‘Market neutrality may not be the appropriate benchmark’ says ECB as it mulls exclusion of climate-risky bonds

Market neutrality may not be an appropriate benchmark for central bank asset purchase programmes in the face of climate change, a European Central Bank (ECB) representative has said, as the bank relaunches a review of its monetary policy strategy.

At the European Sustainable Finance Summit yesterday, ECB executive board member Isabel Schnabel said the central bank could “consider reassessing the benchmark allocation of its private asset purchase programmes” in a speech outlining key steps the ECB could take in response to climate risk in its roles as a prudential supervisor, large scale investor and monetary policy actor.

Schnabel explained: “In the presence of market failures, market neutrality may not be the appropriate benchmark for a central bank when the market by itself is not achieving efficient outcomes”.

She also said the ECB could exclude bonds that are used to finance projects at odds with the EU’s decarbonisation objectives from its bond buying programmes, if not enough progress is made towards transparency and alignment with Net Zero.  

“In doing so, we could avoid a scenario in which our monetary policy contributes to locking in investments in sectors and technologies that are more acutely exposed to the disruptive effects of the transition to a carbon-neutral economy,” she said. 

Schnabel said the ECB could also opt to only accept securities as collateral if they are “able to fully assess climate-related risks” through the issuing firms’ disclosure regime. The EU’s Non Financial Reporting Directive is due to be revised in coming months, paving the way for a stricter disclosure regime for some European listed companies, as well as potentially widening to cover more firms. There is speculation that the updated rules could include requirements around the Taskforce on Climate-related Financial Disclosures and the EU’s green taxonomy. 

Last week, the ECB announced that it would accept sustainability-linked bonds – bonds with coupons linked to a environmental performance target based on the EU Taxonomy or environment-related SDGs – as collateral, starting January 2021. 

Schnabel said the monetary policy measures would be discussed during the ECB’s strategic review, which has just been relaunched after a temporary suspension during the pandemic. 

“These reflections will also include an assessment of the risks that a lack of action on the part of the ECB could imply for our price stability mandate,” she said, concluding: “Prevailing and deep-seated market failures continue to prevent the transition towards a carbon-neutral economy at the pace that is required to ward off the exceptional, and partly irreversible, risks that climate change poses to society. 

“Central banks cannot ignore these risks. Nor should their actions reinforce market failures that threaten to slow down the decarbonisation objectives of the global community.”

Back in September 2019, Christine Lagarde signalled that her presidency over the ECB could include a change in its approach to market neutrality. In a European Parliament hearing, she said: “The current operators [of the ECB] tell me that you need market neutrality. Well yes, but if you have a taxonomy approved by the parliament I think that would have to be taken on board. We will have to look at how it can be applied in practice.” 

The two speeches signal the dramatic change in attitudes around the role of European monetary policymakers in recent years, especially in relation to climate change. 

Back in 2017, President of the Bundesbank, Dr Jens Weidmann, publicly rejected the idea that monetary policy should take climate risk into account, saying that “neutrality is an important principle of the Eurosystem’s operational framework”. 

“To avoid opening Pandora’s box, we should not award preferential treatment to green bonds, for example, either in the Corporate Sector Purchase Programme or in the collateral framework. The Eurosystem’s mandate is to maintain price stability. And in order to safeguard its ability to maintain price stability, monetary policy should not be overburdened by other policy objectives.”

The latest comments come as the ECB confirms it will release its long-anticipated climate risk stress testing framework in the first half of 2021. The pioneering framework will be used to test the Euro banking system for exposure to risks arising from the low-carbon transition such as regulatory changes and the stranding of polluting assets, as well as the physical risks of climate change.

In an update to the European Parliament, Lagarde said: “This framework will rely on highly granular information on banks’ exposures and firms’ emissions, with innovative modelling features capturing sensitivity to physical risk. Importantly, it will also feature trade-offs between the physical risks of climate change and the transition risks as we move towards a low-carbon economy.”

Unlike the ECB’s upcoming framework, current supervisory approaches to climate risk model the impacts of transition and physical risks separately. A Grantham Institute analysis of climate scenarios published in June by green central banking group the Network of Central Banks and Supervisors for Greening the Financial System noted that “the overall economic impacts resulting from the combination and feedback effects of both types of risk are currently unknown”.

“As the financial system will experience them at the same time, integrating transition and physical risks is therefore of fundamental importance,” said the Institute.

Once the framework is released, the ECB intends to include climate stress testing as a permanent component of its biannual Financial Stability Review of the Eurosystem.