Read the technical report “Monetary policy and climate transition: what can the ECB do for the European Green Deal”
Climate change asks central banks to act on multiple fronts: (i) the potential changes induced by climate impacts on the transmission mechanism of monetary policy tools; (ii) the ways in which central banks can contribute to mitigating climate risks, and (iii) the support that monetary action can provide to investments for the green transition[1].
Climate change is becoming a key factor for monetary policies, the effectiveness of which depends on the behaviour of the financial system, particularly the banking system. The banking system plays a central role in the transmission process, and its stability is a cornerstone of that of the entire economic system. In this context, it is operationally essential for central banks to include climate change in monetary policy assessments to preserve their ability to intervene.
Central banks could also play a proactive role that goes beyond protecting the transmission mechanism and extends to facilitating the processes of transformation required to mitigate climate risks at systemic level. There is plenty of empirical evidence to demonstrate that, with their specific tools, monetary policies can have a varied effect on the accessibility and cost of capital, favouring green enterprises, facilitating the decarbonisation of carbon-intensive businesses and penalising harmful activities.
In the context of the European Green Deal, the actual implementation of monetary policies offers great potential scope for the ECB and NCBs[2] to contribute to the pursuit of European decarbonisation goals, while adhering to their own mandates. In short, the ECB and NCBs can adopt operational criteria aimed at encouraging the reallocation of resources by the banking system to favour green financial investments and credit.
Although mitigating the climate crisis is not its main responsibility, the ECB is required by the EU Treaties to support the European Union’s policies, albeit secondarily to its goal of maintaining price stability[3].
The ECB may enact various lines of conduct in order to achieve this objective: (a) It may adopt policies aimed at excluding securities issued by carbon-intensive sectors or businesses (negative screening); (b) It may orient its open market operations (both standard and non-standard) to favour “sustainable” securities (positive screening); (c) It may orient its collateral framework (securities’ eligibility and haircuts) to also properly take into account systemic climate risks and encourage the reallocation of bank assets in line with the goals of the European Green Deal. In all three cases, the methods used by the Central Bank would correct the market bias in favour of carbon-intensive activities.
The ECB started the underwriting of green bonds and sustainability-linked bonds on the open market in September 2020, and in July 2022 it announced further climate sustainability measures that, in the months that followed, were implemented on three levels: (1) The integration of criteria for the selection of eligible securities as collateral for open market and bank refinancing operations (collateral framework) with an internal rating system that takes into account carbon footprint, the quality of reporting and decarbonisation plans of the issuers; (2) The implementation of a progressive “tilting” of its security portfolio for monetary operations, consisting of securities issued by private non-financial enterprises, through the reinvestment of maturing securities on the basis of the aforementioned internal rating systems (portfolio tilting); (3) The integration of climate risk assessments into internal risk-management practices and policies for the reporting of its activities.
However, the inclusion of carbon rating in the selection of eligible securities as collateral for open market and refinancing operations has only been applied to securities issued by non-financial firms (corporate securities) and not to those issued by national authorities or financial intermediaries, or to securitised assets. As a result, the carbon intensity criterion has, in general, only been applied to an extremely limited portion of the total number of eligible securities (11%). Furthermore, the criteria applied for the selection of the latter have not resulted in any differentiation in the “haircuts” applied (i.e., the cost of bank refinancing), with the justification that climate risks are already reflected in the market assessment of the issuers’ credit risk.
Portfolio decarbonisation policies have not included securities issued by public-sector entities, nor those issued by financial institutions, and within the framework of quantitative easing programmes implemented between mid-2022 and mid-2023 (APP and PEPP), were focused exclusively on securities issued by private non-financial companies as part of programmes that were suspended in July 2023 (CSPP) or that are due to expire by December 2024 (PEPP). With the exception of the PEPP (which has been granted increased flexibility), securities operations have been conducted on the basis of the market neutrality principle (i.e., in the same proportion as the market capitalisation of securities). As the majority of securities on the market have been issued by companies with large carbon footprints, this has automatically resulted in the Central Bank’s portfolio also being negatively affected by the same carbon bias. Furthermore, decarbonisation goals have not been taken into consideration in the criteria for granting non-standard bank refinancing as part of the TLTRO programmes (other than the eligibility criteria for private securities), nor have they been adopted when determining the entity of haircuts for collateral for open market and refinancing operations.
