- At this week’s ECB Forum on Central Banking in Sintra, climate change risks and their impact on monetary policy will feature prominently on the agenda. One of the awarded academic papers investigates how the transition to a net-zero emissions economy can affect the transmission of monetary policy. This follows on the heels of ECB President Lagarde’s recent comments at the Future Investment Initiative in Riyadh/Saudi Arabia last week that “we will be toasted, roasted and grilled” if societies fail to effectively tackle climate change. Since mid-2022, the ECB has already begun to include climate-change considerations in its monetary policy strategy by accounting for climate change in its corporate bond purchases, collateral framework, disclosure requirements and risk management.
- Taking cues from the discussion at the Sintra Forum, we examine whether its “climate talk” (and associated actions) has had an impact on ESG bonds. ESG bonds tend to trade at a negative premium (i.e. lower yields) than regular bonds, i.e. investors are willing accept lower returns to hold a bond that funds sustainable investments. We use quantitative signals extracted from the ECB’s communication on climate to see whether we can explain changes in this negative premium over time.
- We find that the ECB’s “climate talk” has helped increase the “greenium,” i.e., the spread difference between conventional and ESG/green bonds, and, thus, created more favorable financing conditions for ESG issuers during a time of rising interest rates. The combined effect of both concurrent and past communication explains about half of the change in the greenium on average over the last 12 months. However, over a longer time horizon, general macro-financial conditions diminish the impact of the ECB’s “climate talk” on the greenium.
- Walking the talk seems to pay off for the ECB. Asset purchases and its collateral framework can be very powerful. By acknowledging and addressing climate-related risks in its operating framework, the ECB can fulfill its mandate of maintaining price stability while supporting the broader economic objectives of sustainable development and financial stability.
Toasted, roasted and grilled? Walking the talk on green monetary policy
Climate change has far-reaching macro-financial implications that matter for central banks
Climate change risks can impact central bank mandates in three ways (Figure 1): (1) the design and implementation of monetary policy (e.g. temporary or permanent impact on the natural rate/potential output), (2) the communication of the policy stance (e.g. divergence of headline and core inflation caused by negative supply side shocks due to natural disasters and/or higher energy prices) and (3) financial risk management in its operational framework (e.g. accounting for climate risk exposures of counterparties in its collateral framework).
Many central banks have already begun to incorporate climate-related risks into their monetary policy frameworks. For example, central banks can incorporate climate-related risks into their economic models and forecasting frameworks to better understand the potential effects on growth, inflation and employment. This can help inform their policy decisions, including setting interest rates and managing liquidity in the financial system. Additionally, they can incorporate climate factors into their asset-purchase programs and collateral frameworks, promoting investments in sustainable assets while discouraging those with high carbon footprints. In this context, central banks can foster climate-related disclosures and transparency by encouraging financial institutions to report on their exposure to climate risks. This enables market participants to make informed decisions and facilitates the allocation of capital towards environmentally sustainable activities.
What has the ECB done so far?
The ECB can play an importance role in facilitating Europe’s green transition by adjusting its monetary policy tools and strategies. As part of its recent Strategy Review, the ECB has completed a comprehensive assessment of how climate change impacts its mandate. While the ECB’s primary mandate is to maintain price stability, it also has a secondary objective of supporting the general economic policies of the EU, including sustainable development.
In July 2021, the ECB presented an action plan to include climate change considerations in its monetary policy strategy – without affecting its primary mandate of price stability. Unlike most other central banks (Appendix, Box 1), the ECB does not want to address climate change only from a risk management perspective but as a monetary-policy maker that can affect investment and saving decisions in time (now rather than later), space (in Europe rather than elsewhere) and sectors (depending on their positive contribution to climate mitigation).
In July 2022, the ECB began accounting for climate change risks in its corporate bond purchases, collateral framework, disclosure requirements and risk management. These measures aim to reduce financial risk related to climate change on the Eurosystem’s balance sheet, encourage transparency and support the green transition of the economy. The concrete measures include:
- Rebalancing corporate bond holdings (from October 2022): Gradual decarbonization of corporate bond holdings through reinvestment of redemptions towards issuers with better climate performance (until end-June 2023 after the ECB announced the end of partial reinvestments until end-June 2022), together with the publication of climate-related information on corporate bond holdings (as of the first quarter of 2023) (Box 1 below).
