Green QE: Should it be used by central banks to combat climate change?
By Oliver Kidd (Research Analyst, Economics Research Division)
Climate change is indisputably one of the greatest, if not the greatest, challenges our generation will face. Purely from an economic perspective, the risks it poses could have severe effects on the financial system. Ignoring any ecological or environmental effects it may have for generations to come, this is a challenge we must devote resources to, or face a significant impact on the way we live in the future. In this article, I aim to use a combination of questions answered by Prof Sir Charles Bean, and my own research, to explore whether central banks should include sustainable criteria in their decision making process and how they may go about mitigating some of the problems surrounding green quantitative easing.
Prof Sir Charles Bean was formerly the Chief Economist at the Bank of England from 2000–08, and then deputy governor for Monetary Policy at the Bank of England from July 2008 to June 2014. He was knighted in 2014 for services to monetary policy and central banking, and is now a professor of economics at LSE; additionally, he holds a concurrent committee appointment at the Office for Budget Responsibility (OBR).
Firstly, why is it important that we do anything about climate change in the first place? The two main types of risk that present themselves as a result of climate change are physical risks and transitional risks. Physical risks arise from climate change and weather-related events, such as heatwaves, droughts and flooding, with global warming resulting in devastating events like sea level rise. They can result in large falls in asset prices, and impair the creditworthiness of borrowers. Transitional risks arise from the process of transferring our economy to a low-carbon state. Changes in policy and technology could cause a reassessment of the value of assets and create exposure risks for banks. Papers like Dafermos, Nikolaidi and Galanis’s ‘Climate Change, Financial Stability and Monetary Policy’ use macroeconomic models to determine the effect of climate change on financial stability, and come to 4 key results. Firstly, due to the destruction of firm’s capital, climate change is likely to deteriorate the liquidity of firms. Secondly, climate change damages can cause a portfolio reallocation that can cause a gradual decline in the price of corporate bonds. Thirdly, instability might adversely affect credit expansion, worsening the impact of climate change on economic activity and lastly, and what this article wants to explore, is how an implementation of green corporate QE program can reduce this instability and restrict global warming (Dafermos et al.).
But how can QE help us make a difference? Well, central banks are in a unique position. Quantitative easing is used to inject money directly into the economy and is an unconventional tool within monetary policy. Banks do this by purchasing assets (QE is often called ‘asset purchase’). By purchasing large volumes of long-term bonds (both government bonds and corporate bonds), this pushes down the long-term interest rates or yields of these bonds. As a result, this pushes down the rates offered on loans, thus making it cheaper to borrow and invest, encouraging spending in the economy. Central banks have traditionally focussed their spending on government bonds, however are increasingly purchasing corporate bonds. The ECB introduced its corporate sector purchase programme in June 2016. Since then, an increasing proportion of the APP (Asset purchasing programme), or the ECBs QE programme, has been spent on the Corporate Sector Purchase programme (CSPP). In other words, an increasing proportion of the ECBs QE programme has been dedicated to corporate bond purchases.
With this growth in activity, it is becoming more important than ever that the funds the ECB has access to are used to purchase bonds that will have a positive impact upon our environment and economy. Our first question addresses the use of Green QE and whether we would even want to use it at all.
Ollie: Do you consider ‘Green QE’ (the targeted purchase of green bonds within a QE programme) to be a sustainable and desirable monetary policy approach?
Prof Bean: It would be fine if the CB were buying lots of different types of bonds and the green bonds were just an appropriate fraction. The trickiness is if the purchases are more heavily weighted to green bonds so that the CB is effectively subsidising those activities. Of course, it may be highly desirable to make such purchases, but it should be politicians rather than the CB driving it. Otherwise the decision lacks democratic legitimacy.
