Greening monetary policy

Dirk Schoenmaker
Rotterdam School of Management, Erasmus University
CEPR

December 2020

Abstract
While there is increasing interest in decarbonising or greening monetary policy, central banks
are keen to maintain market neutrality. However, there is evidence that the market has a bias
towards carbon-intensive companies. The paper develops a method to tilt the European
Central Bank’s (ECB) asset and collateral framework towards low-carbon assets. We find that
a medium tilting approach reduces carbon emissions in the ECB’s corporate and bank bond
portfolio by over 50%. We show that a low carbon allocation can be done without undue
interference with the transmission mechanism of monetary policy.

Key words: Monetary Policy, Collateral, Decarbonising, Carbon Emissions, Cost of Capital

Forthcoming in Climate Policy

Acknowledgements
The author is grateful for feedback from three anonymous referees and audiences at the NGFS
Conference ‘Scaling up Green Finance: The Role of Central Banks’ at the Deutsche
Bundesbank, the Institut Louis Bachelier Conference ‘Green Finance Research Advances’ at
the Banque de France, the Conference ‘Dynamics of Inclusive Prosperity’ at Erasmus
University and a seminar at the European Central Bank. He would also like to thank Dion
Bongaerts, Maria Demertzis, Frank Elderson, Gianfranco Gianfrate, Charles Goodhart, David-
Jan Jansen, Clemens Kool, Andre Sapir, Willem Schramade, Marijn van der Sluis, Bert Smid,
René Smits, Job Swank, Rens van Tilburg, Casper de Vries, Mark Weth, and Guntram Wolff for
useful comments and Tim Kievid for excellent research assistance. The views in this paper are
those of the author.

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1. Introduction
Climate change has an impact on the economy and the underlying financial system in the
medium to long term (Stern, 2008). In their pursuit of price and financial stability, central
banks also adopt a medium to long term view on economic and financial developments. In
their second role of ensuring financial stability, central banks have started to examine the
impact of climate-related risks on the stability of the financial system (Carney, 2015; Battiston
et al, 2017; Campiglio et al, 2018; Reinders et al, 2020). The Financial Stability Board’s Task
Force on Climate-related Financial Disclosures (TCFD, 2017) has developed consistent climate-
related financial disclosures for financial reporting by companies and financial institutions.

By contrast, in their first role of monetary policy, central banks have a long-standing policy of
market neutrality. However, there is evidence that the market has a bias towards carbon-
intensive companies (Matikainen et al, 2017). As carbon-intensive companies, like oil and gas
companies and car manufacturers, are typically also capital intensive (Doda, 2016), market
indices for corporate bonds are overweight in high-carbon companies. By taking assets
proportional to the market index, central banks are thus not climate neutral in their
implementation of monetary policy. The monetary transmission mechanism is the process by
which asset prices and general economic conditions are affected by monetary policy decisions
(Aksoy and Basso, 2014). By favouring high-carbon corporate bonds, central banks improve
the liquidity of these bonds, thereby lowering the cost of capital for high-carbon companies
in comparison with low-carbon ones. This improves the competitive position of high-carbon
companies, resulting in higher overall carbon emissions.

In the case of the European Central Bank (ECB), the market neutral approach undermines the
general economic policy of the EU to achieve a low-carbon economy (European Commission,
2019). This raises the question of what the role of the ECB is regarding the EU’s general
economic policies. The Treaty on the Functioning of the European Union (Article 127) specifies
price stability as the primary objective and supporting general economic policies in the Union
as a secondary objective of the ECB. The Treaty on European Union (Article 3) adopts a broad
definition of economic policies, which include policies that affect society and the environment
(see, for example, Stiglitz, 2009). The legal mandate derived from the EU Treaties thus
provides scope for the ECB to support the transition to a low-carbon economy, without
prejudice to price stability.

The research question in this paper is how the ECB can decarbonise or green its monetary
policy operations. These operations involve allocation decisions when purchasing assets and
taking collateral. The ECB has developed ‘eligibility criteria’ for which type of assets are eligible
for purchase or collateral purposes (Nyborg, 2017). Any greening of monetary policy
operations should follow a general approach, avoiding sector specific allocations (Smits,
1997). Another condition is that the transmission mechanism of monetary policy should not
be unduly affected (Aksoy and Basso, 2014). A green allocation policy must be designed and
executed so that it does not interfere with the effective implementation of monetary policy.

2
The contribution of this paper is twofold. First, we develop a novel method to green monetary
policy operations by steering or tilting the allocation of assets and collateral from high-carbon
companies towards low-carbon companies in a general way. This lowers the cost of capital for
the low-carbon companies in comparison to high-carbon ones.

Next, we investigate which parts of the ECB’s asset and collateral base are affected by our
mechanism to green monetary policy. We also provide some numerical examples based on
European corporate and bank bonds. We find that a tilting approach can counter the carbon
bias and reduce carbon emissions in the corporate and bank bond portfolio by 55%.

The paper is organised as follows. Section 2 develops a methodology to green monetary policy.
Next, Section 3 analyses the effects of greening monetary policy. Finally, Section 4 concludes
with a policy discussion.

2. Towards a method for greening monetary policy

This section develops a methodology to green monetary policy operations. Before doing so,
we examine the conditions that need to be satisfied to ensure an effective conduct of
monetary policy.

2.1 Conditions
The Treaty on the Functioning of the European Union is clear on the conditions for monetary
policy. The Eurosystem (consisting of the ECB and the participating national central banks)
shall support the general economic policies of the EU, without prejudice to price stability (see
Article 127(1) TFEU). Maintaining price stability is thus the priority, and should not be
overridden by the possible greening of monetary policy operations. So, a monetary policy
decision and its implementation should not be affected by low-carbon considerations in
relation to assets and collateral. The ECB should make an independent assessment of whether
the ‘without prejudice’ clause can be fulfilled, because the ECB is not allowed to take
instructions from EU institutions in the exercise of its monetary policy mandate (Article 130
TFEU).

