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Greening monetary policy: An alternative to the ECB’s market-neutral approach

The ECB’s market-neutral approach to monetary policy undermines the general aim of the EU to achieve a low-carbon economy. An alternative tilting appr

Publishing date
21 February 2019

Abstract

Capital-intensive companies are more carbon-intensive. Monetary policy reinforces this effect, as the ECB operates ‘market-neutral’ by buying a proportion of the market portfolio of available corporate bonds. We propose a tilting approach to steer 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. Such a low carbon allocation can be done without undue interference 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 various industrial sectors in Europe.

As expected, 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 a few sectors are responsible for most carbon emissions.

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. A market-neutral approach thus leads to the Eurosystem’s private-sector asset and collateral base being relatively carbon-intensive (Matikainen et al, 2017). Investment in high-carbon companies reinforces the long-term lock-in of carbon in production processes and infrastructure. The ECB’s market-neutral approach undermines the general policy of the European Union to achieve a low-carbon economy.

Under their financial stability mandate, 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

Does the legal mandate of central banks 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 European Union 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, without prejudice to its first objective. Our proposed tilting approach (see next section) does 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 as well but 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 real concern and a top priority of European policy on a consistent basis, the ECB can contribute to this secondary objective in 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

In a new paper, we 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 as part of its Asset Purchase Programme, which includes corporate and bank bonds in addition to government bonds. 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 (e.g. 50% overallocation) and less high-carbon assets (e.g. 50% underallocation). Accordingly, the Eurosystem can 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%.

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

Concluding reflections

A low-carbon allocation policy would reduce the financing cost of low-carbon companies, fostering low-carbon production. The higher cost of capitial could induce high-carbon companies to reform their production process using low-carbon technologies to save on financing costs.

A low-carbon allocation policy in the Eurosystem’s asset and collateral framework would thus contribute to the EU’s general 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.

Moreover, this allocation policy must be designed in such a way that 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’, Working Paper Issue 02, Bruegel.

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

About the authors

  • Dirk Schoenmaker

    Dirk Schoenmaker is a Non-Resident Fellow at Bruegel. He is also a Professor of Banking and Finance at Rotterdam School of Management, Erasmus University Rotterdam and a Research Fellow at the Centre for European Policy Research (CEPR). He has published in the areas of sustainable finance, central banking, financial supervision and stability and European financial integration.

    Dirk is author of ‘Governance of International Banking: The Financial Trilemma’ (Oxford University Press) and co-author of the textbooks ‘Financial Markets and Institutions: A European perspective’ (Cambridge University Press) and ‘Principles of Sustainable Finance’ (Oxford University Press). He earned his PhD in economics at the London School of Economics.

    Before joining RSM, Dirk was Dean of the Duisenberg school of finance from 2009 to 2015. From 1998 to 2008, he served at the Netherlands Ministry of Finance. In the 1990s, he served at the Bank of England. He is a regular consultant for the IMF, the OECD and the European Commission.

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