An idea for central banks seeking to address climate risk

Simon Smiles and Vibeka Mair put forward an approach to QE that focuses on ESG ratings, not green bonds

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Three very senior central bankers have spoken out on climate change in recent weeks. The President of Dutch central bank the DNB, Klaas Knot, gave a speech early in February, followed just two days later by a blog on the topic from Frank Elderson, an alumni of DNB and current Executive Board Member of the European Central Bank (ECB). Shortly afterwards, Banque de France Governor François Villeroy de Galhau suggested in a speech that the ECB should start 'greening' its asset purchasing programmes and collateral frameworks over the next five years (the ECB’s governing council discussed a more lukewarm approach to climate days later, focusing on financial modelling and disclosure). 

The role of asset purchases, or quantitative easing (QE), in tackling climate change has become a battleground for central banking. Just last week, the UK Government changed the mandate of the Bank of England to enable it “to account for the climate impact of the issuers of the bonds [it] holds”, in a move that has potentially major ramifications for corporate debt markets.  

The momentum is clearly building, but it’s not without controversy. When QE was first introduced in the wake of the 2008 financial crisis, it took central banks way beyond their previous remit to set interest rates and was seen by some as an alarming overreach, and one that threatened to skew markets without any evidence of efficacy. That debate has been revived by the recent developments, which add another layer of influence by central banks. 

The ECB can buy more debt from companies with higher ESG ratings. This could facilitate economic stability and improve the quality of central banks’ balance sheets, as evidence grows of the profitability of companies that perform well on ESG.

This article won’t argue whether it was within central banks’ mandate to go on a buying spree of sovereign and corporate debt. Or debate whether the consequent widespread inflation of asset prices (particularly carbon-heavy assets, which has arguably exacerbated climate risk) is right or wrong. Whatever your view, it’s clear that central banks’ traditional role in ensuring economic and financial stability and conducting monetary policy to achieve low and stable economic inflation is changing, and QE is here to stay for the foreseeable future. As the IMF states, since the global financial crisis, central banks have consistently expanded their toolkits to deal with risks to financial stability and to manage volatile exchange rates.

ECB President Christine Lagarde has pledged to make climate change a central part of its upcoming strategy review, which last happened in 2003. She has been discreet about her views on ‘green QE’, but welcomed recent research from campaigners showing that ECB asset purchase programmes have a “massive carbon bias”. 

Ways to tackle this bias range from excluding fossil fuel bonds to prioritising green bonds. But buying green bonds doesn’t necessarily translate into robust climate action: even when labelled, these bonds are very broad in structure, focus and impact, and prioritising existing green bonds risks creating bubbles and distortion by making the debt more expensive. 

In any case, the ECB already buys a bulk of corporate green bonds as part of its Corporate Sector Purchase Programme (CSPP). In 2018, this amounted to around €6bn for all the eurozone central banks, representing at the time close to 20% of the eligible bonds under CSPP. 

Instead, there could be a different way to add positive social and environmental impacts to the already extraordinary scale and scope of QE, without creating additional negative externalities. The ECB can just buy more debt from companies with higher ESG ratings. 

This could facilitate economic stability and improve the quality of central banks’ balance sheets, as evidence grows of the profitability of companies that perform well on ESG. 

This approach has the added benefit that it wouldn’t require QE on the primary market. Central banks would be able to maintain purchases on the secondary market if they simply stated what they will buy – creating the incentive for issuers and buyers.  

This approach isn’t discriminatory; it simply incentivises corporates, financially, to improve their ESG impacts. It would also help drive the standardisation desperately needed in the ESG market, if every participating central bank agreed on the same environmental and social standards.

Federal Reserve Governor Lael Brainard expressed support for mandatory climate disclosures last month, signalling that central bankers are beginning to understand the importance of more harmonisation. The question is: will they use their power to drive it?

Simon Smiles retired from his role as Group Managing Director and CIO for Ultra High Net Worth Clients at UBS in 2020. He established and ran the wealth management sustainable and impact investing teams.

Vibeka Mair is a Senior Reporter at Responsible Investor