Monetary policy can be seen as a two-stage process. In the first stage, the relevant policy
decision is taken. Taking a broad definition of central bank operations, policy decisions refer
to monetary policy (for example, the interest rate), to reserve management (for example, the
asset and currency composition of official reserves) and to large-value payment systems (for
example, safe collateral for real-time gross settlement). In the second stage, policy decisions
are implemented through market transactions following operational procedures. A common
element of these procedures is that central banks aim to remain market neutral wherever
possible in order not to impair the functioning of the markets and price formation (Bindseil et
al, 2017; Cœuré, 2018). Article 127(1) of the TFEU specifies that “The ECB shall act in
accordance with the principle of an open market economy with free competition, favouring
an efficient allocation of resources”.

3
The market pricing mechanism is thus the primary mechanism for resource allocation and is
the main basis of the concept of market neutrality. Hong, Li and Xu (2019) investigated
whether stock markets efficiently price risks caused by climate change. Their findings provide
evidence that the price formation of carbon risk does not work smoothly. Another problem is
that the asset allocation is not neutral with respect to carbon emissions. Matikainen et al
(2017), for example, find an overallocation towards high-carbon companies in the ECB’s asset
portfolio resulting in 57% higher carbon emissions. This paper aims to address this carbon
bias.

Eligibility criteria
As part of their operational procedures, central banks determine the criteria or requirements
for assets and collateral to be eligible for use in monetary policy operations. These eligibility
criteria are important for the market because eligible securities become more liquid due to
their possible use by banks in their operations with their central bank (see Nyborg, 2017, for
an overview). The increased liquidity service translates into a higher security price and lower
yield (Nagel, 2016). The cost of capital thus decreases for the issuer of the security. The same
mechanism is at work for haircuts on collateral.1 A lower haircut increases the liquidity of the
security and reduces the cost of capital for its issuer (Ashcraft et al, 2011).

The greening of monetary policy operations involves steering the eligibility criteria towards
low-carbon assets. The intended effect is that the cost of capital for low-carbon companies
reduces relative to high-carbon companies. Figure 1 shows major differences in terms of the
carbon intensity of business sectors.

In terms of central banks’ ability to conduct monetary policy, we derive three conditions to
avoid disruption to the monetary transmission mechanism. The first is to avoid major
adjustments in the asset mix (ie the mix of government bonds, agency bonds, bank bonds,
corporate bonds and bank loans), currency denomination and maturity, which are chosen to
smooth the conduct of monetary policy and the management of reserves. Term spreads, and
thereby the shape of the yield curve, will, for example, be affected when maturities are varied
(Aksoy and Basso, 2014).

The second is to keep the list of eligible assets within each asset class as broad as possible. A
broad asset and collateral base contributes to minimising the impact on the functioning of
markets and price formation (Bindseil et al, 2017). It is thus very important not to ‘target’
particular assets (for example, only green bonds) or even asset prices of low-carbon sectors.
That would impair the price stability objective of monetary policy and might erode support
for central bank independence (Mishkin, 2001).

The third is to implement a possible low-carbon bias in steps, so central banks can learn about
the possible impact of adjusted criteria on monetary policy transmission. A gradual

1
A haircut reduces the market value of an asset for collateral purposes. The aim of haircut is to protect
against credit risk, as the market value of assets can fluctuate.

4
implementation allows for the carbon criteria to be optimised (see Section 2.2) and the impact
on the monetary transmission mechanism to be analysed. A gradual approach also allows for
a smooth rebalancing of the current portfolio, which reduces the need to sell parts of high-
carbon (and medium-carbon) holdings.

As maturities remain more or less the same, the possible transmission consequences are
cross-sectional. Low-carbon companies face a lower cost of capital, while high-carbon
companies face a higher cost of capital. The resulting transition dynamics in the economy
might have an impact on the transmission channel. Central banks should analyse these
dynamics and assess how monetary policy transmission might change.

2.2 Data and methodology

The EU’s general economic policies aim at achieving a transition to a low-carbon economy
with a 50% carbon emission reductions target by 2030 compared with 1990 levels (European
Commission, 2019). We take this general objective of EU climate policies as a guide for the
methodology to green monetary policy operations.

Indicator
We use carbon emissions as shorthand for all greenhouse gas (GHG) emissions, which include
carbon dioxide (CO2), methane (CH4) and nitrous oxide (N2O). Carbon emissions are the most
widely used metric on the environmental side. The Greenhouse Gas Protocol (WRI, 2015)
distinguishes between direct emissions from sources that are owned or controlled by the
reporting entity and indirect emissions that are a consequence of the activities of the
reporting entity, but occur at sources owned or controlled by another entity. The GHG
Protocol further categorises these direct and indirect greenhouse gas (GHG) emissions into
three scopes:
• Scope 1: All direct GHG emissions of an entity.
• Scope 2: Indirect GHG emissions from consumption of purchased electricity, heat or
steam.
• Scope 3: Other indirect emissions: the full corporate value chain emissions from the
products an entity buys, manufactures and sells (eg for a car manufacturer, this
represents the emissions of the cars in use).

Taking all three scopes into account means that, not only do the emissions of a company
across its value chain matter, the emissions of products and services that it produces for its
customers are also relevant. Another relevant issue is whether companies are in transition to
applying low-carbon technologies and creating low-carbon products and services, or are
preparing for that transition (Schoenmaker and Schramade, 2019). So, it is important not only
to assess current carbon emissions but also expected future emissions using scenarios (TCFD,
2017). This forward-looking perspective incentivises companies to switch investments from
current high-carbon into new low-carbon technologies and products.

