Quantitative easing has become a mainstay of central bank monetary policy in attempting to stimulate demand and support the financial system. However, as articulated by William White in a paper for the Dallas Fed in 2012, ultra-easy monetary policy may lead to undesirable longer-term effects.
Note that a portfolio established under a quantitative easing programme should be seen as distinct from a conventional central bank reserve management investment portfolio, which has a separate purpose and where the incorporation of ESG considerations are well founded1.
The Bank of England leads the way
During the 2021 Conference of Parties in Glasgow (COP 26), the BOE announced its framework for implementing the greening of its £20 billion corporate bond portfolio, held as part of its Corporate Bond Purchase Scheme (CBPS). The framework represents an important contribution as central banks elsewhere look to establish processes to factor environmental considerations into monetary policy decisions.
This move was preceded by an expansion of the BOE’s remit in March 2021 to include “…growth that is environmentally sustainable and consistent with the transition to a net zero economy”. In looking to meet this objective, the BOE has set out as a key principle incentivising companies that take action to achieve net zero. A notable positive element of the framework is the support it provides to investors already trying to push forward the environmental agenda amongst unlisted privately-owned companies, where ESG policies and reporting are typically less advanced.
Despite the BOE’s good intent, there are many potential drawbacks and that can hold lessons for all monetary authorities. (i) central banks are not long term investors – in fact they could find themselves having to unwind their portfolios in short order (ii) the potential to miscalibrate the framework is high, risking a shift in capital away from those companies best placed to deliver on the Paris Agreement; and (iii) the risk of undermining central bank independence and in turn its core contribution to supporting the climate transition – financial stability.
This is greening of policy and not green policy – the distinction matters
Central banks are not looking to implement green policy, instead they are taking a green tinted lens to view the existing objectives and frameworks. The natural consequence of this is that central banks are not able to commit to the strategy of a long-term investor because their investment horizon will be dictated by the uncertainty of the monetary policy cycle. When inflation rises and policy reverses, central banks face selling pressure on those companies they consider green and purport to be supporting when the tide was pulling the other way. This could exacerbate the trading and performance of those bonds in a market backdrop of tightening financial conditions.
The CBPS largely influences the valuations of corporate bonds through a “signalling” effect, in other words telling the market that there will be a backstop for certain assets and influencing investors’ portfolio allocation decisions. This is why the largest moves in financial securities from monetary policy often occurs shortly after the announcement, rather than during implementation, and the effects tend to be felt broadly across asset prices rather than the specific instruments targeted.
Excess valuations on green assets will wax and wane as periods of excess demand meets periods of excess supply of capital opportunities. However, there is little evidence central bank corporate bond buying has so far influenced specific bond prices beyond a more generalised effect across the market. Boneva, de Roure, and Morley (2018) found the eligible bonds in the BOE CBPS outperformed ineligible bonds by 2-5bp, while Makinen, Mercatanti and Silvestrini (2020) found no difference between eligible and ineligible bonds within the ECB’s Corporate Sector Purchase Programme (CSPP).
This brings into question whether placing a green tilt on a central bank bond buying programme will result in a divergence in bond valuations between green and non-green corporates. Indeed, early evidence of the greening of the BOE CBPS shows no clear divergence in performance (beyond market beta effects) of bonds from high carbon emitters versus low emitters eligible for the BOE CBPS portfolio (see chart 1). This could be because the framework for tilting its portfolio is not straightforward, which hinders the power of the signalling effect. A strategy aimed directly at green bonds for example, would offer the market a more direct signal of which assets will be bought.
BOE CBPS eligible bonds – credit spread of high carbon basket versus low carbon baskets. Signalling effect unclear.
Source: Jupiter 31.01.22
Narrow scope leads to a loss of perspective
The BOE has chosen a narrow scope (scope 1 and 2) to consider decarbonisation of companies, largely due to lack of data availability and has been the first to acknowledge it as an area for improvement. Using such a narrow scope could result in a misallocation of capital in reference to its objective. For a material number of companies, scope 3 represents the bulk of their carbon footprint, and therefore electing not to include a scope 3 estimation methodology could result in tilting the portfolio towards those issuers with amongst the highest real-world emissions.
The pitfalls of a narrow scope also apply to the focus on climate change risk within a remit covering broader ’environmental sustainability ‘. Data and metrics encompassing natural capital and biodiversity risks and opportunities are at a very early stage of development and usefulness. However, completely ignoring it within an environmental investment framework fails to recognise the inseparable connection between these challenges.
Thinking beyond transition as a risk to actually delivering on the transition
The BOE framework is focused solely on decarbonisation and carbon footprint of companies, without recognising the role of companies delivering on environmental challenges. This is a fundamental shortcoming in the methodology in our opinion, resulting in a strategy focused solely on transition risk management rather than delivering on the transition.
The shortcoming is perhaps best illustrated with an example. The BOE uses its own sector classification system, with one such sector, Transport & Industrial, consisting of 20 companies eligible for purchase. Of these 20 companies, 14 report carbon data, with European cement companies with the highest emissions and industrial companies such as Siemens and GE with the lowest. However, the companies within the sector that do not yet publicly report carbon are some of the mass transport and rail infrastructure companies. The UK Government has committed to supporting a long-term investment programme as part of its Transportation Decarbonisation Plan. The BOE’s CBPS framework is not consistent or supportive of such a strategy.
Issuers in the BOE Industrial & Transport Sector ranked by carbon intensity and contribution to climate investment
Source: Sustainalytics and Jupiter 31.10.21
Beware of the impact of inflation on the climate transition, rather than the other way around
A central bank’s key role is to attempt to manage the level and stability of inflation. Climate transition and physical risks will have implications for inflation, however predicting the directionality of that impact is fraught with danger. Consensus opinion suggests the climate transition will be inflationary. However, we remain circumspect as we see merit in arguments for both inflationary and deflationary pressures (e.g., excess supply, productivity gains). Therefore, instead of being concerned about the consequences of the climate transition on inflation – we are more concerned about the consequences of inflation on the climate transition itself due to inflation’s destabilising effects on the financial system.
Despite the best of intentions, we argue the unintended consequences of central bank green QE programmes could cause more harm than good. Instead, central banks should focus their efforts on risk management within the financial system as it relates to climate and nature related risks (i.e. macro prudential measures) and most importantly their core role of supporting the stability of financial markets. Given the significant role of capital markets in funding the transition, efforts to decarbonise will not be met without a stable financial system.
Green bonds – in search of dispersion
Safeguarding Biodiversity: Taking a leaf out of climate initiatives
Green bonds: Ensuring outcomes
Notes from the Investment Floor: A ‘lightbulb’ moment for green bonds
Notes from the Investment Floor: Demand for green bonds to remain high
The value of active minds: independent thinking
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