Greening the financial system

The European Central Bank is taking action to reduce the carbon footprint of its portfolio and push banks to better manage climate and environmental risks.

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. These extreme weather events damage infrastructure, destroy crops and increase food prices.

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

Thus, the ECB cannot ignore climate change. It has direct effects on price stability and is therefore at the heart of 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. 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.

Last week, the ECB presented the first step 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 objectives.

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.

The ECB cannot ignore climate change

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.

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.

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. So, we will keep reminding banks that they need to take decisive action to close the gaps and prepare for a timely transition to a carbon-neutral economy.

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

These efforts will make our financial system more resilient to climate and environmental crises and also better equipped for the green transition. There is still a lot of work to do. This is just the start of a long journey.

Isabel Schnabel and Frank Elderson are members of the Executive Board of the European Central Bank.

This opinion piece has been published in various newspapers and websites across Europe.

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Don F. Davis