ECB to decarbonize its corporate bond purchasing and collateral framework: from intent to almost immediate action

Central banks provide credit to banks conditional on collateralization, applying eligibility criteria[9] for the collateral to be provided. The Eurosystem collateral framework (ESCF) is essential to (i) liquidity management and strategic planning of banks and (ii) the feasibility of central bank operations, financial conditions, financial stability and the transmission mechanism of monetary policy, in particular in stress conditions. Note however that it only applies to “unsecured” asset refinancing: as assets are not mobilized, they can be monetized if needed or to act in the event of a crisis.

Collateral frameworks have a “conservative design”, with a focus on strict requirements for collateral quality and high haircuts[10]. Haircuts refer to a reduction applied to the value of an asset. In the context of the collateral framework, the ECB deducts a percentage from the collateral value to establish the borrowing potential. It depends on the price volatility, the relevant assets and the prospective collateral liquidation time. [11]

The ECB has now announced that before the end of 2024, “the share of assets issued by entities with a high carbon footprint that can be pledged as collateral by individual counterparties when borrowing from ECB” will be limited. Note that ECB will only accept as collateral assets and credit claims from companies and debtors that comply with the Corporate Sustainability Directive (CSRD)[12] once the directive is fully implemented. The new eligibility criteria are expected to apply from 2026. This measure should help improve climate-related data and disclosures. At first, this will only apply to marketable debt instruments issued by non-financial corporates. Marketable assets must meet credit quality requirement as defined by the Eurosystem credit assessment framework (ECAF)[13].

As the data quality improves, the measure may be extended to more asset classes[14] according to the ECB’s official communiqué.  In addition, as of this year, the ECB will also consider climate change-related risks when reviewing the haircuts applied to corporate bonds used as collateral. This new regime aims to reduce climate-related financial risks in the ECB credit operations.

New suggested collateral framework may influence investor demand – thinking of bank liquidity buffers for example and demand for HQLA Level 2A and 2B securities. Applying a different haircut and collateral eligibility rules to “carbon intensive securities” may have a knock-on effect on liquidity premiums for such securities both at secondary and repo market levels. The limit placed on the share of the assets issued by carbon-intensive issuers that can be pledged as collateral may indeed trigger a reduced investor demand for such securities. This may result in an additional reduced access to capital for those highly-emitting issuers which may encourage them to undertake transformation of their activities. A parallel can be drawn with the SLB market where inverse dynamics have been observed. In contrast, the decision of the ECB to integrate sustainability-linked Bonds (SLB) in its collateral framework and bond purchase programs may have possibly contributed to the development of the market.

This may also trigger a “second-round effect” as the measures may affect liquidity/bank’s liquid reserve. For collateral with weak ratings, liquidity may be reduced, thereby resulting in an increase of banks’ liabilities.

Overall, the greening of the collateral framework seems to be a strong incentivizing measure. To a certain extent, this is reminiscent of the measures implemented to support access to credit for firms and households (easing of collateral standards and haircut) through targeted longer-term refinancing operations (TLTRO) during the Covid-19 crisis.

Currently, green assets’ universe remains small as compared to the ECB “purchasing” universe. As risk-weighted assets (RWA) constraints currently do not factor decarbonization, such a measure may make green assets less profitable for banks, thereby hampering their own greening strategies. This may further result in a foreclosure effect for some of the financial actors (unless capital and leverage constraints for green assets are simultaneously relaxed). Given green assets scarcity and a fortiori a low profitability for banks (due to heighted demand and higher price), the main way to detain green assets would be through central bank refinancing. This means that it would not create additional collateral but rather that the bank will only act in “pass through” for the ECB to act as lender of last resort (LOLR). For the ECB to perform such an investor role, the availability of green assets is crucial.

“The Eurosystem aims to gradually decarbonize its corporate bond holdings, on a path aligned with the goals of the Paris Agreement”[15]. Starting in October 2022, the ECB’s €~345 bn corporate sector purchase[16] portfolio will be “tilted towards issuers with better climate performance, through the reinvestment of the sizeable redemptions expected over the coming years.” The figure 3 below presents the ECB’s top 15 corporate holdings under CSPP according to our estimates.

According to Frank Elderson and Isabel Schnabel, two members of the ECB Executive Board, approximately €30 billion will be reinvested towards companies with a better climate performance every year[17]. While corporate bond purchases will continue to be guided by ECB’s inflation target, the central bank will gradually reinvest matured bonds towards good climate performers by looking at (i) lower greenhouse gas emissions, (ii) more ambitious carbon reduction targets and (iii) better climate-related disclosures.

