Will the ECB use corporate-bond purchases to target net zero?

In the sustainability section of Alphorum, our fixed-income quarterly, we consider how the likely greening of the portfolio of corporate bonds held by Europe’s central bank will benefit companies on clear and credible decarbonisation trajectories, irrespective of sector. We call them ‘ice cubes’.
 

For more than a past decade, loose monetary policy has been the defining factor behind the performance of financial markets. A key element has been the use of quantitative easing in the form of sovereign and corporate-bond purchases by dovish central banks. In Europe, the central bank has operated a series of corporate bond purchasing programmes that have made it a hugely significant investor in the region’s market. This has reduced net supply and increased prices, resulting in a hunt for yield that has driven investors further out along the risk scale.

As discussed in the developed-markets section of Alphorum, continuing upside inflation surprises have finally compelled central banks to turn hawkish. Faced with potential stagflation, the European Central Bank (ECB) has been less aggressive than some, announcing an end to net asset purchases but continuing to reinvest the maturities from its corporate bond buying programmes. But how the ECB intends to reinvest these maturities is likely to change, as it seeks to align its actions with the bloc’s climate goals. Will the central bank use its immense bond purchasing power to target net zero?

A short history of buying (nearly) everything

The ECB first became involved in the corporate-bond market in June 2016, when it implemented the corporate sector purchase programme (CSPP) as part of its wider asset-purchase scheme. At March 2022, total net cumulative purchases of euro-denominated corporate bonds under the CSPP amounted to EUR 330.6 billion. In the wake of Covid-19, corporate-bond buying was stepped up further via the pandemic emergency purchase programme, which had added a further EUR 40.3 billion by the time it ended in March. At that point, total net cumulative purchases of corporate bonds under both programmes stood at EUR 370.9 billion.¹

Bond buying under both programmes has been guided by the ECB’s eligibility criteria:²

• Bonds must be investment grade
• Maturities must be between six months and 31 years
• They must be denominated in euros
• Issuers must be a non-bank corporate entities

Purchases have been implemented under the principle of market neutrality, with the ECB buying securities in proportion to their relative market capitalisation.³ In other words, it has bought bonds in relation to the amount of debt outstanding. At 17 June, 2022, the ECB had accumulated corporate-bond holdings of about EUR 340 billion.² That represents around 30% of the eligible market, and approximately 10% of the entire euro-denominated investment-grade credit market (including banks).⁴

As part of its shift away from quantitative easing, the ECB announced that net asset purchases would end on 1 July 2022. However, the ECB intends to continue reinvesting the principal payments from maturing securities from the CSPP for “an extended period of time past the date when it starts raising the key ECB interest rates”, and to reinvest maturities from the PEPP until “at least the end of 2024”.⁵

A change of approach

While the ECB has confirmed it will continue reinvesting in corporate bonds, it has been surprisingly open about its plans to change the composition of this reinvestment. Given central banks’ historical influence on the pricing of financial assets, it is perhaps equally surprising that the market has failed to pay much attention to the ECB’s announcements. 

One of the first indications that the ECB intended to use bond buying as part of its wider strategy to address climate change came in a June 2021 speech by Isabel Schnabel, a Member of the Executive Board of the ECB.³ Schnabel’s comments foreshadowed the bank’s detailed roadmap of climate-change-related actions published the following month, which stated its intention to integrate climate-change risk in the CSPP.

Then, on 17 March this year, Schnabel gave another speech which offered further direction on how the bank intended to ‘green’ its monetary-policy framework under quantitative tightening. First, she addressed the practicalities:

“While we intend to reinvest, in full, maturing securities for an extended period of time after policy rate lift-off, we can change the structure of our bond portfolio even when keeping the size of the portfolio unchanged, or when we start to reduce the size of our balance sheet."⁶

Schnabel then went further, clearly highlighting the potential for the ECB to focus on greening its bond purchases:

“While the degree of policy accommodation, and hence the size of our bond portfolio, is solely determined by monetary policy considerations, we could actively tilt our portfolio towards the Paris objectives once we have decided on how the market neutrality principle, which is currently guiding our bond purchases, should be modified".⁶

It is worth noting that although the ECB is guided by the market-neutrality principle, in practice it already deviates from it. The application of the eligibility criteria for bond rating, maturity and denomination implies that the ECB’s holdings are not necessarily proportional to the market capitalisations of the instruments. With this in mind, tilting bond purchases away from heavy emitters is not such a radical step. So, what could it mean for the European corporate-bond market?

Bad news for ‘burning logs’

To assess the potential impact of such a change in approach, we assessed the ECB’s estimated CSPP portfolio using Lombard Odier’s implied temperature rise methodology.⁷ Our analysis shows the CSPP contains a weighting of about 14% to what we define as ‘burning logs’ – high-emission companies with no credible decarbonisation strategy – with these issuers representing approximately 11% of bonds within the programme reaching maturity this year (see figure 1). In our view, this portion of CSPP reinvestments could be excluded from re-entering the portfolio.

FIG 1. Burning logs as a proportion of the ECB’s total CSPP, by maturity date

Source: LOIM analysis as at June 2022. For illustrative purposes only.

Breaking down this exposure by sector, we judge that over 80% of the estimated holdings we would categorise as burning logs are in the energy sector. Other sectors in which we see large transition risks are capital goods and utilities, where about 32% and 28% respectively of the ECB’s estimated holdings are burning logs (see figure 2). 

FIG 2. Burning logs as a proportion of the ECB’s total CSPP, by sector

 Source: LOIM analysis as at June 2022. For illustrative purposes only.

Expect market repricing to follow

With the ECB indicating its intention to align monetary policy with the Paris Agreement by ‘tilting’ bond purchases, investors should prepare for the consequences. Such an approach is likely to shift capital away from high-emitting companies lacking credible decarbonisation strategies, towards issuers with credible net-zero targets, better climate disclosures or those in low-emission-sectors. According to recent ECB statements, this change is due to be implemented in October 2022.⁸ If enacted, it could cause a repricing of burning logs and also their opposite, the ‘ice cubes’: companies whose high levels of emissions are declining in alignment with net-zero targets due to credible decarbonisation targets and strategies.

This further increases our conviction in the investment appeal of ice cubes, which are adapting their business models to succeed in a low-carbon future. We believe such firms will be far less exposed to transitional and liability risks as the economy decarbonises, and will attract capital flows. Our TargetNetZero investment-grade credit strategies aim to generate alpha through exposure to repricings like those that could come from the changing composition of the CSPP portfolio – and other inflection points as policymakers and businesses aim to fulfil the Paris Agreement.

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