In a world that’s rapidly trying to go green, our Rates strategists takes a look at the role of the European Central Bank in furthering green finance in Europe.
It’s not just investors that are taking sustainability seriously – major supranational institutions are too. In this note we take a look at the green bond market in Europe, and consider how European institutions, and in particular the European Central Bank (ECB), are helping European finance go green.
For a podcast discussion of this topic listen here: https://open.spotify.com/episode/04Zz5XXXgk4D6HgmXLpTZ5
As a direct result of the increasing focus on climate change and sustainable finance, the market for green bonds – fixed income instruments specifically designed to support specific climate-related or environmental projects – has been growing rapidly. The European green bond market has more than doubled in size since 2008, to around EUR 350 billion.
The green bond market has grown rapidly in recent years
Europe has set some ambitious emission-reduction targets, but to achieve them, investment in the energy transition must accelerate rapidly. EU institutions are reinterpreting their statutes and examining rule changes as they search for ways to support that investment.
As the world has increased its focus on the influence of finance and other socially responsible goals, so too has the ECB. It’s an active investor in green bonds through its quantitative easing programmes, and it’s further cemented its support for green financing by making bonds with coupons linked to environmentally sustainable activity eligible for its quantitative easing (QE) asset purchases and also as collateral for banks to borrow from it, from 2021 onwards.
The EU is currently deciding on its Green Bond Standards, which will create a clear definition of what qualify as green bond instruments (rather than voluntary industry standards). The EU is also set to become a big issuer in the green bond space: 25% of its EUR 750 billion Recovery Fund agreed earlier this year will be funded via green bonds.
3.The EU fiscal framework
There’s already a clause in the Stability and Growth Pact rules (which ensure that countries in the EU pursue sound public finances and coordinate their fiscal policies) that favours the financing of investments “with positive, direct and verifiable long-term effects on growth and on the sustainability of public finances”. Arguably, this should cover green initiatives.
A closer look at the green bond market
One potential concern with ECB investment in green bonds is that it could crowd out private investors in what remains a small market and create a “green asset bubble” in certain segments.
The size of the eligible Green universe has been increasing, but is still small compared to the total universe
To monitor this risk, we’ve created our EGB Relative Value Cruncher and a Supras and Agencies Relative Value Report. For each issuer, these reports give us a snapshot of which bonds look expensive and cheap, splitting out green bonds vs. non-green bonds.
The ECB has made climate change a key pillar of its Strategic Review, and ECB President Christine Lagarde has made it clear that climate change initiatives will be at the top of the ECB’s agenda.
The ECB may encourage and support the growth of the green bond market in such a way that financing for green projects is at preferential rates. Buying green bonds is an obvious way in which the ECB can help green rates to fall, but that wouldn’t necessarily help the market grow sustainably, and it could risk distorting yields or reducing liquidity. The bank will have to tread carefully.
The ECB will also have to ensure that any decisions are anchored in EU rules – principally the still-to-be-finalised EU Taxonomy and the Green Bond Standards. Together, these will help protect against “greenwashing” – suggesting bonds are involved in financing green projects when that’s not really the case – and help ensure common market standards.
Let’s now consider some of the ways that the ECB might further the cause of sustainability (in order of likelihood – most likely first).
1. Buying green bonds through asset purchases
The most obvious way in which the ECB can incorporate climate change objectives in its policy decisions is through its asset purchases. Indeed, the ECB has already gradually increased its purchases of green bonds as the green bond universe itself has broadened.
2. Buying green bonds for pension funds
The ECB could send a strong message about its commitment to sustainable investment by choosing to allocate more to green bonds in its pension funds and non-monetary policy portfolios.
3. Incorporating the impact of climate change on output, inflation and financial stability in the ECB’s projections
It will be hard for the ECB to incorporate climate change into its own projections given they cover such a short time horizon, but it will no doubt be a much larger factor in the debate than it has previously been.
4. Investing in green companies / activities, not just bonds
To get around the risks related to crowding out private investors from the green bond market, the ECB might invest in green issuers rather than just green bonds in its asset purchases. An extreme version of this would be to exclude all “brown” sectors from asset purchases, but this is very unlikely in our view.
5. Incentivise banks to go green
Rates at which the ECB provides funding to banks could be linked to the banks’ green credentials or the amount of green lending they provide. But we believe this is unlikely at this stage as green scores are still quite unreliable.
We expect climate change to feature very prominently in the ECB’s Strategic Review, and that the coming months and years will see a marked increase in ECB investment in green bonds as a natural consequence of the green bond market’s growth.
Innovations such as linking green criteria to other policies may not occur immediately (work still needs to be done on the taxonomy, green bond standards and ESG ratings), but this should not stop the ECB from incorporating climate change in its decision-making process (through its impact on growth and inflation) or increasing its investment in green financing.