The carbon impact of these policies on the system has therefore been modest, firstly because they have only influenced a relatively small proportion of securities, and secondly due to the extremely short period of time over which portfolio tilting policies were implemented (October 2022-July 2023), as a result of the deactivation of QE policies dictated by new restrictive monetary policies.
In the deflationary period 2015-2021, in which the ECB continued to make net acquisitions of public-sector securities, and in the period that followed, until mid-2023, when the Central Bank kept reinvesting maturing securities, there would have been no contraindications to monetary policies aimed at a progressive and aggressive portfolio reorganisation through QE to favour both private securities with lower carbon footprints and GB/SLB-type securities. This long period of time represented a significant missed opportunity to: (a) reorient not only businesses, but also the public sector and financial intermediaries through the issuing of GB/SLB; (b) encourage private and public-sector issuers to adopt behaviour in line with EU climate goals through incentives (eligibility and haircuts); and (c) facilitate the granting of bank credit on the basis of decarbonisation programmes, energy efficiency and/or green investments (TLTROs).
The general situation has changed drastically since the end of 2021. The inflationary tensions that resulted from the Russia-Ukraine conflict and the energy crisis that followed have completely overturned the expansive stance of monetary policies, which have set in motion intense increases in interest rates. In this new phase, QE no longer represents a viable measure for the central bank to foster the decarbonisation of the economy.
However, the transition requires significant investment, both for the development of innovative technology and for the transformation of infrastructure, production processes, mobility and residential real estate. A prolonged period of high interest rates tends to be more detrimental to investments in renewable energy and sustainable technology, while failing to penalise fossil fuels and energy intensive manufacturing processes. The pursuit of a monetary policy to support decarbonisation and technological transformation could serve to create conditions for differentiating the cost of capital to favour green activities while penalising brown activities, through:
- The extension of carbon-rating criteria for the selection of eligible securities (currently only applied to corporate securities) to also cover categories of securities issued by financial institutions (covered bonds and ABS) that are explicitly linked to the funding of energy efficiency and/or decarbonisation programmes.
- The application of preferential haircuts for categories of GB/SLB or compliant issuers with credible decarbonisation plans (which would foster the growth of secondary markets and would also indirectly render it advantageous for banks to grant securitisable credit of a similar nature).
- The implementation of long-term subsidized bank refinancing, similar to TLTROs, aimed exclusively at refinancing bank credit issued in favour of green investments and decarbonisation programmes.
These operations would be policy neutral, i.e., they would be compatible with any general monetary policy goal (as they can be calibrated according to antinflationary targets), but their effects would be anyway highly selective (as they tend to segment the market and promote the substitution of types of securities without necessarily having undesired monetary policy impacts).
There are, however, at least three strategic aspects that need to be addressed by the Central Bank before defining a monetary action aligned with the objectives of the European Green Deal:
- The adoption of an “impact approach” of assessing the effectiveness of monetary policy operations with reference to the processes for decarbonising the economy. This implies: (a) measuring the reduction in absolute financed emissions (and not only carbon intensity); (b) setting targets (or adopting benchmarks) to periodically assess the extent to which monetary policy impact is aligned with the European Union’s climate goals.
- A switch from an exclusively risk-based logic to a policy-oriented logic, acknowledging that the latter is necessary to address the systemic dimension of climate risks.
The abandoning of the market-neutrality criterion in the composition of the Central Bank’s open market operations, recognising that the market is unable to suitably value climate risk and is therefore incapable of avoiding the resulting biases in favour of carbon-intensive activities to the detriment of investments required for the transition.
Read the technical report
NOTES
[1] In this report, the generic expression “green” is used in a restrictive manner with specific reference to activities aligned with the Green Deal strategy and the sustainability criteria defined by the European Taxonomy. The expression “brown” is used to identify activities that do not fall into this category.
[2] The European Central Bank (ECB) and National Central Banks (NCBs) form part of the Eurosystem (the system formed by the central banks of the countries that have adopted the Euro currency) which is currently also identified with the acronym ESCB (European System of Central Banks) adopted in European Union Treaties. For the purposes of this report, the ECB is considered as a synonym of the Eurosystem or of the ESCB.
[3] Art. 127 of the TFEU: “The primary objective of the European System of Central Banks (hereinafter referred to as “the ESCB”) shall be to maintain price stability. Without prejudice to the objective of price stability, the ESCB shall support the general economic policies in the Union…”
Photo by Charlotte Venema
