Central banks have become large-scale buyers of assets as they seek to stimulate inflation and growth. Targeting these purchases can influence the allocation of capital and the level of emissions in an economy. Should central banks aim for carbon-neutral interventions?
It is now clear that environmental degradation demands a sustainable approach across all sectors. As a result, debate over the role of public institutions in all matters ‘green’ intensifies. This discussion is a sensitive one for central banks, which are traditionally mandated to act in a politically neutral way. One of the most pressing questions relates to whether central banks should engage in non-neutral interventions, by favouring green developments in their asset purchases.
Recent analysis shows that European Central Bank’s (ECB) unconventional monetary policy – large investments in corporate bonds – is currently not neutral. But rather than favouring green developments, the ECB’s portfolio tends to give greater weight to sectors with a higher share of the carbon emissions that cause climate change. This is because sectors with higher emissions tend to issue more bonds than cleaner sectors, causing an imbalance.
At the annual meetings of the Allied Social Science Association (ASSA), Monika Piazzesi of Stanford University presented research assessing the neutrality of these asset purchases. To find out more about the state and extent of green monetary policy being pursued by the ECB, I listened to her online presentation of the ASSA’s 2021 European Economic Association Lecture.
What is unconventional in unconventional monetary policy?
Monetary policy relates to the money supply in a given economy. Dimensions of economic activity, such as growth and job creation, are contingent on monetary policy. The main objective of central banks – via the lever of monetary policy – is to maintain price stability by controlling inflation.
There are several tools that central banks use to control the money supply and its cost. The main mechanisms are interest rates and ‘quantitative easing’ (QE, the purchase of assets such as corporate and government bonds by the bank).
Changing short-term interest rates – which is called a central bank’s ‘policy interest rate’ – influences other interest rates in an economy (such as those offered by banks or other financial institutions for loans or savings accounts). This mechanism is an example of ‘conventional’ monetary policy. QE or asset purchases are examples of ‘unconventional’ monetary policy.
Monika Piazzesi explained that unconventional monetary policy is currently predominant, with asset purchases becoming central banks’ main tool. This is because interest rates have already been lowered to levels close to the minimum possible. And in times of deep economic turbulence, conventional monetary policy can be limited in its effectiveness. In such a context, central banks may turn to unconventional monetary policy to maintain price stability.
Unconventional monetary policy can also lead to interest rates being lowered further than under conventional policy rate adjustments, and lower interest rates mean lower borrowing costs. During the Covid-19 crisis, asset purchases have become more frequent in several countries. The ECB, for example, have turned to unconventional monetary policy in response to Covid-19, in particular to asset purchases under the pandemic emergency purchase programme. From 18 March 2020, the temporary programme was set in motion with €750 billion available.
Unconventional monetary policy and environmental concerns
When purchasing assets, central banks must decide what bonds to buy. Monika Piazzesi observed that typically the ECB has been buying government bonds, mortgage-backed securities and a large quantity of corporate bonds. But against the backdrop of the crisis, what bonds should central banks be buying? And what about green bonds? There are strong calls arguing that central banks cannot and should not ignore risks associated to climate change (ECB, 2020).
The traditional view is that monetary policy asset purchases should adopt a principle of market neutrality. This usually translates into central banks purchasing bonds proportional to the amount of bonds outstanding. This principle is in place to ensure that asset purchases have a minimal impact on relative price distortions. When central banks make asset purchases that target specific sectors over others, these interventions will change the overall capital allocation in an economy, which can in turn set off price instability.
But in the research presented by Monika Piazzesi, this idea of market neutrality is questioned in terms of what it might mean in the case of purchasing corporate bonds. This question is intricately linked to the question of green monetary policy.
The appropriate role of central banks in engaging with efforts to combat climate change is a pressing question for policy-makers. The Bank of England has pioneered taking a firmer position on addressing the financial risks that come with global warming (Barber and Giles, 2020). But the predominant focus of central banks on the risks to financial stability has been considered a largely passive attitude, and there have been calls for even greater engagement with environmental issues (van’t Klooster, 2020).
Are ECB asset purchases neutral interventions?
