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ECB climate-related portfolio tilt may add to standards confusion

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Company and sector sustainability will become the focus of the ECB’s latest approach to investing in corporate bonds. The central bank plans to use a climate score combining three sets of criteria to decarbonise its portfolio.

  • The central bank will invest in corporate bonds and seeks to decarbonise its €387 billion corporate bond portfolio effective October 1, 2022.
  • Selection criteria will be tilted towards companies with low historical levels of emissions, aggressive decarbonisation targets and high level of disclosure.
  • The move may provide further impetus to green issuance, especially in sustainability-linked bonds which are eligible credit collateral by the Eurosystem.

This shift in focus is designed to reduce the climate-related financial risk in the Eurosystem’s (the ECB and national central banks of EU countries using the euro as their currency) bond holdings by aligning it with the goals of the Paris agreement.

The new approach only applies to reinvestment of proceeds from maturing bonds. Corporate bonds make up a small portion (8%) of the ECB’s overall balance sheet (€ 4.5 trillion).

How it will work operationally

An overall climate score will be used by the ECB to decide which corporate bonds to buy, which will be a combination of sub-scores from the following three categories – 

  1. A backward-looking emissions sub-score – This takes into account past greenhouse gas (GHG) emissions, including Scope 1 and 2 emissions at the issuer level, but only looks at Scope 3 at the sector or industry level. Non-reporters will be penalised by being assigned a lower value in this category. 
  2.  A forward-looking target sub-score – Designed to incentivise issuers to set-up targets, this approach rewards those ambitious targets aligned with the Paris agreement that are science-based and verifiable by a third party. A lack of firm targets, or unverifiable ones, will be assigned the lowest score.
  3. A climate disclosures sub-score –This score rewards those with verified disclosures, and assigns the lowest score possible to those with no, or unverifiable data. Estimated or modelled data will be viewed similarly, as the score is designed to encourage issuers to increase disclosure. 

The ECB plans to begin publishing climate related portfolio information from 1Q 2023 onwards, and expects to monitor developments in terms of reporting and regulation to update its scoring methodology.

The use of estimates is particularly relevant in the case of Scope 3 emissions, which are not widely reported, but account for over 75% of total company GHG emissions, on average.

A lack of harmonisation of reporting and disclosure standards may also add to the challenges faced by issuers, especially relating to the third sub-score.

New portfolio tilt raises transition, sector-omission concerns

From a portfolio perspective, a climate-related tilt will have a diversification impact, which may be beneficial, reducing the risk of higher carbon pricing through lower exposure to heavy emitters.

But the potential for increased stranded asset risk from excluding high-emitting sectors may have systemic economic implications, and hurt portfolio returns. A further portfolio effect of sector exclusion, like excluding large fossil fuel companies, may generate a higher tracking error, which measures portfolio performance against a benchmark. 

A further wrinkle stems from the limits that the ECB will use to determine purchases of  individual corporate debt instruments. As stated in related FAQs published in July, it will raise limits for higher scoring issuers and will result in greater purchases from issuers with a better climate performance.

Further clarity is required on this – for example will it purchase more from a fossil fuel company with lower carbon emissions intensity relative to its peers, and hence a high ESG rating, or a company in the low-emitting financial services sector that has a poor ESG rating within its sector? 

The omission of certain high-emitting sectors in the ECB’s climate-related approach may also signal a lack of support for financing their transition plans.

Does the ECB’s approach go far enough?

Concerns have been raised by civil society organisations that it is the duty of the ECB to stop financing companies with the most harmful climate impact, even if they are improve performance in comparative terms.

Following the release of the ECB’s position, Reclaim Finance made a statement which said that: “While the decarbonization of asset purchases was the main climate announcement made by the central bank in its “climate roadmap” , the criteria defined will not end its support to major polluters – including fossil fuel developers. The ECB ignores the recommendations of NGOs and risks failing its own climate pledges.”

This is continuing a trend at the EU level of being called for failing to maintain consistency between its climate goals and its approaches to finance.

How will the ECB view green and sustainable issuance?

A further point of clarification needed, especially relating to purchasing limits, is the treatment of green and sustainable bonds. The bank acknowledges that it may give preferential treatment to green bonds.

Nevertheless, the ECB plans to adopt a strict process for identifying green bonds, including using ICMA and CBI frameworks, requiring a second-party opinion, and insisting on third-party oversight on use of proceeds.

The above does not clarify whether the ECB will continue to purchase sustainability-linked bonds, which are clearly not use-of-proceeds issuances, and are largely used as a means of transition financing by hard-to-abate sectors. 

The spirit of the ECB’s move to add a climate-related tilt to its corporate bond portfolio is well intended. As with many of its policy initiatives related to combat climate change, there are complexities and challenges that require clarification, which will keep consultants and lawyers busy for the foreseeable future.

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