An environmental mandate, now what? Alternatives for greening the Bank of England’s corporate bond purchases

7 January: In March 2021, the UK Government explicitly included the support for the transition to a net zero economy in the mandate of the Bank of England. In response, the Bank announced it would green its Corporate Bond Purchase Scheme (CBPS) and by November 2021 it provided details about the greening framework. The Bank plans to use a climate scorecard that evaluates the bond issuers’ climate performance and tilt purchases towards companies that are stronger climate performers within their sectors.

The new environmental mandate has created a unique opportunity for the Bank to play a leading role in the decarbonisation of monetary policy. However, the approach that the Bank has taken to green the CBPS lacks ambition. The Bank’s greening strategy has two fundamental limitations. First, it relies on a ‘carrots first, sticks later’ principle that precludes the introduction of substantial penalties for poor climate performers, at least at a first stage. Second, the Bank remains committed to the principle of ‘market neutrality’, despite having recognised its inherent carbon bias. This restricts the Bank’s ability to reduce subsidies it extends to carbon-intensive activities in the CBPS.

We explore these limitations through a quantitative analysis that replicates the tilting of CBPS holdings as proposed in the Bank’s approach, and we show the following: ˆ

  • The Bank’s tilting framework cannot reduce the representation of carbon-intensive activities in the CBPS and can paradoxically lead to some carbon-intensive companies getting better treatment than environmentally friendly companies. This is a consequence of the Bank’s continued adherence to the market neutrality principle, which leads to the tilting of CBPS holdings within sectors so that the scheme continues to reproduce the underlying sectoral composition of the bond market. ˆ
  • The Bank’s tilting approach is not going to substantively reduce the Weighted Average Carbon Intensity (WACI) of the CBPS portfolio. In our replication, the WACI would only decline by 7%. Thus, the Bank will find it challenging to achieve even its own target of 25% reduction in WACI by 2025.

To help the Bank of England genuinely lead by example on the decarbonisation of monetary policy, we propose two alternatives: Strong Tilting and Strong Tilting+Exclusion. The Strong Tilting option adds activities-based taxonomies into the tilting strategy and reallocates purchases across different sectors without being restricted by the market neutrality principle. In the Strong Tilting+Exclusion option, we additionally exclude from the Bank’s holdings the bonds of fossil fuel companies and the bonds issued by non-renewable electricity utilities with a poor climate performance. Our quantitative analysis shows the following:

  • Our proposals would substantially reduce the subsidies that the Bank of England extends to companies engaged in carbon-intensive activities. Under the Strong Tilting option, the proportion of carbon-intensive bonds in the total CBPS holdings declines from 54% to 48%. In the Strong Tilting+Exclusion option, this proportion declines even more to 36%.
  • Under the Strong Tilting option, the WACI of the CBPS portfolio declines by 11%, while Strong Tilting+Exclusion leads to a decline of WACI by 39%, allowing the Bank to achieve its 2025 target right now instead of waiting for three more years.

Importantly, the Strong Tilting+Exclusion option will likely have the strongest impact on the decarbonisation of the UK economy. It would directly penalise those companies that have done nothing or too little to address the climate crisis. Excluding these companies from CBPS would not just increase their cost of borrowing through bond markets. It would entail adverse reputational effects by sending a strong signal to markets that companies which fail to contribute to the achievement of the Paris targets can suffer financially. Such reputational consequences can increase the pressure on companies to decarbonise their activities and fundamentally change their business models. In comparison, such pressures are minimal under the Bank’s tilting option, whereby some carbon-intensive companies could even benefit from the incorporation of climate criteria into the Bank’s monetary framework.

Our proposals remain applicable should the Bank decide to taper its corporate asset purchases in the coming months. For example, the Bank can implement tapering by excluding from the eligible universe, or reducing the holdings of, those bonds that have been issued by poor climate performers. A green tapering would give a powerful signal to financial markets.

The climate emergency cannot be addressed through economic policies that simply tinker around the edges. A sharp reduction in emissions requires bold changes in the design of economic policies and the implementation of unprecedented measures that will transform the structure of our financial systems. As a powerful policy institution with a new environmental mandate, the Bank of England should take up the challenge, lead by example, and contribute decisively to the fight against climate change.

Central bank collateral as a green monetary policy instrument

14 December: Central banks can play an important role in the transition towards a climate-neutral economy. This paper discusses different green monetary policy instruments along the dimensions of feasibility of implementation and impact on the transition process. We identify the inclusion of ‘brown’ collateral haircuts into a central bank’s collateralized lending framework as the most promising conduit of green monetary policy. The impact of such interventions on the real economy is then formally explored by extending a general equilibrium transition model to include a simple banking sector with central bank lending facilities and collateral adjustments. We find that both ‘brown’ collateral haircuts and ‘green hairgrowth’ increase carbon neutral investment while decreasing carbon intensive investment and emissions. Consequently, in addition to decreasing the exposure of the central bank balance sheet to climate-related risks, climate-based collateral adjustments have the potential of increasing the political feasibility of a timely transition to a carbon neutral economy by affecting emission levels. Despite ‘green hairgrowth’ having a stronger effect on investment and emissions, ‘brown’ collateral haircuts remain the recommended policy as the former is not necessarily ‘market neutral’ and thus cannot be broadly applied across central banks.