By looking at a model of the economy from a sectoral perspective, Monika Piazzesi and her co-authors set out to analyse the neutrality of monetary policy interventions and to assess how ‘green’ (or not) they are.
The relative importance of bond finance across different sectors is an important starting point. Working on the assumption that market-neutral interventions are those that keep the relative returns on capital investment across different sectors unchanged, they test whether the corporate sector purchase programme undertaken by the ECB can be considered neutral in these terms.
Once the distribution of bond finance has been assessed, measures of the market portfolio – that is, of the portfolio of capital holdings in the economy by sector – are constructed. The idea is that by comparing the proportion of bonds that each sector of the economy issues to the proportion of bonds by sector that the ECB holds, the neutrality of the central bank’s purchases can be assessed.
The results suggest non-neutrality: sector capital stocks are not in keeping with what the ECB is holding. Comparisons reveal that the ECB bond portfolio is closely aligned with the portfolio of bonds outstanding by sector. In turn, the ECB bond portfolio does not align closely with the market portfolio. This element of the ECB’s monetary policy strategy is not neutral. Particular sectors are favoured by the programme, meaning that the ECB’s interventions can contribute to changing capital allocation – as well as overall emissions – in the wider economy.
The ECB’s portfolio, the research shows, is close in distribution to sector shares of emissions, instead of nearing the distribution of the market portfolio. In other words, sectors like manufacturing, utilities and transport – all of which have higher emissions – are more heavily weighted in the ECB portfolio. In contrast, services and agriculture (sectors that do not issue bonds) are underweighted in comparison to their market shares.
By looking into relative proportions of bonds that are eligible for the corporate sector purchase programme by the ECB and its holdings by sector, the analysis uncovers various key results. The ECB’s interventions are not neutral, and are tilted towards industries that are heavier in emissions.
The main reason for the overweighting of polluting sectors may be that they issue more bonds than cleaner sectors, such as the services sector. They can do this because heavy industry often involves fixed assets – such as factories and machinery – that serve as collateral. By contrast, the ECB cannot buy cleaner sector bonds if they do not exist: in 2019, green bonds accounted for less than 5% of total issuance volumes (ECB, 2020).
What does this mean for green monetary policy?
Green monetary policy would involve buying green bonds. Given the lack of issuance from less polluting companies, this seems some way off. A first step would be a more neutral monetary policy. To achieve this, the ECB could buy corporate bonds in proportion to sectors.
But such a change would not necessarily address the issue of emissions differing by sector. As Isabel Schnabel, a member of the ECB’s executive board, has argued, where there are market failures, ‘market neutrality may not be the appropriate benchmark for a central bank.’ Attempting to maintain neutrality in the face of an economy composed of sectors more or less heavy in emissions can end up with the policy strategy supporting those that emit more heavily.
To meet this challenge, interventions may need to be rethought. Greener industries, and especially young renewable energy firms, issue few bonds, without which monetary policy cannot be used to reduce their funding costs. To engage in green monetary policy, the ECB needs a greater supply of green bonds. Central banks are playing a role in providing incentives for issuance by making green bonds suitable for central bank operations (ECB, 2020).
Collective problems require collective action by multiple actors, and the debate continues on the appropriate role for central banks in the face of climate change. The research presented by Monika Piazzesi clarifies the role that central banks can play in achieving a carbon-neutral economy.
Where can I find out more?
- Article by Jens van ‘t Klooster in the Financial Times: ‘The ECB needs to do more to ‘green’ its monetary policy‘.
- Report published in 2020 by the European Central Bank (ECB): ‘When markets fail – the need for collective action in tackling climate change‘.
- Article by Claire Jones in the Financial Times: ‘Greening central banks’ reserves‘.
- American Economic Association Allied Social Science Associations Annual Meeting: The AEA, in conjunction with 64 associations in related disciplines known as the Allied Social Science Associations (ASSA), holds a three-day meeting each January to present papers on general economics topics.
Who are the experts on this question?
- Monika Piazzesi
- Dirk Schoenmaker
- Dimitri Zenghelis
- Melina Papouti
- Martin Schneider
- Mark Carney