fixed income
How the ECB’s climate tilt favours ice cubes
The European Central Bank is gradually decarbonising its corporate bond holdings in a move that will be beneficial to borrowers with clear net-zero targets. We expect increased spread differentiation between transition leaders and transition laggards, and consider how the design of our TargetNetZero strategy is well-positioned to capture the opportunities.
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Policy drives the transition to net zero
Policy is one powerful force driving the transition to net-zero greenhouse gas emissions. A recent example comes from the European Central Bank (ECB) introducing a climate tilt to its corporate bond purchase programme in favour of more climate-aligned borrowers.
What is the ECB’s new approach and how could it provide strong support for fixed-income decarbonisation strategies such as TargetNetZero?
ECB: assigning a climate score to credit
The ECB is one of the largest players in the EUR-denominated corporate bond market. It currently holds EUR 344bn of corporate bonds as part of its Corporate Sector Purchase Programme (CSPP), which is equivalent to approximately 10% of the EUR corporate bond market. In the coming year, ECB will reinvest maturities of up to EUR 24bn. From 01 October 2022, these reinvestments will be made with the bank’s new climate-tilt approach.
The central bank is assigning a climate score to specific issuers and orienting its reinvestments towards borrowers with better scores in order to incentivise issuers to decarbonise. The climate score is based on three factors:
- A backward-looking emissions sub-score based on issuers’ historical emissions including scope 1, 2 and 3 emissions. The ECB uses company-reported scope 1 and 2 emissions, and sector average data for scope 3 emissions. The central bank considers how companies perform compared to sector peers as well as compared to all eligible bond issuers. Superior performers receive a better score
- A forward-looking target sub-score based on the objectives set by issuers to reduce their emissions in the future. The ECB considers the type of target and if it is science-based, as well as if the target is verified by a third party. Companies not reporting emissions or those with no interim targets receive the lowest score for targets. Companies with more ambitious decarbonisation targets receive a better score
- A climate disclosure sub-score based on the assessment of issuers’ reporting of greenhouse gas emissions. If issuers have no self-reported emissions data, they will be given the lowest sub-score value. Those issuers with high-quality disclosures, however, receive a better score
The ECB will implement the climate tilt by applying preferential treatment to green bonds in the primary market. It will limit the maturity profile of its exposure to high-emitting issuers without net-zero targets. How CSPP reinvestments are assigned by issuer will be guided by the climate tilt.
As of Q1 2023, the ECB will start publishing climate-related information on its corporate bond holdings and will regularly report on the progress towards alignment with the goals of the Paris Agreement.
A carbon-neutral approach
Corporate bond purchases by the ECB previously followed the principle of market neutrality, whereby purchases reflected the composition of the overall market relative to the amounts of outstanding bonds. As emission-intensive sectors tend to have more bonds outstanding due to their large investment needs, however, this market-neutral approach created high emissions intensity for ECB’s corporate bond holdings. Essentially, it meant the ECB financed and supported high emitters through its corporate bond purchases.
Now the ECB is actively managing its portfolio in light of the Paris Agreement objectives. This marks a move away from its previously market-neutral approach to a carbon-neutral approach. The new approach serves to: reduce financial risk relating to climate change on the central bank’s balance sheet; incentivise firms to disclose climate-related risks; and support the green transition, in line with the European Union’s climate neutrality objective.
Market implications
Our TargetNetZero strategy is well-positioned to capitalise on the ECB’s climate-tilt because the strategy was designed to use forward-looking decarbonisation trajectories to favour companies that are aligned with the goals of the Paris Agreement.
The ECB’s new approach means it will overweight strong climate performers across all sectors. This should create favourable funding conditions for what our TargetNetZero IG credit strategy deems ‘ice cubes’: businesses in hard-to-abate areas of the economy that have credible plans, reinforced by science-based targets, to cut emissions to levels aligned with a net-zero pathway. Ultimately, more favourable funding conditions for ice cubes could result in strengthened credit quality.
Our TargetNetZero strategy also minimises exposure to ‘burning logs’, or heavy emitters with no apparent plans to decarbonise. The ECB approach similarly penalises dirty issuers, reducing their weight in the new, climate-tilted benchmark which guides the ECB’s reinvestments of CSPP and limiting their maturity exposure. This could result in a relative spread widening of borrowers that are low-carbon laggards.
More generally, the ECB is favouring green bonds in the primary market, meaning the price premium or ‘greenium’ could increase. In its ECB podcast in July, the bank said that the climate tilt “will have an impact”, indicating it will increase the tilt if the current measures do not result in spread differentiation between the dirty-high-emitting companies and transitioning issuers.
Transition risk in action
The ECB’s move is a solid example of transition risk in action, demonstrating how climate-aligned portfolios are well-positioned to capture the opportunities from the transition to net zero.
Discover more in our video.
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