Key policy insights

  • ‘Brown’ collateral constraints as green monetary policy is a feasible instrument that can be broadly implemented across different central bank frameworks and mandates.

  • ‘Brown’ collateral haircuts increase the financing costs and decrease the volume of carbon intensive investments.

  • ‘Green hairgrowth’ has a similar effect but is in conflict with market neutrality and, therefore, not as broadly implementable.

  • The synergy of a price instrument and ‘brown’ collateral constraints results in a significantly lower and potentially politically more feasible carbon tax.

The Effects of Mandatory ESG Disclosure around the World

10 December: We examine the effects of mandatory ESG disclosure around the world using a novel dataset. Mandatory ESG disclosure increases the availability and quality of ESG reporting, especially among firms with low ESG performance. Mandatory ESG reporting helps to improve a firm’s financial information environment: analysts’ earnings forecasts become more accurate and less dispersed after ESG disclosure becomes mandatory. On the real side, negative ESG incidents become less likely, and stock price crash risk declines after mandatory ESG disclosure is enacted. These findings suggest that mandatory ESG disclosure has beneficial informational and real effects.

Quantifying the impact of green monetary and supervisory policies on the energy transition

As we transition our economies to a low-carbon path, climate-related transition risks to the financial sector pose a challenge to policymakers in their policy design. Central banks can play an essential role in facilitating a successful transition by directing the funds needed to achieve this transition in a timely manner and thus reducing systemic risks. However, any intervention by central banks should be evaluated across sectors and across scenarios in order to guarantee effectiveness, efficiency, and coherence with fiscal policies.

Our methodology is scenario analysis based on a modified Computable General Equilibrium model, which allows us to capture feedback loops across sectors, along with tracking the change in prices and quantities following an exogenous change in policies, technologies, or consumer preferences. Moreover, in order to capture both risks and opportunities associated with the transition process, our model distinguishes between clean and dirty subsectors. It also uses sector-specific capital stocks, which allows us to differentiate the cost of capital across sectors and scenarios. The model output includes quantitative effects of exogenous policy change on cash flows, return on invested capital, asset values, price levels, inflation, and many other variables across modelled sectors and scenarios. Such information can be used to stress test investment portfolios and financial stability under different monetary, supervisory, and fiscal interventions. We believe that our approach is an innovative one that contributes to answering key questions about the impacts of central banks’ policies and operations on the costs of different pathways for the energy transition, through both the performance of the financial system and the possible changes in the real economy.

The Financial Geography of Green Finance Policy: Evaluating Policy Effectiveness across over 50 countries

In the past decade, over 390 finance policy initiatives aimed at greening the financial sector have been spearheaded by various public authorities around the world. So far, scholarship has offered insights into how traditional environmental policy such as carbon taxes, emission trading schemes, or low carbon R&D subsidies impact green financing, innovation, and financial performance. However, we still know surprisingly little about the impact of green finance policies on the real economy and the financial sector itself. In particular, we run major knowledge and policy deficits in managing climate risks in primary capital markets. Furthermore, we still have a limited understanding of the effectiveness of green finance measures and how they interact with other existing environmental policy regimes across countries; particularly how they might be undercut by subsidy regimes towards emissions-intensive industries that governments pursue in parallel.

We address this gap by conducting an in-depth mapping of green finance policies and traditional environmental policy instruments across more than 50 countries. We propose to quantitatively analyse the impact of extant green finance policies in shifting capital towards green solutions and away from emission-intensive activities. These objectives will be achieved via a three-pronged approach:

  • Analyzing the largest datasets on sustainable finance policy initiatives and instruments,
  • Interviewing NGFS members, and
  • Analyzing a comprehensive global dataset of syndicated loans, equity, and bond issuances.

Our research seeks to inform and enhance the capacity of central banks and financial supervisors to implement effective green capital market policies that are well-adapted to broader policy and subsidy regimes. In addition, we will discuss the implications of more stringent capital market regulation for just transition outcomes.

Climate change and central bank asset purchases: An empirical investigation for the euro area and the UK

The aim of this project is to provide the first integrated analysis of how the corporate asset purchases of the Bank of England and the European Central Bank can become climate-aligned, as well as the impact that this could have on economic/financial factors and emissions. We explore the implications of two different approaches for the incorporation of climate issues into central bank asset purchases: (i) the ‘climate footprint’ approach whereby the asset purchases are adjusted based on the climate performance of the bond issuers and (ii) the ‘climate risk’ approach in which the recalibration of asset purchases relies on the exposure of companies to climate risks under different climate scenarios.

 

For each approach, we explore several options that include both the ‘tilting’ of purchases and the exclusion/inclusion of corporate bonds. In the case of the ‘climate footprint’ approach, the adjustment of purchases relies on the combined use of backward-looking and forward-looking metrics about the emissions of companies and other environmental factors. In the ‘climate footprint’ approach, the adjustment is based on the credit risk that the bond issuers face under the NGFS climate scenarios. We use econometric techniques to investigate the potential effects of the different policy options on the climate performance of bond issuers.  

