A catalyst for greening the financial system

July 8, 2022

By Frank Elderson and Isabel Schnabel

The ECB is taking action to reduce the carbon footprint of its portfolio and push banks to better manage climate and environmental risks. As part of our mandate, we integrate climate change considerations into our monetary policy and banking supervision.

Climate change is important for central banks. This is not only an existential threat to civilization, it also carries serious risks for the economy. Floods, storms and wildfires have become more frequent. Extreme weather events damage infrastructure, destroy crops and increase food prices.

To ensure a viable future, the European Union is committed to achieving climate neutrality by 2050. This will require huge investment and innovation, and it will have implications for inflation during the transition phase. It also makes part of the social capital surplus and creates financial risks.

The ECB therefore cannot ignore climate change. It has direct effects on price stability and is therefore central to the main mandate of the ECB. It creates financial risks, which matter both for the ECB’s risk management of its own operations and for banking supervision. And with climate change being a priority for European lawmakers, the ECB will take climate change into account, in reference to its objective of supporting general EU economic policies without prejudice to price stability.

In doing so, the ECB can, within its mandate, serve as a catalyst for greening the financial system. It can support the development of green capital markets, needed to finance the transition to a low-carbon economy. And it can ensure that banks properly factor climate-related risks into their lending decisions.

Chart 1

Global and European temperatures

(difference in degrees Celsius from pre-industrial levels)

Source: Annual Global Temperature Anomalies (Land and Ocean) – HadCRUT (degrees Celsius) provided by Met Office Hadley Center Observations datasets.

Notes: Temperature anomalies are presented relative to the pre-industrial period between 1850 and 1899. The latest observation is for 2020.

From market neutrality to carbon neutrality

This week, the ECB presented the first milestone in integrating climate change considerations into its monetary policy. An important step concerns our purchases of private sector assets. The ECB’s corporate bond portfolio has so far been guided by market neutrality and therefore reflects the existing bond universe. However, it is mainly companies in carbon-intensive sectors that issue these bonds. This has led to a carbon bias in our portfolio and an accumulation of climate risks on our balance sheet. To reduce these risks, we will start directing reinvestments of maturing corporate bonds – around €30 billion each year – into assets issued by companies with better climate performance. This will gradually bring our corporate bond holdings onto a trajectory aligned with the Paris Agreement and the EU’s climate neutrality goals.

In addition, we will limit the share of assets of high-carbon companies that can be pledged by a bank as collateral when borrowing from us. Going forward, we will limit guarantees to companies and debtors that meet European sustainability reporting standards.

These measures have two effects: first, they reduce our own climate-related financial risks and, second, they incentivize bond issuers to improve their information and reduce their carbon emissions. This will ultimately help direct capital towards supporting the green transition.

Testing the resilience of banks to climate stress

Climate change also plays a major role in our monitoring activities. Over the past few years, we have started to take a closer look at how climate change is affecting the banks under our watch. Since we clarified our oversight expectations in 2020, we have been pushing banks to improve how they manage and disclose climate and environmental risks.

Banks earn half of their revenue from big greenhouse emitters. It might be profitable today, but it won’t be tomorrow

As part of these efforts, we have now concluded a pioneering “bottom-up” climate stress test. We found that three out of five banks still do not have a climate stress testing framework in place. Only one in five banks take climate risks into account when granting loans. And most banks rely heavily on proxy data to quantify their customers’ emissions with, in total, half of banks’ revenues currently coming from large emitters of greenhouse gases. It might be profitable today, but it won’t be tomorrow. We will therefore continue to remind banks that they must take decisive action to close the gaps and prepare for a rapid transition to a carbon neutral economy, while engaging closely with their customers.

Towards a greener financial system

All financial market players will need to prepare for the green transition and deal with the associated risks. Our climate stress test proves, once again, that banks need to act boldly and urgently to better manage the risks associated with climate change. Our monetary policy actions will not only reduce our own exposure to these risks, they will also encourage companies and banks to be more transparent about their carbon emissions – and ultimately reduce them.

These efforts will make our financial system more resilient to climate and environmental crises and better equipped for the green transition. There is still a lot of work to do. This is just the start of a long journey. Although the ECB’s actions are no substitute for ambitious and decisive action by governments and parliaments, within our mandate, we have a duty to play our part, and we will.

This blog post has appeared as an opinion piece in various newspapers and websites across Europe.

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Don F. Davis