Stockholm (NordSIP) – Inflation was one of the dominant themes of 2022 and looks set to remain on top of investors’ agenda in 2022. However, tackling inflation while holding steadily onto the sustainable investment agenda is not always clear, particularly given the hurdles inherent to pursuing the climate transition agenda and the global trend of central bank shrinking their balance sheets.
The ECB’s View
In a speech at the International Symposium on Central Bank Independence, held in Stockholm at the Swedish Central bank on January 10, Isabel Schnabel (Pictured), a Member of the Executive Board of the ECB, presented the central bank’s new position on this topic.
According to Schnabel, “failing to arrest high inflation in a timely manner would jeopardise the green transition more fundamentally and that a restrictive monetary policy stance today will benefit society over the medium to long run by restoring price stability.”
The monetary policy maker did not fail to emphasise the importance of political action from governments on the issue of climate change, noting that “fiscal policy needs to remain in the driving seat and accelerate the green transition, and that the decline in the ECB’s balance sheet as part of our monetary policy tightening requires us to make additional efforts to align our actions with the objectives of the Paris Agreement.”
However, Schnabel noted that “the ECB needs to intensify its efforts to support the green transition” as per its obligation to “support the EU’s general economic policies in line with our secondary objective. We must therefore ensure that all of the ECB’s policies are aligned with the objectives of the Paris Agreement to limit global warming to well below 2 degrees Celsius.”
Recognising that efforts are still falling short of this goal, Schnabel presented a new three-part approach to fulfilling these goals.
The New Paradigm – From Flow to Stock
The first step that the ECB will take to reinforce its climate change mitigation approach is to switch its perspective of asset purchases from a flow to a stock approach. “For our corporate bond portfolio we are following a flow-based tilting approach where we adjust our reinvestments of corporate bonds based on a climate score that reflects issuers’ carbon intensity, their decarbonisation plans and the quality of their climate-related disclosures,” Schnabel explains.
“The forthcoming reduction in reinvestments will further significantly constrain the ability of a flow-based approach to decarbonise our corporate bond portfolio at a pace that is consistent with our climate ambitions. (…) assuming full reinvestment, we would achieve only half of the total decarbonisation of our corporate bond holdings by 2030 if firms were to stop taking steps to decarbonise their activities (…). This effect depends to a significant extent on the actions of a few high-emitting companies,” Schnabel adds.
“A flow-based tilting approach is thus insufficient to achieve our goal. (…) We therefore need to move from a flow-based to a stock-based tilting approach for our corporate bond portfolio. This means that, absent any reinvestments, actively reshuffling the portfolio towards greener issuers would need to be considered,” she continues.
The New Paradigm – Greening Public Sector Bonds
Increasing the stock of green bonds means the ECB needs to take a hard look at its balance sheet. Given that government bonds represent approximately half of the ECB’s balance sheet it seems like a very natural channel through which to pursue climate mitigation policies. However, this is not straight forward.
“First, purchases of sovereign bonds are guided by the capital key, which limits the scope for tilting strategies based on countries’ carbon intensities. Second, there is not yet a reliable framework in place to assess the extent to which sovereign bond portfolios are aligned with the Paris Agreement. And, finally, the amount of green sovereign bonds is still limited, in particular when compared with the size of our current bond portfolio.”
Schnabel presents two potential solutions to these problems. “One is to increase the share of bonds issued by supranational institutions and agencies. (…) The second, complementary option is to steadily reshuffle our sovereign bond portfolio towards green bonds as governments expand their supply of green bonds over time,” she adds.
The New Paradigm – Greening Lending Operations
The ECB’s lending operations are another part of its balance sheet that can play an important role in supporting the Paris Agenda. Since the ECB requires financial institutions that its lends to to post collateral in exchange for cash, the central bank can use that channel to incentivise banks to hold more green assets.
“As a first step we will limit the share of assets issued by entities with a high carbon footprint that can be pledged as collateral by individual counterparties when they borrow from the Eurosystem. We will also consider climate-related risks when determining haircuts for corporate bonds.”
A Welcomed Paradigm Shift
Ulf Erlandson, CEO of the Anthropocene Fixed Income Institute, welcomed this paradigm shift. “From AFII’s perspective, this represents a welcome paradigm shift in central bank climate policy and addresses concerns previously raised regarding the ECB’s policies,” Erlandson said.
“The ECB owns around €345bn of corporate bonds and trillions of sovereigns and sub-nationals, as well as very large collateral exposures, and so is a key driver of fixed income flows and valuations in Euro denominated markets.”