- Amending the collateral framework (before end-2024): Limiting the share of assets from issuers with a high carbon footprint that can be pledged as collateral to access central bank money to reduce climate-related financial risks in Eurosystem credit operations. Additionally, since mid-2022, climate change risks will be considered in reviewing haircuts applied to corporate bonds used as collateral. Once the EU’s delayed Corporate Sustainability Reporting Directive (CSRD) comes into force in 2026, the Eurosystem will only accept marketable assets and credit claims from companies and debtors that comply with prevailing climate-related disclosure requirements.
- Enhancing climate-related risk assessment and management (before end-2024): In addition to urging rating agencies to be more transparent about how they incorporate climate risks into their ratings, the national central banks within the Eurosystem agreed on a set of common minimum standards for how in-house credit assessment systems should include climate-related risks in their ratings.
As a potential next step, the ECB is also exploring the possibility of establishing a targeted green loan facility. This facility would provide funding to banks specifically for green projects and investments, promoting environmental sustainability. However, there is still no consensus on the issue. Alternatively, as the conventional TLTRO program phases out, the ECB could introduce “green TLTRO” auctions to support green lending (to governments, firms, households), especially for energy-efficiency renovations of buildings or climate investments by companies. This could be achieved by lowering risk minimum eligibility, haircuts and/or refinancing rates. A symmetric option would be to impose a penalty on carbon-intensive assets (Schoenmaker, 2019). Even if literature shows limited and/or temporary effects of collateral eligibility on asset prices before the crisis, non-standard measures targeting specific segments have been found to have an impact on credit growth and rates.
Box 1: Greening the ECB’s asset purchase program
The gradual decarbonization of corporate bond holdings has been the Eurosystem’s first and most advanced operational climate initiative. In July 2022, the ECB committed to green its corporate bond holdings, even if this might require deviating from its long-standing objective of preserving market neutrality in monetary operations (based on the assumption that current market prices still do not fully reflect the economic cost of climate change risks in the future).
The total greenhouse gas emissions associated with the ECB’s holding of corporate debt securities have declined since 2018 due to issuers’ ongoing decarbonization efforts (Box 1, Figure 1). At the end of 2022, the corporate sector portfolio’s share of financial exposure invested in assets of issuers with certified science-based carbon reduction targets stood at 59%, thanks to the introduction of the Eurosystem framework for incorporating climate considerations into corporate sector purchases. Since only 42% of all eligible corporate issuers have carbon-reduction targets, the ECB’s corporate debt holdings are skewed towards more ambitious issuers (Box 1, Figure 1).
Box 1, Figure 2: Share of holdings and issuers in the ECB corporate sector portfolios with science-based carbon-reduction targets (December 2022) (%)
Words speak as loud as actions ?
Against the background of the ECB’s evolving green monetary framework, we examine whether its related communication has impacted the pricing of ESG bonds relative to conventional bonds. While the ECB’s concrete actions were too recent to draw firm conclusions, it is possible to assess whether its “green talk” may have already influenced investors in the way they price corporate bonds. After all, there is a large literature showing that central bank communication significantly influences asset markets.
We use Natural Language Processing (NLP) techniques and dictionary analysis to extract two quantitative signals – topics of interest and implicit sentiment – as proxy measure of the ECB’s communication on green monetary policy. In recent years, the ECB has broadened the scope of its information disclosure, speeches and press statements beyond the traditional topics, such as monetary policy and price stability. Extending the model by Fortes and Le Guenedal (2020) to a longer time period (until May 2023) confirms that structural challenges, such as climate change, have become increasingly prominent in the ECB’s communication since 2021, together with social topics such as gender equality (Figures 2 and 3). Sentiment analysis using a lexicon of general and financial market-specific terms also suggests that the tone of ECB speeches shifted from optimistic to neutral over time (Figures 4).
Have ECB actions influenced asset prices?
