Approaching green central bank balance sheets

In 2020, the Bank of England (BoE) became the first central bank to disclose climate-related risks associated with its monetary portfolio. In a report, the UK’s central bank took stock of its climate-related financial risks across all its operations, including how it was managing them.

There is now no doubt among central bankers that understanding how specific economic and financial activities relate to climate change is crucial to ‘greening’ the global economy.

Speaking to Central Banking last year, Sarah Breeden – the BoE executive director who leads its climate change-related activities – said the central bank’s report showed it was holding itself to the same high standards as it holds the firms it regulates. It was “a necessary step for transparency as a public body that has designated climate change as a priority”, she said. Unfortunately, the BoE’s disclosures revealed its corporate bond-buying portfolio was associated with an estimated average global temperature increase of 3.5° Celsius, a far cry from the Paris Agreement on climate change’s aims of keeping global temperature increases below 2°C.

In response to the Covid‑19 pandemic, the BoE increased its bond-buying programme: by November 2020, the programme had grown to £875 billion ($1.2 trillion) in government bonds and an additional £20 billion in sterling non-financial investment-grade corporate bonds.

None of the UK’s government debt is currently rated green, making it very difficult for the central bank to green the sovereign bonds in its portfolio. Breeden, appearing before parliament at the end of the 2020, said, if the UK government issued green bonds, the BoE would purchase some. The UK government has since indicated it will launch a green bond issuance.

The lack of a green bond market is just one of the issues central banks face when considering whether to green their balance sheets, according to a panel of market participants and central bank officials who spoke at a roundtable held as part of Central Banking’s Summer Meetings, held in conjunction with Invesco.

“The world is demanding investment in assets where the proceeds are not contributing to the deterioration of the planet. As a result, there is more demand than supply right now, meaning these assets effectively trade at a premium,” one participant explained.

“This provides an incentive to treasuries and debt offices to issue green bonds, but this then puts the onus on external asset managers to differentiate whether this is greenwashing.”

Not easy being green

There are two ways for central banks to green their balance sheets – through international reserves portfolios or through monetary operations portfolios for those that have embarked on quantitative easing.

But, while many central banks have begun incentivising lenders to fund green projects, they have been more hesitant to buy the debt themselves – partly due to liquidity concerns and unclear guidelines as to what makes a bond green.

“Without a definition of what counts as green, there is a risk of greenwashing and a lack of additionality,” the Reserve Bank of New Zealand (RBNZ) said in a report in March 2021. Worldwide, numerous central banks have partnered with public entities to create bespoke domestic taxonomies to try and rectify this issue.

Thailand’s central bank partnered with the country’s Securities and Exchange Commission and Finance Ministry to create an environmental taxonomy of financial assets tailored to the country’s needs.

Similarly, in Singapore and Malaysia, regulators are assessing the potential of a green taxonomy specific for local financial institutions. “We need to find a way to bridge the language and information gaps between scientists, government and financiers,” said Fraziali Ismail, assistant governor at Bank Negara Malaysia. “What science says about climate effects, what climate action the government is prioritising, what industries are providing and investing in are quite incongruent at this point.”

Jacqueline Loh, deputy governor of the Monetary Authority of Singapore (MAS), said the central bank was working with the local financial sector to determine whether a taxonomy would help channel capital more effectively to support Asia’s green transition needs.

Taxonomies developed by policy-makers in Europe and China are used more widely among the international finance industry. However, there is evidence banks are applying these taxonomies very differently to their holdings.

A study conducted by the European Banking Authority (EBA) in May 2021 found that banks are using a wide range of methods for estimating the greenness of their assets. Several banks’ estimates were much higher than those of the EBA, indicating that banks’ own approaches tend to overestimate the greenness of the exposure.

Overall, the EBA estimates a ‘green asset ratio’ of 7.9%. This means that, of all the assets covered by the European Union’s taxonomy, only around 8% comply with the definition of green assets.

Arguably, the best example of a collaborative approach has been the joint initiative undertaken by the Task Force on Climate-related Financial Disclosures, which has provided a set of guidelines on how to disclose climate-related financial risks and opportunities. This, in theory, will allow financial markets to price them correctly.