5
The carbon intensity of companies can be measured as follows:
()#**#+,*-,./0
𝐶𝐼#,% = 1234*-,./0
(1)

where 𝐶𝐼#,% represents the carbon intensity of company 𝑖 at time 𝑡 in years. The carbon
intensity is calculated as a company’s scope 1 to 3 emissions divided by its sales at time 𝑡 + 𝑘.
Emissions are measured with some delay, so 𝑘 would typically be -1. We propose to start with
historical carbon emissions (𝑘 = −1). When companies have more experience of reporting
expected future carbon emissions following the TCFD principles for scenarios and auditors are
able to provide assurance on these reported emissions, the indicator could be based on a mix
of current and future emissions.

While the carbon intensity of non-financial companies issuing corporate bonds can be
assessed directly, it is more difficult for synthetic or financial institution securities. The look-
through approach can be applied, whereby the underlying beneficiary instead of the
intermediary is assessed (Gorton and Souleles, 2007). In the case of asset-backed securities,
the carbon intensity of the assets in the vehicle (eg real estate underlying mortgage-backed
securities) can be measured. In the case of bank loans, the carbon intensity of the borrower
can be assessed. In the more general case of bank bonds, the carbon intensity of a bank’s total
loan portfolio should be evaluated.

Banks lend not only to companies, but also to households mostly in the form of mortgages.
The carbon intensity of a mortgage can be measured by the energy label of the house, which,
in the EU, ranges from A (most efficient) to G (least efficient). In the EU, all properties when
sold have to obtain an energy performance certificate that places the property on an A-G
scale.

Data
Data on companies’ carbon emissions is available at ASSET4 ESG Scores in Datastream
(Thomson Reuters) and the Carbon Disclosure Project (CDP). When external emissions data or
energy efficiency labels are not available, banks must provide an internal rating when
supplying assets or collateral to the central bank. This is in line with the general ECB asset and
collateral framework, under which banks are allowed to provide an internal credit rating for
assets for which no external credit ratings exist (ECB, 2015).

We take emissions and sales data from ASSET4 Datastream for the largest 60 companies in
the euro area. As we are interested in corporate bonds, we selected the largest companies by
long-term debt. The Appendix provides a list of companies and their carbon intensity (Table
A1). Figure 1 summarises the average carbon intensity for each sector. As expected, the oil,
gas and coal sector has the highest carbon intensity at 4,179 (measured as metric tonnes of
carbon emissions divided by sales in millions of euros) followed by the materials sector (metal
producers and construction) at 3,855, utilities at 1,916, chemicals at 1,340, transportation
(airlines) at 1,135 and automotive (carmakers) at 941, while the weighted average is 1,355
(see the Appendix for details).

6
Figure 1. Average carbon intensity by industry

Carbon Intensity
(CO2 Emissions in Mt / Sales in € millions)
5000
4179
3855
4000

3000
1916
2000 1355
1340 1135 941 841
1000 347
121 38 19
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Note: The graph depicts the average carbon intensity of sectors, measured as average of emissions in
metric ton CO2 divided by sales in millions euro. Scope 1, 2 and 3 emissions are included for the 60
largest corporates in the euro area. Table A1 provides a detailed breakdown.
Source: Author calculations based on ASSET4 ESG Scores in Datastream and company reports.

Methodology
Which perspective should central banks adopt in their approach towards carbon emissions?
Climate change poses a physical risk (in case of insufficient mitigation) and a transition risk (in
case of sudden implementation of carbon policies). It is often argued that central banks should
manage the carbon risk in their operations, just like managing credit and market risks. While
the risk perspective is relevant for the financial stability side (Carney, 2015), both the risk and
opportunity perspective 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.

Amel-Zadeh and Serafeim (2018) distinguish several methods for considering environmental,
social and governance (ESG) issues:
1. Exclusionary/negative screening: a method of deliberately not investing in companies
that do not meet specific ESG criteria.
2. Best in class: an approach to sustainable investing that focuses on investing in
companies that perform better on ESG issues than their peers do.
3. Portfolio tilt: the use of certain investment strategies or products to change specific
aggregate ESG characteristics of a fund or investment portfolio to a desired level.

7
 4. Active ownership: use of shareholder power to engage with companies to improve
their ESG performance.
5. Thematic investing: focusing on those parts of the universe that benefit from and
provide solutions for certain ESG trends.
6. Impact investing: an approach to investing that deliberately aims for both financial
and societal value creation, as well as the measurement of societal value creation.
7. Full ESG integration: the explicit integration of E, S and G issues into the valuation and
selection of securities.

The advantages and disadvantages of the different methods can be judged on (i) political
acceptability; (ii) objective and expected impact; and (iii) compatibility with the central bank’s
mandate. On the first criterion, Smits (1997) argues that a general approach avoids politically
sensitive decisions on specific sectors and companies. While the first three methods are
generally applicable, the last four methods are not. They require specific choices, valuations
or actions. Full ESG integration, for example, would require that central bank officials
investigate individual companies and come to a judgement on their ESG performance and
transition preparedness (Schoenmaker and Schramade, 2019).

Amel-Zadeh and Serafeim (2018) report that negative screening is the most used method
among investment professionals. At the same time, however, investment professionals
perceive negative screening as the least useful method, because it aims only to avoid the
worst performers from a risk perspective. So, negative screening is less able to achieve the
objective of addressing the carbon bias and achieving the desired impact.