The relative reduction of assets purchased from poorer climate performers aims at reducing ECB’s balance sheet exposure to environmental risk according to the ECB. The central bank will start publishing climate-related information on its corporate bond purchase scheme regularly from the first quarter of 2023. As most market players (banks, insurers, asset managers) and even the ECB now seek green assets to decarbonize their balance sheet, the prices of the latter might increase while risk premiums and margins may decrease. However, as evidenced by the experience with quantitative easing, the arrival on the market of central banks whose macroprudential liquidity, capital and leverage constraints differ from banks may compress the margins of the latter.

From an issuer perspective, given the rise of interest rates, this measure could possibly provide incentives to companies looking to reduce their borrowing costs and/or enhance their access to capital to improve their climate performance and/or disclosure.

Overall, the combination of the greening of the collateral framework and of the corporate sector purchase programme may have a scissor effect. It could increase credit cost for issuers in heavily emitting industries due to a double penalty: less mobilizable assets and increased cost of capital. Such outcomes may even go beyond the EU by adding pressure on non-EU companies that issue EUR denominated bonds.

IV. Is “further” enough? A Benchmark of central bankers’ practices

Some observers described the measures “to incorporate climate change into ECB’s monetary policy operations” as “overdue”. As compared to the roadmap published in 2021 (see Figure 2 above), the announcement thus comes late in particular as significant more details are still awaited, including on the implementation steps, but also on the mechanisms themselves. As the CSRD has been delayed, this new debt collateral eligibility criteria are not expected to apply before 2026.

From a more macro-financial perspective, the corporate bond holding scheme accounts for ~11% of the assets bought under quantitative easing policy (APP accounted for ~3,2tn in June 2022[18]). As shown under by the cumulative net purchases of the ECB as of the end of June 2022, most of those assets are bought under the Public Sector Purchase Program (PSPP). Adapting tilting strategies for the public sector would however be challenging as those schemes are guided by capital key[19] (the key equally reflects the respective country’s share in the total population and gross domestic product of the EU[20]). From a risk management perspective, this means that the ECB will significantly remain exposed to climate-related risks.

Figure 4: the cumulative net purchases of the ECB as of June 2022 [21]

Given the considerable expansion of the role of central bankers and the systemic importance of the ECB, that does not make the measures any less significant. As of today, the ECB’s measures are the most expansive in terms of size (~€386bn corporate bond portfolio as compared to a ~20bn portfolio for the bank of England).

• Scope: SEK 12.4 bn (as of June 30th 2022 according to Riksbank’s website)
• Eligibility:   in June 2022, Riksbank announced that, as of September 1st, 2022, it will only “purchase corporate bonds issued by companies that report their annual direct and indirect emissions of greenhouse gases (scope 1 and scope 2) in accordance with the recommendations of the Task Force for Climate-related Financial Disclosures”[23].
• Mechanism: This means that it only purchases corporate bonds from companies deemed to comply with international standards and norms for sustainability (see our Article “Swedish Central Bank as a first mover” on the matter).

b) The Bank of England (BoE): a similar “tilting purchases towards stronger climate performers” approach

The Bank of England (BoE) has published significantly more information on its approach to the greening of monetary policies than counterparts[24]. As the United Kingdom has committed to a target of net zero greenhouse gas (GHG) emissions by 2050, the BoE targets a 25% reduction in the carbon intensity of the Corporate Bond Purchase Scheme (CBPS) by 2025.

• Scope: the £20bn corporate bonds holding programme. 
• Eligibility: firms that meet public climate disclosure in line with the UK Government’s requirements, from 2022, and for higher-emitting sectors (energy and utilities) public emissions reduction targets. Issuers with any coal mining activities are ineligible. Unless stringent criteria in line with science-based pathways are met, issuers using thermal coal in their activities are also ineligible. 
• Tilting: the scorecard incorporates level of emissions intensity in latest data, past reductions in absolute emissions (relative to sector-specific pathways for high emitters), publication of a climate disclosure, and publication and third-party verification of an emissions reduction target.
• Escalation: annual review of the calibration of CBPS, increase of the requirements as coverage and robustness of data and metrics improve, escalation of the intensity of actions, including, where appropriate, loss of eligibility and divestment where climate performance is inadequate.