So, it seems that one benefit of Green QE is that it would act as a kind of subsidy to green activities. But how would this work? Purchases of green bonds allow bond sellers to incur lower costs and to gain earlier access to capital. This encourages sustainable projects and will improve our response to the climate emergency. The purchase of corporate green bonds also reduces the interest rate on green bonds relative to conventional bonds. This makes firms more willing to invest in projects related to renewables, and this lower interest rate also makes them more likely to issue bonds rather than relying on traditional bank loans.
Central bank purchases of green bonds also send a signal to the market. These signals promote the seriousness of green bonds as sound investments and also demonstrate the potential future growth of green bonds. This will be reflected in the increased issuance of green bonds, as we have seen in the European Area.
However, there seems to be concern about decisions relating to Green QE “lacking democratic legitimacy”. President of the Deutsche Bundesbank (the German central bank) Jens Weidmann stated in a speech in October 2019: “I see demands for a green monetary policy, for example in the form of a ‘Green QE’ or targeted privilege within the collateral framework, very critically”, going on to explain why “Such decisions should not be made by central bankers, because they are not democratically legitimised” (Arnold and Storbeck). This is a problem when we consider the market-distorting effects that Green QE could cause. Any situation where central banks engaging in QE are favouring one market over another — in this example, corporate bonds supporting sustainable activities — and staying clear of other carbon-intensive markets, like oil or gas, will have implications for their respective sectors. The important concern here is that central bankers are not democratically-elected officials, meaning it is harder to hold them accountable to the electorate or the people living in the society they are governing, than would be the case for elected politicians. And the independent nature of modern central banks have mandated that central bankers are by definition unelected and not a part of government.
Could we argue that the use of green QE by central bankers could be considered an abuse of power? This was one of the questions I put forward.
Ollie: Would the use of QE by a central bank to achieve goals outside of the remit to stabilize the business cycle represent an abuse of this tool? In this case specifically, using it to achieve sustainable goals?
Prof Bean: I’m not sure I’d call it abuse but, unless it is part of its mandate, the CB is venturing into territory that it is properly the domain of elected politicians. So it’s fine, for instance, for the CB to buy green bonds if it’s necessary to maintain financial stability. But it’s more debatable if the CB is focusing its purchases on such bonds in order to further climate change objectives that are not part of its mandate and the political authorities have not provided the appropriate direction (for instance, in the UK, the Chancellor could ask the Bank of England to make such purchases in his annual remit letter to the Governor).
What do we mean by using green QE to maintain financial stability? Because climate change will likely cause instability within our financial system, it may not even be necessary for central banks to adapt their mandate to include sustainability targets. With the target of maintaining financial stability along with price stability, as is the case in many central banks, the climate emergency is something that could already be considered within their mandate, and so may not require an update to the central bank’s mandate.
As I have touched upon, the distortionary effects of Green QE are of large concern to us.
Ollie: How significant are the distributional effects (central banks favouring the market for green bonds over other bond markets, which may lead to distortionary price effects that negatively impact high-carbon industries) of a green QE policy in its effectiveness and is this something we should be concerned about?
Prof Bean: How quantitatively significant the distortion is will depend on the circumstances, parameters of the purchase program, etc. But the fact that distortions are potentially present (and indeed are the reason for making the purchases!) is exactly why governments really ought to be in the lead (i.e. government(s) should first decide it wants to favour green projects in this way and then asks the CB to facilitate it).
But do governments really need to be the ones dictating the central bank’s purchase decisions when it comes to sustainable activities, or do they already have a reason that would allow them to provide Green QE in a non-distortionary way? Recent research by the Grantham Research Institute on Climate Change and the Environment and the Centre for Climate Change Economics and Policy have analysed the high-carbon skew in the ECB and Bank of England Corporate Bond purchases by comparing the sectoral distribution of purchases to the sectoral distribution of the eurozone economy in terms of contribution to gross value added (GVA). In the graph below, there is a 45° dotted line passing through the origin. This reflects where sectors should be if asset purchases perfectly reflected their relative contribution to the economy (GVA). We can see that some sectors are clustered around this line (for example financial and insurance activities), however, some sectors are a large distance from this line. By analysing which sectors are furthest from this line, and which represent a large proportion of purchases relative to their GVA, there seems to be a skew towards sectors that have high greenhouse gas emissions (Matikainen et al.).
