Sustainability

How the European Central Bank and other institutions are helping European finance go green

In a world that’s rapidly trying to go green, our Rates strategists takes a look at the role of the European Central Bank in furthering green finance in Europe.

For a podcast discussion of this topic listen here: https://open.spotify.com/episode/04Zz5XXXgk4D6HgmXLpTZ5

What's going on in the world of green finance?

As a direct result of the increasing focus on climate change and sustainable finance, the market for green bonds – fixed income instruments specifically designed to support specific climate-related or environmental projects – has been growing rapidly. The European green bond market has more than doubled in size since 2008, to around EUR 350 billion.

The green bond market has grown rapidly in recent years 

*Source BondRadar

Europe has set some ambitious emission-reduction targets, but to achieve them, investment in the energy transition must accelerate rapidly. EU institutions are reinterpreting their statutes and examining rule changes as they search for ways to support that investment.

*Source BondRadar

Europe has set some ambitious emission-reduction targets, but to achieve them, investment in the energy transition must accelerate rapidly. EU institutions are reinterpreting their statutes and examining rule changes as they search for ways to support that investment.

Three ways European institutions are supporting the energy transition

1.The ECB

As the world has increased its focus on the influence of finance and other socially responsible goals, so too has the ECB. It’s an active investor in green bonds through its quantitative easing programmes, and it’s further cemented its support for green financing by making bonds with coupons linked to environmentally sustainable activity eligible for its quantitative easing (QE) asset purchases and also as collateral for banks to borrow from it, from 2021 onwards.

2.The EU

The EU is currently deciding on its Green Bond Standards, which will create a clear definition of what qualify as green bond instruments (rather than voluntary industry standards). The EU is also set to become a big issuer in the green bond space: 25% of its EUR 750 billion Recovery Fund agreed earlier this year will be funded via green bonds.

3.The EU fiscal framework

There’s already a clause in the Stability and Growth Pact rules (which ensure that countries in the EU pursue sound public finances and coordinate their fiscal policies) that favours the financing of investments “with positive, direct and verifiable long-term effects on growth and on the sustainability of public finances”. Arguably, this should cover green initiatives.

A closer look at the  green bond market

One potential concern with ECB investment in green bonds is that it could crowd out private investors in what remains a small market and create a “green asset bubble” in certain segments.

The size of the eligible Green universe has been increasing, but is still small compared to the total universe

PEPP and CSPP universes and respective green universes (in EUR billion)

*Source: ECB

PSPP = Public sector purchase programme

CSPP = Corporate sector purchase programme

To monitor this risk, we’ve created our EGB Relative Value Cruncher and a Supras and Agencies Relative Value Report. For each issuer, these reports give us a snapshot of which bonds look expensive and cheap, splitting out green bonds vs. non-green bonds.

The ECB's future involvement in green financing

The ECB has made climate change a key pillar of its Strategic Review, and ECB President Christine Lagarde has made it clear that climate change initiatives will be at the top of the ECB’s agenda.

The ECB may encourage and support the growth of the green bond market in such a way that financing for green projects is at preferential rates. Buying green bonds is an obvious way in which the ECB can help green rates to fall, but that wouldn’t necessarily help the market grow sustainably, and it could risk distorting yields or reducing liquidity. The bank will have to tread carefully.

The ECB will also have to ensure that any decisions are anchored in EU rules – principally the still-to-be-finalised EU Taxonomy and the Green Bond Standards. Together, these will help protect against “greenwashing” – suggesting bonds are involved in financing green projects when that’s not really the case – and help ensure common market standards.

What might the ECB do from here?

Let’s now consider some of the ways that the ECB might further the cause of sustainability (in order of likelihood – most likely first).

1. Buying green bonds through asset purchases

The most obvious way in which the ECB can incorporate climate change objectives in its policy decisions is through its asset purchases. Indeed, the ECB has already gradually increased its purchases of green bonds as the green bond universe itself has broadened.

2. Buying green bonds for pension funds

The ECB could send a strong message about its commitment to sustainable investment by choosing to allocate more to green bonds in its pension funds and non-monetary policy portfolios.

