Greening capital requirements

Capital requirements play a central role in financial regulation and have significant implications for financial stability and credit allocation. However, in their existing form, they fail to capture environment-related financial risks and act as a barrier to the transition to an environmentally sustainable economy. This paper considers how capital requirements can become green and explores how green differentiated capital requirements (GDCRs) can be incorporated into financial regulation frameworks

Greening collateral frameworks

Central bank collateral frameworks play a powerful role in contemporary market-based financial systems, affecting demand for financial assets and access to finance. However, existing collateral frameworks suffer from a carbon bias: they create disproportionately better financing conditions for carbon-intensive activities. This paper highlights the need to green the collateral frameworks and explores how central banks can incorporate environmental criteria into these frameworks

Decarbonising the Bank of England's pandemic QE: 'Perfectly sensible'

According to the new governor of the Bank of England, Andrew Bailey, aligning the Bank’s corporate bond purchase scheme with the government’s climate goals is a ‘perfectly sensible thing to do’ and should be made a ‘priority’. Yet in its current framework, the pandemic corporate bond purchase programme is heavily biased towards carbon-intensive sectors – and thus at odds with the government’s environmental objectives. This carbon bias means the programme may lower the cost of borrowing (an implicit subsidy) and encourage more debt issuance by the most carbon-intensive firms relative to low-carbon firms. To help support the governor’s efforts, this briefing sets out two alternative purchase strategies – the ‘Lower-carbon pandemic QE’ scenario and the ‘Low-carbon pandemic QE’ scenario − that would help decarbonise the Bank’s corporate bond purchases (boosting green investment in the process) and ensure that the Bank’s policy interventions are consistent with its rhetoric

Decarbonising is easy: Beyond market neutrality in the ECB's corporate QE

Christine Lagarde, the President of the European Central Bank (ECB), has recently promised to explore every avenue for greening the ECB’s operations, including its quantitative easing (QE) programme. Yet the current corporate QE programme remains biased towards carbon-intensive sectors: these sectors are over-represented in the ECB purchases, when compared to their contribution to the euro area employment and economic activity. An important consequence of the carbon bias is that it may lower the cost of borrowing (an implicit subsidy) and encourage more debt issuance by the most carbon intensive firms relative to low-carbon firms. By favouring access to finance for highly polluting companies, this carbon bias is an important barrier to the decarbonisation of the euro area economies. We argue that the ECB should abandon its market neutrality approach, the key driver of this carbon bias, and adopt alternative low-carbon strategies. We suggest two such strategies in which carbon-intensive bonds are replaced with more climate-friendly bonds. These strategies would significantly reduce the climate footprint of the ECB corporate QE and would make companies’ access to finance more aligned with the targets of the Paris Agreement

Greening the UK financial system - a fit for purpose approach

The transition to a low-carbon economy consistent with the 2015 Paris Climate Agreement represents the greatest challenge of our time. It requires structurally re-aligning our financial sector with the challenges and risks posed by climate change. The deregulated and market-oriented approach to greening finance taken by the current UK government will not go far enough. A fit for purpose Green Finance Strategy is needed to address the market failures and systemic financial risks posed by climate change and the transition to a low-carbon economy. This entails getting the UK’s institutional architecture right by developing a green and dirty public taxonomy, making climate related disclosures mandatory based on such a public taxonomy, and setting up a Green Finance Action Taskforce composed of state actors to oversee the greening of the financial system. It further entails greening monetary policy and banking regulation, by decarbonising corporate bond purchases and the Bank of England’s collateral framework, and aligning risk-weighted capital adequacy rules with the greenness/dirtiness of the assets that banks hold. It would finally entail the decarbonisation of shadow banking and market based-finance. This can be achieved by establishing green-supporting/dirty-penalising haircuts and margins, and implementing a dirty penalising factor for Global Systemically Important Banks (G-SIBs). Fiscal, industrial and environmental regulation policies have a stronger and more substantial role to play in achieving the low-carbon transition quickly. But the urgency of the climate crisis requires that all policy tools are used for the purpose of avoiding a climate breakdown. Our proposals ensure that the UK financial system will support climate economic policies, instead of undermining them