As can be seen in the graph above, high-carbon industries like electricity, gas, steam and air conditioning contribute relatively less to the Gross Value Added compared to other industries, yet make up a large proportion of the central banks asset purchases.
Therefore, the ECB increasing their purchases of green bonds could actually offset this skew, by decreasing the proportion of purchases spent on sectors such as manufacturing, electricity, gas, steam and air conditioning supply, and transportation and storage, which are mostly large greenhouse gas emitters. As a consequence, the ECB could increase their alignment of corporate bond purchases with Gross Value Added, while positively contributing to sustainable projects.
I put this argument forward to Prof Sir Charles Bean, and linked the paper containing the graph and analysis, to see what he had to say.
Ollie: A Policy Paper from the Grantham institute on the climate impact of quantitative easing has found that there is an inconsistency between the sectoral distribution of purchases and the sectoral distribution of the gross value added within the euro-area (See paper: here, Page 16) which results in a skew towards sectors characterised by high greenhouse gas emissions. Do you think this could legitimise the use of green QE as a corrective tool? Or would Green QE still be viewed as a distortionary and non-neutral use of QE?
Prof Bean: Ideally you’d want the original QE purchases to create as little distortion as possible; this was one of the reasons the BoE has focussed heavily on buying government bonds rather than corporate bonds (except when markets have been dysfunctional). But if past purchases have discriminated against particular sectors, then I guess there is a justification for trying to address that. But I’d rather avoid any distortion in the first place, unless the political authorities have said they want to favour a particular sector and there is general public support for it.
He makes the very valid point that central banks should avoid distortion in the first place rather than try to correct it after it has occurred. However, there is some substance in this argument, and if central banks do need to correct for a bias, it could make sense that they do this while also improving climate change.
There are some other arguments against the use of green QE that are relevant to this discussion and that I would like to share. These are any crowding out effects that may occur, and any watering down effects within the green bond market.
The crowding out effect usually occurs as a consequence of public sector spending, and results in a reduction in private sector spending. This generally occurs as a result of large-scale government borrowing, where the scale of borrowing can push up the interest rate in the economy. This has the effect of absorbing the economy’s lending capacity and discouraging capital investments, as often firms finance such projects by borrowing. This could be a problem in green bond markets, where the small size of the market relative to other fixed-income markets coupled with its high growth rate makes the risk that the central banks owns a significant proportion of the green bond market much greater, due to the large amount of QE usually necessary for the policy goal to be achieved. Too much ECB involvement could inhibit the market’s ability to accurately price climate risk, deterring some investors from getting involved. To get around this issue, the ECB could invest in green issuers rather than just green bonds in its asset purchases to encourage sustainable projects at the firm level rather than relying on just green bonds to make a difference, but this is more of a policy issue that is not particularly relevant to this discussion (Stubbington and Arnold).
A similar argument concerns the watering down effect that large central bank purchases of green bonds could cause. Greenwashing occurs when a company focuses too many resources to try and make themselves look environmentally friendly rather than minimising their environmental impact, or in this example, make their bonds appear green when in fact they are not, or at least not as green as they claim. Large, publicised purchases of green bonds by central banks could lead to opportunists jumping on the bandwagon and making unsubstantiated claims about the green credentials of their bonds. Analysis by Insight Investment has found that 17% of green bonds that they analysed received a red rating, meaning they do not pass the criteria to be classed as green bonds, and 46% rated amber, indicating weakness in their adherence to impact classification measures.