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

The best in class method selects the X% of best performers in a sector, that is, the X% of
companies with the lowest carbon emissions in this sector. To keep a broad asset and
collateral base for central bank operations, X should be set relatively high, say 50 to 60%. Even
with these high numbers, 40 to 50% of the companies in the market is excluded. By contrast,
a tilting approach increases the share of low-carbon companies at the expense of the share of
high-carbon companies. A tilting approach is less distorting in the monetary transmission, as
no assets are excluded (only the weights in the portfolio are adjusted). The central bank can
thus maintain a broad asset and collateral base in line with its monetary policy mandate.

Tilting towards low carbon

To minimise distortions in the asset and collateral base, we propose a tilting approach for a
central bank’s direct asset holdings (eg related to official reserves or asset purchases under
quantitative easing) and collateral holdings. A straightforward application is to relate the
relative share of a company’s securities inversely to its carbon intensity. In a tilting approach,

8
a central bank overweights low-carbon companies and underweights high-carbon companies
in its portfolio:
<= )
𝑆#,% = >1 + 𝑝𝑡#,% @ 𝑆#,% (2)
) <=
where 𝑆#,% represents the share of asset 𝑖 in the available market portfolio 𝑚; 𝑆#,% the share of
asset 𝑖 in the central bank portfolio 𝑐𝑏 , and 𝑝𝑡#,% the tilting factor of asset 𝑖 . Note that
∑,# 𝑝𝑡#,% = 0. Combining equations (1) and (2), the reduction 𝑅%<= in carbon intensity of the
central bank portfolio is as follows:

∑,H −𝑝𝑡#,% ∙ 𝑆#,%

)
∙ 𝐶𝐼#,%
𝑅%<= = I∑, 𝑆 ) ∙ 𝐶𝐼 (3)
H #,% #,%

The aim of a haircut is to reduce the market value of an asset for collateral purposes, as this
market value can fluctuate. An additional haircut can be directly related to carbon intensity,
just like credit risk. A central bank then applies an additional haircut for medium and high-
carbon assets. Following Nyborg (2017), the impact of an additional haircut on asset values
works as follows:
< )
𝑉#,% = >1 − (1 + 𝑎#,% )ℎ#,% @ 𝑉#,% (4)
< )
where 𝑉#,% represents the collateral value of asset 𝑖; 𝑉#,% the market value of asset 𝑖, ℎ#,% the
standard valuation haircut of asset 𝑖, and 𝑎#,% the additional haircut of asset 𝑖. Table A2 in the
Appendix provides an overview of the standard valuation haircuts used by the ECB (ECB,
2015). The collateral framework aims to reflect market realities and to ensure a level playing
field across different jurisdictions and counterparties. Its main focus is on protecting against
counterparty risk. While haircuts are often presented in absolute terms (eg 1 or 2%), we
propose a multiplier approach for the additional haircut to ensure proportionality. An
additional haircut of, for example, 2% is very punitive for short-dated high-quality liquid assets
with a valuation haircut of 0.5 or 1% and not very effective for longer-dated illiquid assets of
a lower quality with valuation haircuts of up to 44%. The aim is to tilt towards low-carbon
assets within each category.

Table 1 presents a simple structure for carbon factors in the ECB’s asset and collateral
framework. Three carbon categories 𝐶O are introduced: low (𝐶 3+P = 1), medium (𝐶 )4Q#R) =
2) and high (𝐶T#UT = 3). Companies 𝑖 = 1, . . , 𝑛 are divided in tertiles according to increasing
H H \
carbon intensity 𝐶𝐼#,% : the bottom tertile is [1, Z 𝑛], the middle tertile is ( Z 𝑛, Z 𝑛] and the
\
top tertile (Z 𝑛, 𝑛]. Houses (used as collateral in mortgages) are divided according to their
energy efficiency label, ranging from A to G. For bonds of financials (eg (un)covered bank
bonds) or special purpose vehicles (eg asset-backed securities), a weighted average of the
carbon category of the underlying assets with weight 𝑤# is taken, whereby a strict definition
O
is applied: 𝐶O ≥ 𝐶O,2_U = ∑# 𝑤# 𝐶# .

Moving to the carbon factors, the minimal value of the tilting factor 𝑝𝑡# is -1, as asset shares
cannot become negative. The tilting factor range is [−1, 𝑗 − 1) in a structure with 𝑗

9
categories. The maximum tilting factor in our setting with 3 carbon categories approaches 2.
To avoid major distortions, we suggest a medium tilting factor of +1 for low-carbon assets,
which is divided as follows: one-third (-0.33) for medium-carbon assets and two-third (-0.67)
for high-carbon assets. The additional haircut for collateral is initially set at 0.1 for medium-
carbon assets and 0.2 for high-carbon assets in Table 1. The Eurosystem can introduce the
tilting factors and additional haircuts in a stepwise order until the current carbon bias of 57%
is eliminated in the ECB’s asset and collateral holdings. A stepwise implementation also
softens the impact on the value of companies.

Table 1: Carbon factors in the asset and collateral framework

Carbon intensity
Portfolio tilt Additional
Carbon category Companies Houses
(pt) haircut (a)
(tertile) (eco-label)

Low 1.00 0 Bottom A, B

Medium -0.33 0.1 Middle C, D, E

High -0.67 0.2 Top F, G

Note: Assets are divided over three carbon categories according to their carbon intensity. The tilting
factor (pt) is applicable to a central bank’s asset purchases and the additional haircut (a) to its
collateral.