However, according to Reclaim Finance, the Bank of England approach “falls short on several fronts, notably by failing to oppose fossil fuel development and to cover all GHG emissions” (scope 3 emissions). It finds additionally that the use of a carbon intensity target for the portfolio is flawed in the sense that it allows absolute emissions to grow if the portfolio does. Note that the first limit emphasized is now also applicable to the approach announced by the central bank of Sweden last week.

V. Acknowledging market failures: towards market efficiency

The adequacy of the market neutrality (i.e., implying that the corporate sector purchase programme should reflect the overall eligible market to ensure no distortion) has been questioned by multiple influential personalities, including Banque de France Governor François Villeroy de Galhau[25], ECB Executive Board Member Isabel Schnabel and President Christine Lagarde. As it is increasingly evidenced, there is an inherent debt capital market bias towards carbon-intensive industries. This means that the corporate bond buying programmes, as developed by central banks may be benefitting heavily emitting industries (see table below) in conflict with the EU Climate Agenda.

Figure 5: Contribution of the carbon-intensive sectors to the euro-non bank corporate bond market (outstanding amount), the ECB list of bonds held under CSPP/PEPP (outstanding amount) and the euro area gross value added (GVA)

Source: “Decarbonizing is easy: beyond market neutrality in the ECB’s corporate QE" study

Interestingly, the study “an environmental mandate, now what?”[27] on the greening of the monetary policy by the Bank of England finds that “continued adherence to the market neutrality principle, leads to the tilting of the CBPS holdings within sectors so that the scheme continues to reproduce the underlying sectorial composition of the bond market”. Consequently, “the Bank’s tilting cannot reduce the representation of carbon-intensive activities in the CBPS and can paradoxically lead to some carbon-intensive companies getting better treatment than environmentally friendly companies”.

Two alternatives to the current design of the greening of the Bank of England’s corporate bond purchases - the strong tilting and the strong tilting and exclusion – are explored in the aforementioned study (see Box 1 below), meaning that lessons can be drawn for the limits underlined above when designing the ECB’s tilting mechanism.

As of today, no exclusion policy for the corporate bond portfolio has been brought up by the ECB. Yet, should the ECB opt for a “strong tilting” or “strong tilting and exclusion approach”, the European Taxonomy could serve as a basis for the tilting mechanism.

VI. Conditions for a successful portfolio rebalancing approach

Assessing good climate performers by looking at (i) lower greenhouse gas emissions, (ii) more ambitious carbon reduction targets and (iii) better climate-related disclosures raises multiple questions. ESG data challenges are well known, and one may wonder on which source the ECB will rely for climate data. Note that, last March, Carbon4 Finance was chosen to provide the Eurosystem (i.e., the European Central Bank as well as the National Central Banks of the euro area) with climate-related sustainable and responsible investment (SRI) data[28]

On top of data collection matters, it is not clear yet whether GHG emissions will be assessed on an intensity, absolute gross or net basis. Carbon offsets as well as carbon capture and sequestration are prone to debate. The scope of GHG emissions (scope 1,2 and 3) adopted has not been clarified either but as indirect emissions (scope 3) are most often material, it would make sense to include them.

Some research, like the “sustainable investing and climate transition risk: a portfolio rebalancing approach”[29] study published by Giacomo Bressan, Irene Monasterolo and Stefano Battiston however finds that GHG emissions, in particular scope 3 emissions, face accounting limitations as well as limited reliability and comparability. Due to these limitations and as GHG emissions do not take into account the issuers’ energy technology profile “which plays a key role in the firm’s alignment to climate objectives and drives the forward-looking exposure to transition risks” which makes it insufficient “alone to inform climate-related portfolio rebalancing” according to the same researchers.  

For this reason, the authors suggest using enhanced measures of greenness such as one based on Climate Policy Relevant Sectors (CPRS). Beyond the GHG emissions profile of an activity (scope 1,2,3), the CPRS classification also integrates the energy technology profile, its business and revenue model as well as the relevance for climate policy implementation (i.e., their costs sensitivity to climate policy change), which makes it a more holistic but qualitative proxy. Under weaker allocation constraints (“weaker neutrality principle”), a rebalancing of the asset purchase program can achieve an aggregate reduction of exposure to economic activities with high climate transition risk of about 10% and a reduction of total aggregate GHG emissions of about 6%.