3. Incorporating the impact of climate change on output, inflation and financial stability in the ECB’s projections

It will be hard for the ECB to incorporate climate change into its own projections given they cover such a short time horizon, but it will no doubt be a much larger factor in the debate than it has previously been.

4. Investing in green companies / activities, not just bonds

To get around the risks related to crowding out private investors from the green bond market, the ECB might invest in green issuers rather than just green bonds in its asset purchases. An extreme version of this would be to exclude all “brown” sectors from asset purchases, but this is very unlikely in our view.

5. Incentivise banks to go green

Rates at which the ECB provides funding to banks could be linked to the banks’ green credentials or the amount of green lending they provide. But we believe this is unlikely at this stage as green scores are still quite unreliable.

Key Takeaways

We expect climate change to feature very prominently in the ECB’s Strategic Review, and that the coming months and years will see a marked increase in ECB investment in green bonds as a natural consequence of the green bond market’s growth.

Innovations such as linking green criteria to other policies may not occur immediately (work still needs to be done on the taxonomy, green bond standards and ESG ratings), but this should not stop the ECB from incorporating climate change in its decision-making process (through its impact on growth and inflation) or increasing its investment in green financing.

Login to Agile Markets for full analysis here.

This article has been prepared for information purposes only, does not constitute an analysis of all potentially material issues and is subject to change at any time without prior notice. NatWest Markets does not undertake to update you of such changes.  It is indicative only and is not binding. Other than as indicated, this article has been prepared on the basis of publicly available information believed to be reliable but no representation, warranty, undertaking or assurance of any kind, express or implied, is made as to the adequacy, accuracy, completeness or reasonableness of the information contained in this article, nor does NatWest Markets accept any obligation to any recipient to update or correct any information contained herein. Views expressed herein are not intended to be and should not be viewed as advice or as a personal recommendation. The views expressed herein may not be objective or independent of the interests of the authors or other NatWest Markets trading desks, who may be active participants in the markets, investments or strategies referred to in this article. NatWest Markets will not act and has not acted as your legal, tax, regulatory, accounting or investment adviser; nor does NatWest Markets owe any fiduciary duties to you in connection with this, and/or any related transaction and no reliance may be placed on NatWest Markets for investment advice or recommendations of any sort. You should make your own independent evaluation of the relevance and adequacy of the information contained in this article and any issues that are of concern to you.

This article does not constitute an offer to buy or sell, or a solicitation of an offer to buy or sell any investment, nor does it constitute an offer to provide any products or services that are capable of acceptance to form a contract. NatWest Markets and each of its respective affiliates accepts no liability whatsoever for any direct, indirect or consequential losses (in contract, tort or otherwise) arising from the use of this material or reliance on the information contained herein. However this shall not restrict, exclude or limit any duty or liability to any person under any applicable laws or regulations of any jurisdiction which may not be lawfully disclaimed.

NatWest Markets Plc. Incorporated and registered in Scotland No. 90312 with limited liability. Registered Office: 36 St Andrew Square, Edinburgh EH2 2YB. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and Prudential Regulation Authority. NatWest Markets N.V. is incorporated with limited liability in the Netherlands, authorised and regulated by De Nederlandsche Bank and the Autoriteit Financiële Markten. It has its seat at Amsterdam, the Netherlands, and is registered in the Commercial Register under number 33002587. Registered Office: Claude Debussylaan 94, Amsterdam, the Netherlands. Branch Reg No. in England BR001029. NatWest Markets Plc is, in certain jurisdictions, an authorised agent of NatWest Markets N.V. and NatWest Markets N.V. is, in certain jurisdictions, an authorised agent of NatWest Markets Plc. NatWest Markets Securities Japan Limited [Kanto Financial Bureau (Kin-sho) No. 202] is authorised and regulated by the Japan Financial Services Agency. Securities business in the United States is conducted through NatWest Markets Securities Inc., a FINRA registered broker-dealer (http://www.finra.org), a SIPC member (www.sipc.org) and a wholly owned indirect subsidiary of NatWest Markets Plc.

Copyright 2022 © NatWest Markets Plc. All rights reserved.