Monetary operations

For central banks, the safest way to invest green is buying bonds issued by the government. Like the BoE, the Central Reserve Bank of Peru has said it will look to buy green bonds that the country’s government is preparing to issue for the first time.

But issues still remain. “There can be a conflict between policy objectives and climate objectives – especially with regard to monetary policy. How should central banks reconcile these two objectives?” one roundtable panellist mused.

Historically, monetary policy has been guided by the principle of market neutrality – central banks buy a portion of the market portfolio of available corporate and bank bonds in addition to government bonds. However, capital-intensive companies also tend to be more carbon-
intensive companies.

According to a report by US-based climate research group Oil Change International, 12 of the world’s leading central banks are “insufficiently” aligning their operations towards the Paris Agreement targets.

The People’s Bank of China continues to direct large financial flows towards coal, the US Federal Reserve has “worked to maintain and increase fossil fuel finance” and the European Central Bank (ECB) continues to support fossil fuel finance “despite some positive rhetoric”, the report finds.

Meanwhile, there is evidence the Bank of Canada has not taken any steps to restrict fossil fuel finance, and the monetary policy and financial supervision of the Bank of Japan “strongly supports fossil fuel finance”.

Change in the tide

About half the world’s central banks have secondary objectives that usually require them to support governments’ broader economic policies. Climate change is likely to form a core part of the majority of governments’ agendas, and so central banks will have a duty to play their part.

In Europe, the ECB’s mandate states: “Without prejudice to the objective of price stability, the European System of Central Banks shall support the general economic policies in the Union with a view to contributing to the achievement of the objectives of the Union.”

Since January 2021, the ECB has been accepting certain sustainability-linked bonds as collateral and as part of its asset purchase programmes. Similarly, in 2021, the UK government explicitly included climate change in its guidance and remit letters to the BoE’s policy committees.

So far, only a handful of central banks have taken the leap into greening their balance sheets – France and Hungary, for example, have created funds for ecological investments.

One of the biggest issues is the size of current green and sustainable bond markets. “In terms of international reserves, we are limited to holding only fixed income instruments,” a reserve manager from the Americas said during a roundtable discussion. At the moment, green and sustainable bonds make up just a fraction of the broader fixed income market.

Many green bonds are issued by governments or government agencies, making them harder for central banks to buy at a good price. In Finland, the central bank cannot invest in green bonds in the primary market if they are issued by another member of the eurosystem; instead the central bank has to wait for the bonds to come to the secondary market, at which time everything is priced up.

Green bonds also tend to be issued over durations too long for central banks. The Bank of Finland, for example, typically aims to keep duration lower than two years. “It is not clear yet that green bonds are green, and the market is still small,” one roundtable panellist concluded. “There is probably only $500 billion worth of green bonds, or less, out there that would even meet central bank criteria, and they tend to have a very long duration.”

To circumvent some of these issues, a central banker from the Americas said their team was exploring the possibility of holding green bonds through “special funds offered by multinationals – particularly the Bank for International Settlements [BIS]”.

In September 2019, the BIS launched a USD-denominated open-ended fund for central bank investments in green bonds in response to growing demand among official institutions for climate-friendly investments. The fund pools BIS clients’ assets to promote green finance through climate-friendly investments.

Eligible bonds have a minimum rating of A- and comply with the International Capital Market Association’s Green Bond Principles and/or the Climate bonds standard and certification scheme, published by the Climate Bonds Initiative. In January 2021, the BIS launched a second fund – this time euro-denominated. Together the two funds will manage $2 billion in green bonds for central banks.

Investing in these types of funds “makes our lives easier because we don’t have to do the screening or validation on the domestic side”, the reserve manager from the Americas said.

These types of efforts appear to be having the desired effect. A survey conducted by the Network for Greening the Financial System (NGFS) in 2019 revealed that almost all of the 27 respondents said they have already adopted sustainable and responsible investment principles in their portfolio management or are planning to do so.

 

This feature forms part of the Central Banking focus report, ESG for central banking 2021

Sponsored content