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By Thomas DeSouza
Under pressure to do more on climate, the central bank’s new ESG framework for corporate bonds could be applied to its sovereign debt holdings.
The European Central Bank has committed to encouraging corporate issuers to invest in the climate transition. However, additional monetary support may be needed for sovereign issuers to do the same. With the recently announced Transmission Protection instrument—designed to prevent fragmentation of sovereign spreads during the transition to tighter monetary policy—the ECB could add a similar framework to shift the reinvestment of its nearly €2.6 trillion Public Sector Purchase Programme portfolio to support countries through the climate transition.
Thus far, the ECB has been tilting reinvestment of its corporate bond holdings by using a “climate score” based on past emissions, target setting and issuers’ greenhouse gas reporting. Additionally, the ECB will be adjusting its collateral framework to limit the share of assets from issuers with a high carbon footprint, as well as considering climate risk when reviewing haircuts applied to corporate bonds. Corporate issuers will be incentivized to invest in the climate transition in exchange for lower funding costs. While the investments may be detrimental to earnings in the short run, over time they should make these companies more sustainable, which may result in eventual market premiums.
Sovereigns, by nature, have different incentives: With limited budgets and political sensitivity, fiscal policy often favors mitigating near-term political volatility. As Russia’s war in Ukraine has sent European energy prices higher, many nations have shifted investment toward more carbon-intensive energy like coal and liquid natural gas. The European Commission has supported investment in green energy through the Next Generation recovery instrument. However, many sovereigns, especially those on the periphery, may need further monetary support for climate investment in a volatile rates market.
If monetary policy can be used to help corporate issuers that are sensitive to higher funding costs to invest in climate, could a similar tool be developed to encourage sovereigns as well?
In our view, the ECB could include a climate-change framework in the Transmission Protection instrument that would shift the reinvestment of government bond holdings toward countries that continue to make investments in the climate transition. While this may not be significant for countries that are not dependent on the ECB to lower funding costs, for a country like Italy, which saw a material sell-off in its sovereign yields and has about €850 billion in debt that will need to be rolled over the next four years, lower funding costs could potentially provide greater flexibility to maintain climate commitments.
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