by climate policy failures (D’Orazio & Popoyan, 2022). Yet research shows the market-neutrality defence is logically shaky once a central bank’s balance sheet is large enough to move markets: asset purchases are never truly neutral, because capital markets already display a structural bias toward large, carbon-intensive issuers, so “neutrality” in practice means passively subsidising incumbents (van ’t Klooster & Fontan, 2020). Christine Lagarde’s 2021 remarks moved the ECB rhetorically toward this recognition, suggesting the Bank should reflect on whether market neutrality remains an adequate benchmark for its asset-purchase programmes and explore alternative approaches (Lagarde, 2021) - a shift from neutrality-as-passivity to neutrality-as-active-stewardship of ecological risk.


3. The Emerging-Economy Perspective: Exposure Without Balance-Sheet Space


For advanced-economy central banks, biophysical limits show up mainly as transition risk to portfolios. For most emerging economies - India prominent among them - the more immediate exposure is physical risk to real activity, layered onto much thinner fiscal and monetary buffers. Tropical emerging markets face disproportionate physical climate exposure because a large share of GDP and employment sits in climate-sensitive sectors such as agriculture, while households hold lower savings buffers to absorb shocks from heat and erratic rainfall (Raga et al., 2023). This is a structurally different problem from the ECB’s greenflation debate: it is not “how do higher green-metal prices feed into core inflation,” but “how does a monsoon failure simultaneously spike food inflation, cut rural incomes, and stress agricultural credit portfolios in the same quarter.”

Institutionally, emerging-market central banks are still in the early, capacity-building phase of even measuring this exposure. The RBI has run a pilot Climate Vulnerability Assessment and Stress Test using NGFS scenario sets - orderly, disorderly, and “hot house world” pathways - leaning heavily on NGFS scenarios and technical expertise that individual emerging-market institutions could not easily build alone (Rao, 2023). Broader surveys across emerging markets find that most still lack the granular data and modelling capacity that advanced-economy central banks take for granted, recommending a phased roadmap running from awareness-raising and mandate integration, through policy development and pilot stress tests, to full supervisory implementation calibrated to each institution’s capacity (Raga et al., 2023).

This asymmetry matters for the biophysical-neutrality debate because it exposes a distributional dimension that the advanced-economy discourse tends to underplay: countries with the least historical responsibility for ecological overshoot face the most acute physical constraints on monetary and fiscal policy, with the least institutional capacity to price or hedge them.


4. The International Finance and Monetary-Order Dimension


Biophysical constraints do not stop at national borders - they run straight through the architecture of the international monetary system. Three linkages are worth foregrounding for a commentary grounded in international finance.


First, the dollar system and stranded-asset transmission. Much emerging-market debt, and much of the global trade in energy and commodities, is dollar-denominated. A disorderly transition that strands fossil-fuel assets in exporting economies does not merely hit corporate balance sheets; it can hit sovereign external accounts, reserve positions, and currency stability simultaneously - precisely the kind of cross-border, non-linear cascade that the BIS’s Green Swan framework was designed to describe, where physical and transition risks propagate through multiple feedback loops that cut across sectors, countries and financial systems at once (Bank for International Settlements, 2020).


Second, the North–South distributional question embedded in post-growth economics. The review of post-growth science in The Lancet Planetary Health - spanning ecological economics, wellbeing economics and degrowth - makes an argument directly relevant to international monetary design: post-growth trajectories in high-income economies could, in principle, ease the resource and demand pressure historically imposed on the Global South, but only if low-income countries simultaneously pursue monetary sovereignty and industrial policy to delink from dependence on exports to high-income economies (Fanning et al., 2025). In other words, biophysical neutrality in advanced-economy central banking cannot be evaluated in isolation from the capital-flow and exchange-rate constraints facing emerging economies - a slower advanced-economy growth path without reformed international financial architecture could simply transmit contraction outward via trade and capital-flow channels.


Third, the more radical academic challenge to the entire framework. Ecological economists - Jason Hickel and co-authors among the most cited - have gone further to ask whether monetary financing itself needs re-engineering for a degrowth or post-growth transition, including work explicitly proposing instruments akin to Modern Monetary Theory to fund an ecologically bounded transition (Hickel et al., 2023). These are minority positions within the profession, but CEPR- and NBER-adjacent institutions are increasingly commissioning empirical work that takes the underlying physical premise - that growth has an energetic floor and ceiling - seriously enough to model, rather than dismiss.


5. The Counter-Case


Establishing biophysical neutrality as a viable framework requires testing it against its key institutional and theoretical objections.


• Mandate overreach and the Tinbergen principle. Critics such as Cochrane and Weidmann argue that using a single instrument (the policy rate or balance sheet) to pursue multiple objectives - price stability and ecological allocation - violates the classical Tinbergen rule that you need as many independent instruments as targets, and risks threatening central bank independence by dragging monetary authorities into inherently political, distributive choices that are properly the domain of elected fiscal authorities (D’Orazio & Popoyan, 2022).


• Legal constraint, not just reluctance. Cullen’s (2023) review of this debate in the Journal of Financial Regulation notes that current legal mandates in most jurisdictions genuinely constrain what central banks can do, and that advocates for bolder action are often relying on creative reinterpretation of existing regulatory tools rather than a clear legal basis for climate-oriented intervention - a fair warning against overstating what monetary policy alone can achieve.


• Growth is still the primary poverty-reduction lever for most of the emerging world. A biophysical-limits framing that too readily imports degrowth prescriptions risks colliding with the real, immediate developmental needs of economies where growth remains strongly correlated with poverty reduction, formal employment, and fiscal capacity to build climate resilience in the first place.


6. Where This Leaves the Policy Conversation


The most defensible synthesis, and the one increasingly visible in NGFS and BIS output, is not full-blown “degrowth central banking” but a recalibrated notion of neutrality: instead of neutrality toward current market composition (which passively embeds carbon bias), central banks are being nudged toward neutrality toward future physical risk - treating climate and resource constraints as endogenous to their existing price-stability and financial-stability mandates rather than as an externality to be waved toward fiscal policy. For advanced economies, that means taking Schnabel’s (2022) climateflation/fossilflation/greenflation taxonomy seriously in forecasting models. For emerging economies, it means accelerating NGFS-scenario capacity building (Rao, 2023; Raga et al., 2023) without pretending that Global North transition timelines map cleanly onto economies with far less fiscal and monetary space. And for the international financial architecture, it means recognising that a “green swan” event is, almost by construction, a cross-border event (Bank for International Settlements, 2020) -one that will test dollar liquidity backstops, sovereign debt sustainability frameworks, and multilateral coordination as much as it tests any single central bank’s model.


Whether “biophysical neutrality” develops into a useful analytical framework, alongside concepts such as market neutrality, financial stability, and price stability will depend on whether it can generate empirically testable predictions and improve our understanding of how ecological constraints interact with inflation, productivity, financial stability, and long-run growth. The opportunity is therefore not to replace the existing monetary-policy framework, but to broaden it where the changing structure of the economy makes previously external risks increasingly relevant to the variables central banks already monitor. This is ultimately an empirical question, and one that merits serious attention as central banks confront a world of more frequent supply shocks, energy transitions, and increasingly binding physical constraints.

 

References



Disclaimer: The views and opinions expressed in this article are purely personal and do not reflect the official policy or position of any affiliated institution.

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Mumbai, India 

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