3. Results and effects of greening monetary policy

3.1 Asset and collateral base

We examine the effects of greening monetary policy on the assets acquired under quantitative
easing (ie the ECB’s Asset Purchases Programme or APP) and the collateral used in regular
monetary policy operations. Table A3 in the Appendix provides an overview of the
consolidated balance sheet of the Eurosystem, which comprises the ECB and the participating
national central banks. The largest items on the Eurosystem balance sheet refer to securities
holdings under the Asset Purchases Programme (€2,639 billion in item 7.1) and lending to EU
credit institutions as part of monetary policy operations (€619 billion in item 5). The remaining
items refer to gold (item 1), IMF drawing rights and other external claims (item 2), euro
government securities (item 8) and other assets (item 9). The carbon factors are not relevant
for these remaining items.

Table 2 breaks down the securities holdings under the APP. The first column indicates the
eligible market securities, the second column the holdings under the APP and the third column
the holdings as percentage of eligible market securities. Government securities (€2,157
billion) form the vast majority of these securities at more than 80%. The carbon factors are
only relevant for the private securities, which amount to €483 billion. These comprise covered

10
bank bonds (10.3% of total securities holdings), corporate bonds (7.1%) and other assets
(1.1%).

Table 2: Outstanding holdings under Asset Purchases Programme, 20 December 2019

1. Eligible 2. Holdings 3. Holdings as 4. Carbon

market share of market factors
securities applicable
Securities
(in € billions) (in € billions) (2. as % of 1.) (2. as % of total)
Government securities 7,903.5 2,156.9 27.3% n.a.
Covered bank bonds 1,515.3 268.8 17.7% 10.3%
Corporate bonds 1,558.9 184.8 11.9% 7.1%
Asset-backed securities 596.8 29.0 4.9% 1.1%
Total 11,574.5 2,639.4 22.8% 18.5%
Source: ECB (EURO outright operations). Note: The second column presents marketable securities that
are eligible under the APP. The third column presents the holdings under the APP. The fourth column
presents APP holdings as share of eligible market securities. The fifth column indicates whether the
carbon factor would be applicable to the respective collateral category and measures the percentage
of total holdings.

Table 3 provides the collateral data of the Eurosystem taken from the ECB. The first column
indicates the eligible market assets, the second column the amount used as collateral and the
third column the collateral holdings as percentage of eligible market assets. Table 3 shows
that banks keep the most liquid and high-quality assets, like government bonds, on their own
balance sheet, and pledge covered bonds (€381 billion), asset-backed securities (€359 billion)
and bank loans (€380 billion) as collateral at the Eurosystem. 2 The carbon factors can be
applied to slightly over 80% of the Eurosystem’s collateral holdings (see last column of Table
3). This indicates that the tilting approach has a bigger impact on collateral (81.0%) than on
asset purchases (18.5%).

2
Some asset classes are heavily used as collateral. Banks use, for example, their asset-backed securities
as collateral for the ECB, up to 60% (Table 4). Also, covered bank bonds are popular as collateral (24%)
and in the APP (21% in Table 3). With such high initial fractions, there is less scope for tilting. So, the
tilting needs to be moderated for these asset classes to say +0.30 for low-carbon assets and -0.10 and
-0.20 for medium- and high-carbon assets.

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Table 3: Collateral data of the Eurosystem, 20 December 2019

1. Eligible 2. Use of 3. Collateral as 4. Carbon

market assets collateral share of factors
market applicable
Collateral categories
(in € billions) (in € billions) (2. as % of 1.) (2. as % of total)
Central government securities 7,432.8 225.2 3.0% n.a.
Regional government securities 470.7 59.6 12.7% n.a.
Uncovered bank bonds 1,679.6 81.2 4.8% 5.1%
Covered bank bonds 1,515.3 380.8 25.1% 23.9%
Corporate bonds 1,558.9 54.2 3.5% 3.4%
Asset-backed securities 596.8 359.1 60.2% 22.5%
Other marketable assets 874.3 36.8 4.2% 2.3%
Bank loans 379.9 23.8%
Total 14,128.4 1,576.8 8.5% 81.0%
Central bank operations
Monetary policy operations 619.0
Other operations 957.8
Source: ECB (Eurosystem collateral data). Note: The second column presents marketable assets that
are eligible as collateral. The third column presents the collateral holdings in the Eurosystem, at market
values after haircuts applied (see Table A2). The fourth column presents collateral as share of eligible
market assets. The fifth column indicates whether the additional carbon haircut would be applicable
to the respective collateral category. The bottom rows specify for which central bank operations
collateral is used. Other operations include large-value payment system operations.

3.2 Numerical examples

The way central banks can put the tilting method into operation is illustrated with numerical
examples. We take corporate bonds, unsecured and covered bank bonds, which are large
asset classes in the ECB’s asset and collateral framework alongside government bonds.
Starting with corporate bonds, we examine the impact of the tilting factor on the carbon
footprint of a portfolio with corporate bonds. For the calibration of the corporate bond
portfolio, we construct the market portfolio of eligible corporate bonds by taking the
corporate bonds of the 60 largest companies in the euro area, which means that 𝑛 = 60,
measured by long-term debt 𝐷#,% (see the Appendix). The value weighted share of company 𝑖
𝐷
)
in the market portfolio is then: 𝑆#,% = #,%I∑, 𝐷 .
# #,%

Table 4 reports the results from the tilting. Applying the carbon factors of Table 1 to equation
(2), the fraction of low-carbon corporate bonds increases from 0.33 to 0.67 and the fraction
of medium and high-carbon corporate bonds decreases from 0.33 to 0.22 and 0.11
respectively. A sensitivity analysis is conducted with a low set of tilting factors (+0.75, -0.25
and -0.50) and a high set (+1.25, -0.42 and -0.83). In the medium tilting scenario, the carbon
footprint of the central bank’s corporate bond portfolio is reduced by 55% to 610 compared
to the original market portfolio at 1,355 ( 𝑅%<= = 0.55 in equation (3)). The lopsided

12
distribution of carbon emissions with very high carbon intensity in some sectors (ie the fossil
fuel, materials and utilities sectors in Figure 1) explains this strong reduction of 55%, with a
medium tilting factor of +1 for low-carbon and -0.33 and -0.67 for medium and high-carbon
companies. The low tilting scenario reduces emissions with 41%, while the high tilting scenario
reduces emissions with 69%. These results indicate that medium tilting suffices to counter the
current carbon bias of 57% (see Section 2).