The ambition of carbon reduction targets is a well-worn subject for investors, that poses multiple challenges. First, carbon reduction targets suffer from little comparability in the sense that ambition levels, baseline years, intermediate dates selected, objectives (breadth of scope, changes in scope, gross or net figures), methodologies and geographies widely vary across issuers.

One may wonder how the ECB intends to look at the performance and against which universe. A best-in-class approach seems plausible. On ambition level more specifically, one can wonder how the ECB will manage to opine on “more ambitious” carbon reduction targets and against which scenario and benchmark. The benchmark adopted can be one of the following:

• International agreement (i.e., the Paris Agreement);
• EU legislative package (i.e., the Fit for 55 net neutrality objectives);
• Market standards (i.e., SBTi, ICMA’s recently published registry or climate transition finance guidelines , see our article on it);
• Peers? Against geographical and/or sectorial criteria?

Another issue with such a forward-looking component is that a target does not necessarily translate into results (Read our article on the matter “To pledge or not to pledge…Net neutrality, an international dilemma”).  What if issuers then miss their targets? Will any “penalty mechanism” (i.e., selling the assets as the issuers can no longer be considered as a good climate performers) be envisioned?  

The extent to which EU Sustainable finance regulation (i.e., the Sustainable Finance Disclosure Regulation, the Corporate Sustainability Reporting Directive and the EU Taxonomy) will allow “better climate-related disclosures” is as of today unknown.  So far, we only know that to improve disclosures and generate better data for all stakeholders, the ECB will only accept assets and credits claims from companies and debtors that comply with the Corporate Sustainability Reporting Directive (CSRD) as collateral in Eurosystem credit operations. Yet, as pinpointed by the ECB, a “significant proportion of the assets that can be pledged as collateral in Eurosystem credit operations, such as asset-backed securities and covered bonds, do not fall under the CSRD”. To “ensure a proper assessment of climate-related financial risks for those assets as well”, this means that harmonized and better climate disclosures are necessary.

In ECB’s attempt to further enhance risk assessment tools and capabilities, rating agencies are urged to increase transparency on how climate-related risks are incorporated in ratings and their requirements on climate risks disclosures. This may be because for eligibility purposes, the ECB is reliant on credit ratings for its collateral framework. Credit rating agencies’ inertia, increasingly come under a cloud. Following the Call for Evidence (February 2022) to gather information on the market structure for ESG rating providers in the EU, the European Securities and Markets Authority (ESMA) found that shortcomings include a “lack of coverage of a specific industry or a type of entity, insufficient granularity of data, and a lack of transparency around methodologies used by ESG rating providers.” However, the role of credit agency is key in transparency, tackling greenwashing and improving ESG risk assessment in debt capital markets and in the Eurosystem.  

VII. What’s next?

As first responder to economic policy, central banks are essential to address and ease the transition to a low carbon economy. As demonstrated by the ECB’s roadmap, central bankers can cascade environmental considerations in wide arrays of the monetary policy operations.

Some relevant areas for the greening of the monetary policy have not been explored yet even though they are meant to be so by the ECB according to its climate action plan. The next step of the decarbonization strategy of the ECB may be the introduction of requirements into the Eurosystem Credit Assessment Framework (ECAF) targeted to climate change risk. For corporates, eligibility rules are stringent and considerably reduce the universe of claims that can be used as collateral. Note that if the same rules were to apply to the green assets, this would considerably reduce the scope of the measures.

Even beyond monetary policy, environmental considerations are meant to be increasingly integrated in the banking supervision. Given the relative scarcity of green assets, a supervisory effort is necessary to enhance the origination of such assets. A coordinated action both on the monetary and the supervision sides may therefore initiate a virtuous circle. Greater origination of green assets through adequate supervision of capital (through risk models, pillar 2 supervisory practices, ect.) would reinforce the logic which underpins the greening of the asset purchase programme, and vice versa. Only a balance between those two axes would prevent a “second round” effect that would penalize the poorest performers without letting them have the time to put balance sheet greening strategies into place.  Still on the supervisory level, there are still many areas for improvements in climate risk management. Indeed, as of today, the ECB found that:

• Three in five banks do not yet have a climate risk stress-testing framework.
• Most banks do not include climate risk in their credit risk models,
• Only one in five banks consider climate risk as a variable when granting loans.

Such results call for a greater push in supervisory activities to facilitate an orderly transition to a low carbon economy and thus minimize the bank’s losses.