How Central Banks Square the Circle: Supporting Renewable Infrastructure While Maintaining Price Stability

Central banks are built to do one thing well: keep prices stable. Yet climate change is increasingly forcing a second, uncomfortable question onto their agenda — how to support the capital-intensive transition to renewable energy without letting inflation run loose. For the Reserve Bank of India (RBI), this tension is not theoretical. It is playing out now, in real data, across monetary transmission, bank balance sheets, and inflation dynamics.

The RBI has already signalled its awareness of the challenge. Its discussion paper on climate risk and sustainable finance, and its draft disclosure framework on climate-related financial risks for regulated entities, mark important first steps. But the deeper problem is structural: the very instrument RBI relies on to control inflation — the repo rate — may, under certain conditions, actively impede the green investment India urgently needs. Squaring this circle requires a clearer diagnosis before it can admit a solution.

The Two-Way Street: Monetary Policy Affects Climate, and Climate Affects Prices

The starting point is recognising that the relationship between monetary policy and the environment runs in both directions.

In the conventional view, tighter monetary policy benefits the environment through what economists call the scale effect: higher interest rates cool aggregate demand, reduce industrial output, and by extension cut pollution. But this logic breaks down when green investment is highly sensitive to the cost of finance. Low-carbon infrastructure — solar farms, wind parks, grid upgrades — is inherently capital-intensive. When borrowing becomes more expensive, firms delay or abandon exactly the kind of investment the energy transition requires.

Indian evidence bears this out. Villanthenkodath, Pal, and Ansari (2024) show that broader monetary conditions — proxied by money supply as a share of GDP — are associated with a lower ecological footprint in India, while fiscal policy appears comparatively insignificant. Pradeep (2022) finds that higher interbank rates are associated with higher per capita CO2 emissions, in both the short and long run. Together, these results suggest that restrictive monetary conditions may unintentionally slow the shift toward cleaner technologies by making the financing of such investments prohibitively costly.

The reverse channel is equally consequential. Climate shocks are now feeding back into the very inflation RBI is mandated to control. Kumar (2025), studying India from 1991 to 2022, finds that temperature fluctuations are statistically significant drivers of headline inflation — and that rising temperatures tend to precede inflationary movements. This is reinforced by SenGupta and Atal (2026), who estimate that a unit increase in their composite climate indicator is associated with a 0.463 percent rise in inflation while also reducing GDP in both the short and long run.

For an inflation-targeting central bank, the implication is stark: climate change is no longer only a long-run growth concern. It has become an active, near-term source of price instability — one that sits awkwardly alongside the instruments available to address it.

The Banking Squeeze: Green Lending and Competitive Pressure

The challenge does not stop at the level of monetary policy. It runs through the banking system itself, which is the primary channel through which any shift in credit allocation — toward or away from renewables — must flow.

Banks that expand green lending may not enjoy immediate competitive rewards. Reddy, Panda, and Ngo (2026) find that green credit reduces bank competitiveness in the short run, with the adverse effect most pronounced among smaller banks, public sector banks, and during crisis periods such as COVID-19. Notably, they also find that bank stability negatively moderates this relationship — meaning that even relatively stable institutions face competitive disadvantages when expanding green portfolios, if the opportunity costs are high.

This creates a collective action problem. Individual banks, acting rationally in their own interest, may under-invest in green lending relative to what would be socially optimal — not out of indifference to the energy transition, but because the short-run economics do not fully reward it. Without a coordinating mechanism, the market will not resolve this on its own.

There is a further and more fundamental risk lurking in the background. Bandyopadhyay, Roy, and Manickaraj (2022) document a statistically significant correlation between corporate default rates in the manufacturing sector and CO2 emissions — suggesting that carbon-intensive business models carry rising credit risk over time. Meanwhile, market-based green indices in India, such as BSE Greenex and BSE Carbonex, have not consistently outperformed traditional benchmarks like the Sensex in the short run. The broader implication is clear, however: decarbonisation is increasingly a question of long-run financial resilience, not merely of environmental virtue.

The Policy Dilemma: One Instrument, Two Targets

Economic theory has a precise formulation for this predicament. The Tinbergen Rule holds that a policymaker needs at least one independent instrument for every independent policy target. RBI currently has one primary instrument — the repo rate — and is now being asked, implicitly or explicitly, to use it against two targets: inflation control and the facilitation of a green transition.

The collision is not hypothetical. Raising rates to curb climate-induced food and energy inflation may inadvertently choke off the capital-intensive investment needed to decarbonise the supply side — the very investments that would reduce climate-related supply disruptions over time. Keeping rates low to support green investment, conversely, risks entrenching the inflationary pressures that climate shocks are already generating. Attempting both with a single lever may produce outcomes that are worse on both dimensions.

This is not a counsel of despair. It is an argument for institutional clarity about what monetary policy can and cannot do, and for building the complementary instruments it cannot.

Squaring the Circle: A Practical Roadmap for RBI

The resolution lies not in asking monetary policy to carry more weight than it can bear, but in unbundling the objectives across different instruments. RBI’s policy rate should remain focused on price stability. The task of channeling credit toward the energy transition belongs to a different toolkit — one that RBI can develop and deploy without compromising its inflation mandate.

The most direct lever already available is Priority Sector Lending (PSL). Renewable energy is currently included under PSL. Expanding loan limits within this category could meaningfully redirect credit toward climate-supportive sectors without distorting the overall interest rate environment — in effect, using the quantity of directed credit rather than the price of all credit as the instrument of transition.

Beyond PSL, Bandyopadhyay, Roy, and Manickaraj (2022) point to risk-weight concessions for borrowers with stronger environmental, social, and governance profiles as a targeted incentive for commercial banks. By reducing the capital cost of green lending at the regulatory level, RBI can shift the portfolio economics without touching the repo rate. This would also strengthen the system’s ability to manage transition risks — the financial disruptions that can arise from abrupt regulatory or technological change affecting carbon-intensive sectors.

Climate risk should also be formally embedded in the prudential framework. Treating it as a Pillar 2 risk — requiring banks to develop internal machinery for climate risk assessment and governance — would align India with emerging international practice and improve the quality of credit allocation across the system. Complementary instruments, including green bonds and the gradual development of carbon markets, form part of a broader sustainable-finance architecture that would reduce the burden placed on any single lever.

The broader lesson from this body of evidence is that the macroeconomic and the environmental are no longer separable. Climate change is not an external shock that central banks can note and move past. It is now endogenous to the inflation dynamics, investment conditions, and financial risks that RBI monitors at the core of its mandate.

Squaring the circle — supporting infrastructure for renewables while keeping prices stable — will not come from asking the repo rate to do what it cannot. It will come from recognising that two distinct challenges require two distinct families of instruments, coordinated around a shared understanding of what a climate-resilient financial system must look like.

The authors synthesise evidence from: Villanthenkodath, Pal, and Ansari (2024); Pradeep (2022); Kumar (2025); SenGupta and Atal (2026); Reddy, Panda, and Ngo (2026); and Bandyopadhyay, Roy, and Manickaraj (2022).