Table 4: Tilting of corporate bond portfolio

Fraction in central bank Carbon intensity central

Fraction Carbon portfolio bank portfolio
Carbon Carbon in intensity
category intensity market market medium low high medium low high
portfolio portfolio tilting tilting tilting tilting tilting tilting
pt=1 pt=0.75 pt=1.25 pt=1 pt=0.75 pt=1.25
Low 134.0 0.33 44.7 0.67 0.58 0.75 89.3 78.2 100.5
Medium 751.0 0.33 250.3 0.22 0.25 0.19 166.9 187.8 146.0
High 3,179.5 0.33 1,059.8 0.11 0.17 0.06 353.3 529.9 176.6
Portfolio 1.00 1,354.8 1.00 1.00 1.00 609.5 795.8 423.2
Reduction 55.0% 41.3% 68.8%

Note: Corporate bonds are divided over three carbon categories according to their carbon intensity
(measured as metric ton CO2 divided by sales in million euros; see Figure 1); the average carbon
intensity for each tertile is presented. The medium tilting factor of Table 1 is applied (pt=1 for the low
carbon tertile) and a sensitivity analysis with low tilting (pt=0.75 for the low carbon tertile) and high
tilting (pt=1.25 for the low carbon tertile). The carbon footprint of the central bank portfolio after
tilting is reduced with 55, 41 and 69% respectively.

The second numerical example concerns the unsecured bonds of two single-A rated banks.
The bonds have a residual maturity of four years and a fixed coupon, which gives a valuation
haircut of 11% (see Table A2). The carbon category of unsecured bank bonds is derived from
the carbon factors of the underlying loan portfolio. Table 5 reports that Bank A has 40% of its
loans to companies and 60% to households (in the form of mortgages) spread across the three
carbon categories. The weighted average carbon factor is 2.32, which leads to an additional
haircut of 0.2 based on the carbon factors of Table 1. The total haircut increases from 11 to
13.2%, according to equation (4). Bank B has slightly lower carbon intensity in its loan portfolio
with an average carbon factor of 1.92. The additional haircut of 0.1 increases the total haircut
from 11 to 12.1%.

13
Table 5: Additional haircut for uncovered bank bonds

Bank A Bank B
Carbon category Carbon factor
Companies Mortgages Companies Mortgages
40% 60% 60% 40%
Low 1 0.04 0.12 0.18 0.16
Medium 2 0.12 0.24 0.24 0.16
High 3 0.24 0.24 0.18 0.08
0.40 0.60 0.60 0.40
Average carbon factor 2.32 1.92
Valuation haircut 11.0% 11.0%
Additional haircut 0.2 0.1
Total haircut 13.2% 12.1%
Increase of total haircut 20% 10%
Note: The single A rated banks have a loan portfolio of corporate loans and mortgages. The average
carbon factor is calculated as a weighted average of a bank’s asset carbon factors. The valuation haircut
is based on a residual maturity of 4 years and a fixed coupon (Table A2). The additional haircut (Table
1) is based on the upward rounded carbon factor. The total haircut is calculated according to equation
(4).

The third numerical example concerns a covered bank bond. Again the bank is single-A rated
and the bond has a remaining maturity of four years with a fixed coupon. The valuation haircut
is 3%. In the case of a covered bond, the average carbon factor of the underlying houses has
to be calculated. The bank has a portfolio with relatively energy efficient houses: 60% with
label A or B, 30% with label C to E, and 10% with label F or G. The average carbon factor is 1.5,
which gives rise to an additional haircut of 0.1 (Table 1). The total haircut for this covered
bond increases from 3 to 3.3%, according to equation (4). Only when all houses have an A or
B label, is there no additional haircut.

These numerical examples show a substantial reduction in the carbon footprint of the central
bank portfolio in corporate and bank bonds. Nevertheless, a broad asset base is maintained,
minimising the scope for distortions in the monetary transmission mechanism.

3.3 Discussion
Does an allocation bias towards low-carbon assets support the transition to a low-carbon
economy? In Section 2.1, we discuss that increased eligibility for low-carbon assets generates
a liquidity premium that reduces the cost of capital. The cost of capital for high-carbon
companies then becomes higher than that for low-carbon companies. This primary effect
already gives low-carbon companies a funding advantage and thus could contribute to the
transition. But the evidence is mixed. Heinkel et al (2001) show that when more than 20% of
green investors are added to the investor base, the cost of capital for green companies

14
declines so much that polluting companies start to reform and adopt clean technologies. By
contrast, Lilliestam et al (2020) provide evidence that carbon pricing has little effect on the
adoption of low-carbon technologies.

Another channel is engagement. Institutional investors and banks engage with investee and
lending companies inter alia on adopting low-carbon technologies. There is evidence showing
that engagement improves the sustainability outcomes (Schoenmaker and Schramade, 2019).
By increasing (decreasing) the eligibility of low-carbon (high-carbon) assets, the ECB would
further incentivise these engagement efforts on low-carbon technologies.

Van ‘t Klooster and Van Tilburg (2020) go one step further and argue that the ECB should only
provide cheap refunding (in the form of green targeted long-term refinancing operations) for
bank loans that are in line with the new European green taxonomy. More generally, central
bank efforts to green monetary policy operations give a powerful signalling effect to other
financial market participants (Braun, 2018), boosting the case for greening the financial
system.