We use the derived signals to examine whether the ECB’s “climate talk” influences asset prices. Following the approach taken by Pietsch and Salakhova (2022), we complete a pairwise mapping of outstanding green/sustainability bonds (“ESG bonds”) to conventional bonds issued by corporates and government agencies (such as national development banks) to create a time series of spread and duration differences for a portfolio of bonds. ESG bonds tend to trade at a negative premium (i.e. lower yields) than regular bonds (Figures 5-6). Hence, investors are willing to accept lower returns to hold a green bond (“greenium”). We then use the signals extracted from the ECB’s communication on climate to see whether these explain changes in the greenium over time. In a subsequent step, we apply the same approach to a smaller sample of only green bonds to corroborate our results (Annex).
We specify a simple ordinary least squares (OLS) regression model, which is specified as:
+ ΔEuribort + Δ10Y_Bundt + Δduration_difft + ΔVIXt + (T*S) t + (T*S) t-1 + (T*S) t-2,
where the climate-related topic and sentiment signals extracted from the ECB’s communication are T (probability of presence of a climate/green topic in the ECB's discourse) and S (sentiment in the selected ECB mode of communication). We use option-adjusted spreads (OAS) instead of bond yields to calculate the greenium to better capture the return of a bond in excess of the risk-free rate and its embedded options. We also include common explanatory variables, such as the (1) risk-free rates (3-month Euribor and 10-year German Bund yields, (2) the average duration difference between the bond portfolios (including sectoral differences) and (3) the implied equity market volatility to a measure of risk aversion and/financial stress.
We estimate the model using monthly changes in the greenium over a one-year time horizon (May 2022-May 2023). The sample start date coincides with the ECB’s step-implementation of tangible climate actions (including rebalancing of corporate bond purchases and the amendment of the collateral framework). The choice of a shorter time window helps maximize the number of bonds in the sample (272 pairs) but also comes with the tradeoff between the quality of the target variable (which gets noisier as the time period shrinks) and statistical robustness (which might increase with a longer time window and more observations).
We find that the ECB’s “climate talk” has helped increase the greenium, creating more favorable financing conditions for ESG issuers during a time of rising interest rates. Our model estimates suggest that the ECB’s communication on climate has had a persistent positive effect on the spread differential between conventional and ESG bonds. The combined effect of both concurrent and past communication explains about half of the change in the greenium on average over the last 12 months (Figure 7). The effect is even stronger (albeit more short-lived) if we restrict the sample to green bonds only (at the expense of lower robustness). Changes in the duration between conventional and ESG bonds and higher market uncertainty have also increased the greenium, which might confirm that green bonds tend to be less affected by market downturns (as suggested by the literature). However, this result has to be considered very carefully due to the short time window and the monthly frequency of observations (which reflect strong market sensitivity to the ECB’s communication series, rendering the use of daily or weekly frequency for our analysis less useful). The strong results for the short time window might also reflect rising demand for green bonds, which echoes the findings in Pietsch and Salakhova (2022). Indications of a higher issuance premium for green bonds over this time period further supports the positive financing impact of the ECB’s “climate talk.”
Over a longer time horizon, general macro-financial conditions seem to diminish the impact of the ECB’s “climate talk” on the greenium. Using a sample covering 3.5 years, the greenium remains stable but we find no significant effect for the ECB’s communication on its changes. Other explanatory variables also lose explanatory power. However, since the underlying sample of matched bonds differs from the one used for the one-year time horizon, the estimation results should be treated as additional results rather than a robustness check. Both effects might also be influenced by a deteriorating quality of bond mapping and several crisis-related regime changes, which are interesting areas for further research.
Walking the talk seems to pay off for the ECB and confirms that it can play an important role in Europe’s green transition. Asset purchases and its collateral framework can be very powerful, especially once the full implementation of the EU taxonomy on sustainable activities and the EU Green Bond Standard can provide clear guidance and legal certainty. By acknowledging and addressing climate-related risks in its operating framework, the ECB can fulfill its mandate of maintaining price stability while supporting the broader economic objectives of sustainable development and financial stability.
For appendices please see the pdf version of this paper.
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