The European Central Bank will next year start to apply climate risk factors to corporate bonds it accepts as repo collateral.
Under a complicated formula, bonds at high risk from future climate shocks — deriving from their sector, the individual company’s efforts to reduce emissions and their maturity — will be subject to more severe haircuts.
The stated purpose is to protect the Eurosystem of central banks from loss. Many will ascribe a hidden intent: to nudge the corporate sector towards transitioning to more sustainable practices.
Central banks are strict in their thinking, so it would be wrong to suspect the ECB of dissembling. But if that was its true motive, it would be laudable.
Climate change is going to devastate our ecosystems. If the wheat harvest is down 40% because of droughts, price stability rather than bread will be toast. The ECB should do what it can to prevent that.
The ECB is vulnerable to another accusation, however — living in an ivory tower. Faced with a gravely sick patient, the Bank is worrying whether the sufferer’s fingernails have been cut properly.
Corporate bonds are hardly used for repo, making up only 2% of the ECB’s collateral holdings. Banks almost never default either, and that is the only time collateral would have to be used. Changing the haircuts will make no meaningful difference to the ECB’s risk, therefore, nor to corporate bond spreads.
Tackling climate risk embedded in bank bonds — 32% of the total — would be far more powerful. Bank paper, especially covered bonds, is used for repo a lot, so banks are super-sensitive to how favourably the ECB views them as collateral.
That would be controversial to gain acceptance for, which is probably why the ECB has not done it yet — but the justification is at least as strong as for corporate bonds.
Or another place to start could be asset-backed securities, of which the ECB holds €288bn, 19% of collateral. Changing weights there could encourage green mortgages and electric car loans.
But for all the criticism, the ECB has still made an important step forward. This is an official declaration by one of the most powerful authorities in the EU and global central banking that climate transition is a real risk to securities.
Private investors will pay heed — and those already climate-conscious will compare their methodologies with what the ECB thinks.