Greening monetary policy

Dirk Schoenmaker 17 April 2019

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Central banks traditionally take a long-term perspective on economic and financial developments. Through monetary policy they play an important role in the economy, and their mandate to ensure financial stability means they have an important role in the financial system too. 

As part of this commitment, central banks have begun to examine the impact of climate-related risks on the stability of the financial system (Carney 2015). In monetary interventions, central banks have a long-standing policy of market neutrality, but there is evidence that the market has a bias towards carbon-intensive companies, and so monetary policy cannot be climate neutral (Matikainen et al. 2017). Doing nothing to meet this challenge is a decision that undermines the general policy of the EU to achieve a low-carbon economy. 

In a recent paper (Schoenmaker 2019), I propose steering the allocation of the Eurosystem’s assets and collateral towards low-carbon sectors, which would reduce the cost of capital for these sectors relative to high-carbon sectors. A modest tilting approach could reduce carbon emissions in their portfolio by 44% and lower the cost of capital of low-carbon companies by four basis points. This can be done without interfering with the transmission mechanism of monetary policy. Price stability, the primary objective, should remain the priority of the Eurosystem.

Carbon-intensive assets

Carbon-intensive companies – such as fossil-fuel companies, utilities, car manufacturers and airlines – are typically capital-intensive. Market indices for equities and corporate bonds are therefore overweight in high-carbon assets. Figure 1 summarises the average carbon intensity, defined as carbon emissions divided by sales, of industrial sectors in Europe. 

As we might expect, the oil, gas, and coal sector has the highest carbon intensity followed by the materials sector (metal producers and construction), utilities, chemicals, transportation (airlines), and automotive (carmakers). The lopsided distribution of carbon intensity shows that carbon emissions are concentrated in a few sectors.

Figure 1 Average carbon intensity by industry (emissions in tonnes of CO2 divided by sales in millions of euros)

Note: Scope 1, 2 and 3 emissions are included for the 60 largest corporations in the euro area.
Source: Schoenmaker (2019).

In its monetary policy, the ECB – like any other central bank – follows a market-neutral approach in order to avoid market distortions. This means that it buys a proportion of the available corporate bonds in the market. This market-neutral approach leads to the Eurosystem’s private-sector asset and collateral base being relatively carbon-intensive too (Matikainen et al. 2017). 

Investment in high-carbon companies reinforces the long-term lock-in of carbon in production processes and infrastructure. We can conclude that the ECB’s market-neutral approach undermines the broader policy of the EU to achieve a low-carbon economy.

Now that central banks have started to examine the impact of climate-related risks on the stability of the financial system (Carney 2015). Why not address the carbon intensity of assets and collateral in central banks’ monetary policy operations as well?

Legal mandate

First, the legal mandate of central banks must allow the ‘greening’ of monetary policy. The primary responsibility of central banks is to maintain price stability, with a secondary responsibility to support economic growth. Interestingly, the EU applies a broad definition of economic growth. Article 3(3) of the Treaty on European Union says that:

“The Union shall establish an internal market. It shall work for the sustainable development of Europe based on balanced economic growth and price stability … and a high level of protection and improvement of the quality of the environment.” 

This broad definition of sustainable economic growth could provide a legal basis for greening monetary policy.

The ECB can only pursue its secondary objectives as long as they do not conflict with its first objective. The proposed tilting approach would not lead to undue interference with price stability. As everyone is a stakeholder in the environment and the climate (Schoenmaker and Schramade 2019), the ECB could contribute to the climate agenda without getting into political discussions. 

There is thus a need for political space for the ECB to avoid central bankers making policy decisions. As climate policy is a top priority of European policy on a consistent basis, the ECB can contribute to this secondary objective using its asset and collateral framework of monetary policy operations. The European Commission and Council have repeatedly stated their aim to combat climate change by reducing carbon emissions. European Parliament members have also asked questions to the ECB president about the ECB’s lack of carbon policies (see, for example, Draghi 2018).

Greening monetary policy operations

I propose a tilting approach to steer the Eurosystem’s assets and collateral towards low-carbon companies (Schoenmaker 2019). The Eurosystem manages about €2.6 trillion of assets in its Asset Purchase Programme, which includes corporate and bank bonds in addition to government bonds.1 In its monetary policy operations, the Eurosystem provides funds to banks in exchange for collateral, which currently amounts to €1.6 trillion. A haircut is applied to the value of collateral, reflecting the credit risk. 

To avoid disruptions to the transmission of its monetary policy to the economy, the Eurosystem should remain active in the entire market. The basic idea of tilting is to buy relatively more low-carbon assets (for example, a 50% overallocation) and fewer high-carbon assets (in this case, it would be a 50% underallocation). The Eurosystem can then apply a higher haircut to high-carbon assets. Calculations show that such a tilting approach could reduce carbon emissions in the Eurosystem’s corporate and bank bond portfolio by 44%. 

Applying a higher haircut to high-carbon assets also makes them less attractive, reducing their liquidity. Early estimates indicate that this haircut could result in a higher cost of capital for high-carbon companies relative to low-carbon companies of four basis points.

Accelerating the transition

A low-carbon allocation policy would reduce the financing cost of low-carbon companies, fostering low-carbon production. The higher cost of capital incentivises high-carbon companies to reform their production process using low-carbon technologies, because this will save on financing costs. 

A low-carbon allocation policy in the Eurosystem’s asset and collateral framework would therefore contribute to the EU’s policy of accelerating the transition to a low-carbon economy. To avoid political interference, it is important that the Eurosystem remains fully independent in the choice and design of its allocation policies. 

This allocation policy can and must be designed so it does not affect the effective implementation of monetary policy. Price stability is, and should remain, the top priority of the Eurosystem. 

References

Carney, M (2015), "Breaking the tragedy of the horizon: climate change and financial stability", Speech at Lloyd’s of London, 29 September.

Draghi, M (2018), "Letter to the European Parliament", L/MD/18/207, Frankfurt, 12 June.

Matikainen, S, E Campiglio and D Zenghelis (2017), "The climate impact of quantitative easing", Grantham Research Institute on Climate Change and the Environment policy paper.

Schoenmaker, D (2019), "Greening Monetary Policy", CEPR Discussion Paper 13576.

Schoenmaker, D and W Schramade (2019), Principles of Sustainable Finance, Oxford University Press.

Endnotes

[1] While the carbon intensity of corporate bonds can be assessed directly, it is more difficult for bank bonds. The look-through approach can be applied, whereby the underlying beneficiary instead of the intermediating bank is assessed. For bank bonds, the carbon intensity of a bank’s total loan portfolio should be evaluated.

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Topics:  Environment Monetary policy

Tags:  Low-carbon, green, monetary policy, climate change, stability, central back, Eurosystem

Professor of Banking and Finance at the Rotterdam School of Management, Erasmus University Rotterdam; Non-Resident Fellow, Bruegel; and Research Fellow, CEPR

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