Greening collateral frameworks

Central bank collateral frameworks play a powerful role in contemporary market-based financial systems. Collateral rules and practices affect the demand for financial assets by financial institutions, with significant implications for governments’ and non-financial corporations’ access to finance. However, existing collateral frameworks lack environmental considerations and suffer from a carbon bias: i.e. they create disproportionately better financing conditions for carbon-intensive activities. Environmental issues can be incorporated into collateral frameworks in a number of ways, notwithstanding various methodological and data challenges. We distinguish between (i) the environmental risk exposure approach, whereby credit assessments in collateral frameworks are modified to capture the exposure of financial institutions and central banks to climate-related financial risks, and (ii) the environmental footprint approach, in which haircuts and eligibility are adjusted based on the environmental impacts of financial assets. The two approaches have differing implications and design requirements. We argue that the environmental footprint approach should be at the core of central banks’ green transformation of collateral frameworks. This approach contributes directly to the decarbonisation of the financial system, faces fewer practical challenges than the environmental risk exposure approach and does not penalise companies that are exposed to physical risks. It is also conducive to the reduction of systemic physical financial risks. Central banks have a crucial role to play in developing a framework that will accelerate the collection and harmonisation of environmental data associated with financial assets. This will not only help to successfully decarbonise the assets of non-financial corporations included in the collateral framework but will also allow the expansion of greening to other asset classes, such as covered bonds, mortgages, corporate loans and asset-backed securities

Decarbonising the Bank of England's pandemic QE: 'perfectly sensible'

According to the new governor of the Bank of England, Andrew Bailey, aligning the Bank’s corporate bond purchase scheme with the government’s climate goals is a ‘perfectly sensible thing to do’ and should be made a ‘priority’. Yet in its current framework, the pandemic corporate bond purchase programme is heavily biased towards carbon-intensive sectors – and thus at odds with the government’s environmental objectives. This carbon bias means the programme may lower the cost of borrowing (an implicit subsidy) and encourage more debt issuance by the most carbonintensive firms relative to low-carbon firms. To help support the governor’s efforts, this briefing sets out two alternative purchase strategies – the ‘Lower-carbon pandemic QE’ scenario and the ‘Low-carbon pandemic QE’ scenario − that would help decarbonise the Bank’s corporate bond purchases (boosting green investment in the process) and ensure that the Bank’s policy interventions are consistent with its rhetoric

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

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: 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. 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

An Environmental Mandate, now what? Alternatives for Greening the Bank of England's Corporate Bond Purchases

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: 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. 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

Greening collateral frameworks

Central bank collateral frameworks play a powerful role in contemporary market-based financial systems. Collateral rules and practices affect the demand for financial assets by financial institutions, with significant implications for governments’ and non-financial corporations’ access to finance. However, existing collateral frameworks lack environmental considerations and suffer from a carbon bias: i.e. they create disproportionately better financing conditions for carbon-intensive activities. Environmental issues can be incorporated into collateral frameworks in a number of ways, notwithstanding various methodological and data challenges. We distinguish between (i) the environmental risk exposure approach, whereby credit assessments in collateral frameworks are modified to capture the exposure of financial institutions and central banks to climate-related financial risks, and (ii) the environmental footprint approach, in which haircuts and eligibility are adjusted based on the environmental impacts of financial assets. The two approaches have differing implications and design requirements. We argue that the environmental footprint approach should be at the core of central banks’ green transformation of collateral frameworks. This approach contributes directly to the decarbonisation of the financial system, faces fewer practical challenges than the environmental risk exposure approach and does not penalise companies that are exposed to physical risks. It is also conducive to the reduction of systemic physical financial risks. Central banks have a crucial role to play in developing a framework that will accelerate the collection and harmonisation of environmental data associated with financial assets. This will not only help to successfully decarbonise the assets of non-financial corporations included in the collateral framework but will also allow the expansion of greening to other asset classes, such as covered bonds, mortgages, corporate loans and asset-backed securities