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Article: Friday, 26 February 2021

The asset portfolio for monetary policy operations of the European Central Bank (ECB) is burdened in high carbon companies. By steering or tilting its portfolio towards low-carbon companies, the ECB could reduce carbon emissions by 55 per cent, says Prof. Dirk Schoenmaker, who wants to help the financial system transition to a more sustainable model. By diving deep into the economic, legal and operational aspects of financial markets – and listening to those in central banks – he discovered new ways to reduce carbon emissions. Schoenmaker, professor of Banking and Finance at Rotterdam School of Management, Erasmus University (RSM), says: “The joy of research is that you often find solutions which you didn’t know of when you started.

In the financial system, the core business of central banks is setting the interest rate for monetary policy. Central banks execute monetary policy by buying assets or taking assets as collateral from banks. And if monetary policy operations can become more focused on sustainability, then the heart of the financial system can be reformed.

As Prof. Schoenmaker said in an earlier article for RSM Discovery: “We are seeing progress in the acceptance of the validity of sustainability, as a concept and in practice, but we must not overestimate the advances that have been made.” This shift in ECB policy would be a definite step in the right direction.

By shifting its portfolio towards low-carbon companies, the European Central Bank can reduce carbon emissions by 55 per cent.

Steering to low carbon companies

Schoenmaker: “I started to review the different aspects of monetary policy and becoming environmentally conscious: economic, legal and operational. By presenting my early findings at several conferences, some central bankers gave me hints for even better solutions. In that way, I found a very good method to steer or tilt monetary policy operations towards low carbon companies.”

He found that it is possible to increase the proportion of low-carbon companies and reduce the proportion of high carbon companies in the ECB’s portfolio for monetary operations. Climate change poses a physical risk if there is insufficient mitigation, and a transition risk if carbon policies are suddenly implemented.

It is often argued that central banks should manage the carbon risk in their operations, just as they already manage credit and market risks. While the risk perspective is relevant for financial stability (Carney, 2015), both the risk and opportunity perspectives are relevant for monetary policy. Monetary policy operations should avoid the risks of a high carbon bias and grasp the opportunity to support the shift to a low-carbon economy, says Schoenmaker.

There are two routes for central banks to influence the carbon economy, he says; the best-in-class method, and the portfolio tilting method.

1. Best-in-class method

The best-in-class method selects a percentage of best performers in a sector for investment, i.e. those companies with the lowest carbon emissions. If the percentage for selection is set relatively high – say 50-60 per cent – then the central bank can maintain a broad, albeit reduced, asset and collateral base for its operations.

2. Portfolio tilting method

Even with these high numbers, the best-in-class method means that 40-50 per cent of companies in the market would still be excluded from investment. By contrast, the tilting approach increases the proportion of low-carbon companies at the expense of the proportion of high-carbon companies. A tilting approach is less distorting in the monetary transmission because no assets are excluded, and it’s only the weighting in the portfolio that’s adjusted. The central bank can thus maintain the full asset and collateral base in line with its monetary policy mandate.

Targets for investment based on carbon emissions

The best-in-class and portfolio tilt methods are driven by risk and opportunity. These methods can be used to select relatively low-carbon assets, or to tilt the portfolios of assets and collateral towards less carbon-intensive assets. This in turn reduces the exposure to high-carbon assets, meeting the objective. These methods target companies for investment only on their contribution to carbon emissions, according to the EU’s general policy of reducing carbon emissions.

Even a moderate tilting approach can lead to a reduction of carbon emissions of more than 50 per cent. Even if the portfolio is tilted, the ECB can still conduct its monetary policy operations across the entire market in an effective way.


Reduction in the cost of capital

Portfolio tilting reduces the cost of capital for low carbon companies compared to the cost for high carbon companies. This is an incentive for high carbon companies to reform and adopt low carbon technologies.

The central bank’s key role in the financial system means that it would give an important signal to the financial sector when it acts to reduce carbon emissions, and therefore contribute to combatting climate change.

Opinions have changed over just a short time. It shows that academics should just get started with new ideas, even when they don’t yet seem feasible at the time.

A brave new world – just get started!

Monetary policy is one of the latest battlefields for climate policies. While central banks keep financial stability in mind as they look at the risks of climate change, the conventional argument is that monetary policy should remain ‘pure’ and independent, and not be influenced by other government policies.

Prof. Schoenmaker: “I was surprised that it was possible to find an easy-to-apply method to reduce carbon emissions. I was equally surprised by the change of mindset: when I started my research in late 2018, linking monetary policy and climate change was forbidden fruit. Now it is fully accepted and the only question is how to do it.

“Opinions have changed over just a short time. It shows that academics should just get started with new ideas, even when they don’t yet seem feasible at the time.”

Prof. Schoenmaker has presented the results of his studies at several seminars hosted by several central banks including the ECB, De Nederlandsche Bank, and Bundesbank. The ECB is currently working on a review of its monetary policy strategy and aims to include climate considerations.

prof.dr. D. (Dirk) Schoenmaker
Professor of Banking and Finance
Rotterdam School of Management (RSM)
Erasmus University Rotterdam
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Dirk Schoenmaker
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