3.4 Implementation
The implementation of the proposed tilting approach faces several challenges. A first
challenge is reliable data on carbon emissions. These data are available under the EU’s
Emissions Trading System (ETS). The EU ETS company database contains the verified carbon
emissions for more than 1,000 companies from EU countries at group level.

Another challenge is containing undesired side-effects of pushing green investment. There are
risks on both sides. High carbon companies may become stranded assets that lose their value
under a scenario with a high carbon tax and/or a major technological breakthrough in
renewable energy production (Caldecott et al, 2014). This is the earlier mentioned transition
risk. Next, low carbon companies adopt new technologies, which are subject to the standard
business risk of new ventures. Moreover, certain technologies may initially be boosted by
government subsidies and subsequently affected by withdrawal of these subsidies. This is the
so-called policy risk.

4. Conclusions
Central banks have a medium to long-term perspective and are therefore mindful of the
impact of climate change. They have already started to examine the impact of climate change
on the stability of the financial system from a risk management perspective. On the monetary
side, there is no comparable direct impact on price stability, which has a medium-term
horizon. Nevertheless, the Eurosystem’s legal mandate states that it “shall support the general
policies in the EU, without prejudice to price stability”. At the same time, the transition to a
low-carbon economy is a cornerstone of the EU’s general economic policies.

The Eurosystem can support the EU’s climate policy by greening its monetary policy
operations. We develop a methodology to tilt the asset and collateral base for monetary policy

15
operations towards low-carbon assets. A medium tilting approach can reduce carbon
emissions in the central bank’s corporate and bank bond portfolio by 55% offsetting the
current carbon bias. This paper shows how this can be done without unduly interfering in the
smooth conduct of monetary policy. A key element of a tilting approach is that the ECB
remains present in the entire market for eligible assets, which guarantees that monetary
policy gets in “all of the cracks” of the economy (Stein, 2013, p. 17). Tilting only increases the
share of low-carbon assets at the expense of high-carbon assets, but it does not exclude high-
carbon assets.

The required political space for the ECB to adopt low-carbon criteria is already present. The
European Council, the European Commission and the European Parliament are all committed
to the transition to a low-carbon economy as part of the European Green Deal (European
Commission, 2019).

If the Eurosystem were to pick up the challenge of greening its monetary policy operations, it
would be of utmost importance to do that in full independence. The Eurosystem could adjust
the eligibility criteria for assets and collateral in a general way, using a transparent and
objective indicator, such as current and future carbon emissions (TCFD, 2017). It should refrain
from favouring specific projects or setting sectoral targets, which is an issue for government
policy. The EU and the member states can use their multilateral development bank, the
European Investment Bank, and their national development banks to steer financing towards
specific green projects, if they wish to do so.

Our findings are also applicable to other central banks. The exact setting of the carbon factors
(in Table 1) needs to be modified and calibrated according to the specifics of a central bank’s
asset and collateral framework. But the tilting approach is likely to be generally applicable to
correct the carbon bias in monetary policy operations throughout the world.

16
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Appendix

Corporate bond portfolio

Table A1 contains the carbon intensity (based on scope 1, 2 and 3 emissions) of the top 60
companies in the euro area, selected by long-term debt. Two firms (Heineken Holding and
Airbus) were removed from the top 60 due to lack of data and replaced by Linde (rank 61) and
Deutsche Lufthansa (rank 62). The data are taken from ASSET4 EGS Scores in Datastream and
cross-checked with company reports. For some companies, scope 3 emissions data are missing
in Datastream and company reports. These scope 3 emissions are estimated based on the
industry average.

Table A1: Carbon intensity of top 60 companies (CO2 emissions in Mt/sales in EUR million)
Carbon Long term
Company Country Industry sector intensity debt
AENA ES Miscellaneous 642.0 7.3
AIR FRANCE KLM FR Transportation 2,015.4 6.7
AIR LIQUIDE FR Chemicals 1,295.1 12.5
ALD FR Miscellaneous 9.5 9.9
ALTICE EUROPE NL Utilities: Energy 116.3 50.2
ANHEUSER BUSCH INBEV BE Nutrition: Beverages 296.6 90.9
ARCELORMITTAL NL Materials: Metal Producers 3,450.0 8.5
ATLANTIA IT Miscellaneous 151.1 15.4
BASF DE Chemicals 2,372.6 15.6
BAYER DE Chemicals 351.6 12.2
BMW DE Automotive 738.0 52.8
BOLLORE FR Transportation 269.7 7.0
CARREFOUR FR Retailers 37.5 9.1
CASINO FR Retailers 37.6 7.2
CHRISTIAN DIOR FR Diversified 19.6 7.9
CNH INDUSTRIAL IT Machinery & Equipment 19.8 12.0
COMPAGNIE DE SAINT GOBAIN FR Diversified 504.6 7.7
DAIMLER DE Automotive 454.8 78.4
DANONE FR Nutrition: Food 880.8 15.5
DEUTSCHE LUFTHANSA DE Transportation 1,121.0 6.1
DEUTSCHE TELEKOM DE Utilities: Telecom 262.9 48.3
E.ON DE Utilities: Energy 2,091.4 9.9
EDP PT Utilities: Energy 2,349.8 16.1
EIFFAGE FR Materials: Construction 116.4 12.1
ELECTRICITE DE FRANCE FR Utilities: Energy 1,426.1 49.7
ENEL IT Utilities: Energy 1,555.4 43.1
ENGIE FR Utilities: Energy 4,329.0 28.1
ENI IT Oil, Gas, Coal 4,366.9 20.2
EXOR IT Automotive 560.3 28.1
FERROVIAL ES Materials: Construction 306.9 7.5
FIAT CHRYSLER AUTOMOBILES IT Automotive 1,439.4 10.7
FRESENIUS SE & CO DE Drugs, Cosmetics & Healthcare 59.0 16.1
HEIDELBERGCEMENT DE Materials: Construction 14,996.8 8.9
HEINEKEN NL Nutrition: Beverages 164.8 12.2
IBERDROLA ES Utilities: Energy 1,626.6 31.0
INNOGY DE Utilities: Energy 5,231.8 13.2