Something to help this greenwashing effect is certain standards that have been introduced. Greenwashing occurs because there is no solid framework within which bonds can be certified as green. There are commonly used ones, but these are not required for issuance. The ECB has implemented an EU Green Bond Standard, a classification system that indicates which economic activities are designated as green. While this is still a voluntary standard issuers can choose to follow, it is a clear signal to investors that the issuer’s green bond is robust and truly green in nature. Requirements of this standard include explaining how their strategy aligns with the EU’s environmental objectives, the processes they employ and how they plan on using the proceeds (Sievanen). If the ECB, or any central bank for that matter, was to implement a strict APP whereby when considering ‘green bonds’, it only considered those that met its own strict criteria, then greenwashing would be a much harder endeavour assuming the central bank’s own standards were rigorous enough and uniformly enforced.
Overall, both sides of the debate offer compelling and important arguments both for and against the use of Green QE, and it is important to consider these arguments with respect to their impact on the entire economy when deciding whether Green QE is the correct path to go down. Without many empirical studies into its effects for either the short-run or the long-run, it is difficult to say whether this action is the correct one to be taking, or whether it should be left to other institutions within countries that have a direct responsibility to the public for their actions, so they can be solely responsible for the outcomes of a potentially distortionary effect upon green bond markets. Finally, we would like to thank Prof Sir Charles Bean for agreeing to contribute to this article and for his support of the LSESU Central Banking Society. If you found this article interesting, please consider watching a recording of a lecture given by Prof Sir Charles Bean on ‘The Blurred lines between Fiscal Policy and Monetary Policy’, which can be found on the LSESU Central Banking Society Facebook page and offers some very interesting insights into the independence of central banks, helicopter money and his views on the increasingly popular Modern Monetary Theory.
Arnold, Martin, and Olaf Storbeck. “Weidmann opposes using monetary policy to fight climate change.” Financial Times, 29 October 2019, https://www.ft.com/content/60d9832c-fa3f-11e9-a354-36acbbb0d9b6. Accessed 25 11 2020.
Dafermos, Yannis, et al. “Climate Change, Financial Stability and Monetary Policy.” Ecological Economics, vol. 152, no. 1, 2018, pp. 219–234. Science Direct, https://www.sciencedirect.com/science/article/pii/S0921800917315161. Accessed 25 11 2020.
European Central Bank. “Asset purchase programmes.” European Central Bank, 2020, https://www.ecb.europa.eu/mopo/implement/app/html/index.en.html#abspp. Accessed 25 11 2020.
European Central Bank. “ECB Economic Bulletin — Purchases of green bonds under the Eurosystem’s asset purchase programme.” ECB, 2018, https://www.ecb.europa.eu/pub/economic-bulletin/html/eb201807.en.html#IDofOverview_Eb1. Accessed 25 11 2020.
Insight Investment. “Beware ‘impact washing’ as issuance tops $1trn.” Insight Investment, 30 August 2020, https://www.insightinvestment.com/united-states/perspectives/beware-impact-washing/. Accessed 25 November 2020.
Matikainen, Sini, et al. “The climate impact of quantitative easing.” -, vol. -, no. -, 2017, -. Grantham Research Institute on Climate Change and the Environment, https://www.lse.ac.uk/granthaminstitute/wp-content/uploads/2017/05/ClimateImpactQuantEasing_Matikainen-et-al-1.pdf. Accessed 25 11 2020.
Sievanen, Riikka. “Part III — Green Bond Standard.” EU Sustainable Finance explained — Green Bonds, 2019, https://home.kpmg/fi/fi/home/insights/2019/11/eu-sustainable-finance-explained-green-bonds.html. Accessed 25 11 2020.
Stubbington, Tommy, and Martin Arnold. “Pushback and practicalities limit hopes for ‘green QE’ from ECB.” Financial Times, 5 November 2019, https://www.ft.com/content/d3f52ba6-fef2-11e9-b7bc-f3fa4e77dd47. Accessed 25 11 2020.