Implications for Emissions, Investment, and Inflation

Over recent years several instruments for green central bank monetary policy have been proposed but little to no modelling rigour has been applied to further substantiate the debate. We draw on theoretical modelling and numerical simulation to assess two specific proposals of green monetary policy: the greening of central bank collateral frameworks, and targeted green refinancing operations. We hope to deepen our theoretical understanding of these instruments and quantify their impact on the economy and environment. To do so, we draw on formal modelling that can account for cumulative emissions, differentiated investment (based on carbon emissions), economic growth, monetary policy, and inflation.

Our model will be the first to integrate all of these five aspects which are all essential to our research question. The inclusion of monetary policy is self‐explanatory. However, the final requirement, inflation, is often neglected within climate policy analysis. Within the context of green monetary policy, inflation becomes particularly important as it is the principle aim of modern central bank mandates and climate change might create “cost‐push” or “demand‐pull” inflation.

In order to inform policymakers of the potential effects of green collateral frameworks and green refinancing operations, we propose including inflation and monetary policy into a dynamic general equilibrium model that includes a banking model, differentiated sectors (based on carbon emissions), and conventional climate polity. In addition to observing the effects of green monetary policy on emissions and investment, this model would also allow us to analyse the potential trade‐off between climate change mitigation and inflation, which might have large-scale ramifications for social welfare.

Assessing the effectiveness and impact of central bank and supervisory policies in greening the financial system across Asia

The Paris Agreement established the importance of aligning financial flows with a pathway toward low-carbon and climate-resilient development. In response, central banks and financial supervisors have scaled up sustainable finance measures and are increasingly important stakeholders in climate governance. Due to the contemporary and evolving nature of the topic area, there is a knowledge gap regarding the efficacy of adopted measures and their environmental, social, and economic impacts. It is unclear whether sustainable finance measures are having the intended impact on the financial system and the real economy. Analysis is required to understand:

  • The full details of sustainable finance measures that have been implemented;
  • The rationales and processes underpinning their adoption; and
  • The effectiveness, efficiency, and equity of adopted measures, from the perspective of both financial institutions and supervisors.

We address this knowledge gap, focusing specifically on Asia, where many countries have adopted sustainable finance measures. Asia has global relevance as it contains many countries with the largest or rapidly increasing greenhouse gas emissions levels. We employ a sequential research design, utilising both quantitative and qualitative methods to collect primary data. Key elements of the research will be two written surveys with central banks and supervisors, and banking institutions, respectively, as well as detailed follow-up interviews with both groups.

Our research improves understanding of the progress made toward aligning financial systems and flows with the Paris Agreement. It will highlight cases where measures taken by central banks or supervisors have led to measurable positive outcomes, in terms of contributing to the transition to a low-carbon and climate-resilient economy or managing transition and physical risks. It will provide recommendations on data gathering by central banks to enhance their evaluation of the effectiveness of sustainable finance measures. It will provide policy guidance so countries can improve the design and implementation of existing and new measures, thereby enhancing the capacity of central banks.

The Effects of Mandatory Environmental, Social and Governance (ESG) Disclosure Around the World

In recent years, due to the dramatic increase in demand for ESG information to prompt sustainable growth, many countries and jurisdictions have issued regulations that mandate firms and financial institutions disclose their ESG situations and activities. But what are the real impacts of such mandatory ESG disclosure regulations on financial markets? We address this question by examining the financial stability of firms in 44 countries around the world over a sample period of 2000 to 2017.

To assess the stability of a firm, we measure the volatility of equity return and the likelihood of stock price crashes. Using multivariate regressions, we find equity return volatility is lower after mandatory ESG disclosure, and within this, systematic and idiosyncratic volatility are also significantly lower. We find stock price crash risk declines after the enforcement of mandatory ESG disclosure.

Our findings support calls for mandatory introduction of ESG disclosure requirements. In particular, stock exchanges should increase their ESG disclosure policies, as we show that mandatory disclosure improves the information environment. Moreover, our findings on financial stability are of interest to central banks and the enactment of mandatory ESG disclosure enhances the stability of the financial market by improving the ESG informational environment.

Cities as Fossil Fuel Investment Brokers

Using a global dataset of over 840,000 equity, bond and syndicated loan investment banking deals, we build the fossil fuel investment brokerage profile of financial centres worldwide between 2000 and 2018. We also study whether city-level fossil fuel divestment commitments and country level green banking policies impact the profile of fossil fuel financial centres over our study time period. We find that several financial centres shift their fossil fuel investment brokerage profiles substantially, including the asset classes which they are active in. However, we do not find any evidence that this is driven by city-level divestment commitments. We do find however that fossil fuel investment banking brokers situated in financial centres exposed to voluntary green banking policies reduce their fossil fuel financing. This is driven by foreign brokers whose behaviour signals an anticipation of forthcoming mandatory green finance policies.