19
 KONINKLIJKE KPN NL Utilities: Telecom 137.7 8.7
LINDE DE Machinery & Equipment 1,662.7 6.5
LVMH FR Diversified 7.2 7.0
MERCK KGAA DE Drugs, Cosmetics & Healthcare 70.7 7.9
NATURGY ENERGY GROUP ES Utilities: Energy 7,021.8 16.7
OMV AT Oil, Gas, Coal 5,904.5 7.3
ORANGE FR Utilities: Telecom 33.5 31.9
PERNOD RICARD FR Nutrition: Beverages 97.5 7.4
REPSOL ES Oil, Gas, Coal 4,351.7 8.7
ROYAL DUTCH SHELL NL Oil, Gas, Coal 2,801.7 61.6
RWE DE Utilities: Energy 5,198.7 13.6
SANOFI FR Drugs, Cosmetics & Healthcare 232.0 14.3
SIEMENS DE Electronics 19.5 26.8
SNAM IT Utilities: Energy 690.4 10.2
SUEZ FR Utilities: Water 1,864.5 11.3
TELECOM ITALIA IT Utilities: Telecom 392.7 26.2
TELEFONICA ES Utilities: Telecom 87.0 46.0
TERNA RETE ELETTRICA NAZION. IT Utilities: Energy 69.1 8.7
TOTAL FR Oil, Gas, Coal 3,468.6 33.6
UNILEVER NL Nutrition: Food 293.0 16.1
VEOLIA ENVIRONNEMENT FR Miscellaneous 1,672.1 10.7
VINCI FR Materials: Construction 406.2 16.6
VOLKSWAGEN DE Automotive 1,514.2 92.7
WENDEL FR Diversified 105.1 6.4
Grand Total 1,354.8 21.4
Source: Author calculations based on ASSET4 ESG Scores in Datastream (Thomson Reuters) and
company reports. Note: Carbon intensity is measured as average of emissions in metric ton CO2 divided
by sales in millions euro. Scope 1, 2 and 3 emissions are included. Long-term debt is outstanding long-
term debt end-2017, measured in billions euro. The grand total at the bottom row gives the weighted
average.

20
 Table A2: Eurosystem haircut levels for marketable assets
Category I Category II Category III Category IV Category V
Central Other Covered bank Unsecured bank Asset-
government debt government and bonds and debt backed
agencies debt corporate bonds securities
Credit Residual
fixed zero fixed zero fixed zero fixed zero
quality maturity
coupon coupon coupon coupon coupon coupon coupon coupon
(rating) (years)
0-1 0.5% 0.5% 1.0% 1.0% 1.0% 1.0% 6.5% 6.5%
1-3 1.0% 2.0% 1.5% 2.5% 2.0% 3.0% 8.5% 9.0%
AAA to 3-5 1.5% 2.5% 2.5% 3.5% 3.0% 4.5% 11.0% 11.5% 10%
A- 5-7 2.0% 3.0% 3.5% 4.5% 4.5% 6.0% 12.5% 13.5%
7-9 3.0% 4.0% 4.5% 6.5% 6.0% 8.0% 14.0% 15.5%
>10 5.0% 7.0% 8.0% 10.5% 9.0% 13.0% 17.0% 22.5%
0-1 6.0% 6.0% 7.0% 7.0% 8.0% 8.0% 13.0% 13.0%
1-3 7.0% 8.0% 10.0% 14.5% 15.0% 16.5% 24.5% 26.5%
B+ to 3-5 9.0% 10.0% 15.5% 20.5% 22.5% 25.0% 32.5% 36.5% Not eligible
BBB- 5-7 10.0% 11.5% 16.0% 22.0% 26.0% 30.0% 36.0% 40.0%
7-9 11.5% 13.0% 18.5% 27.5% 27.0% 32.5% 37.0% 42.5%
>10 13.0% 16.0% 22.5% 33.0% 27.5% 35.0% 37.5% 44.0%
Source: Author based on Annex X of the Guideline (ECB/2015/510) on the implementation of the
Eurosystem monetary policy framework (ECB, 2015). Note: This table provides the levels of valuation
haircuts for marketable assets applied by the Eurosystem. The top of the table presents five categories
of issuers. The first column provides the credit ratings and the second column the residual maturity of
assets.

21
Table A3: Consolidated balance sheet of the Eurosystem, 20 December 2019

Amounts
Assets (in € billions)

1. Gold 474.1
2. Claims on non-EA residents in foreign currency 357.4
2.1 Receivables from the IMF (drawing rights) 81.6
2.2 Other external assets 275.7
3. Claims on EA residents in foreign currency 22.9
4. Claims on non-EA residents in euro 19.1
5. Lending to EU credit institutions in monetary policy operations 619.0
6. Other claims on EU credit institutions 28.4
7. Securities of EA residents 2,854.2
7.1 Securities held for monetary policy purposes (APP) 2,639.4
7.2 Other securities 214.8
8. General government debt in euro 23.4
9. Other assets 284.1
Total assets 4,682.6
Source: ECB (Balance sheet of the Eurosystem).

22