A blueprint for greening CBPP3
ECB Executive Board member Isabel Schnabel has set out the central bank’s intention to also decarbonise its CBPP3 portfolio (currently greening is focussed only on corporate bonds)
The central bank has not yet set out a framework to do so, so we think about such a blueprint in this note
It will likely resemble the framework it uses for corporate bonds, which includes backward and forward-looking pillars as well as one on data disclosures
The recent publication by the ECB of climate-related indicators is likely to support the setup of a covered bond framework, as it provides information about carbon-intensity of bank loan books
However, there are still many data gaps, so we expect that the ECB will place weight on climate-related strategies of banks as well as publicly available data disclosures
It will be interesting to see whether the ECB will add a pillar related to cover pools, although this also is exposed to a risk of green washing
The ECB might start actively decarbonising its CBPP3 portfolio in H2 of this year
Earlier this month, ECB Executive Board member Isabel Schnabel mentioned in a that the ECB wants to step up its efforts to accelerate the green transition and its own contribution to it as well. Currently, the central bank already has a framework in place to gradually green (or decarbonise) its corporate bond portfolio (CSPP). As such, it tilts reinvestments to ‘green’ companies (so-called flow-based approach). However, to further decarbonise this portfolio once the central bank stops reinvesting maturing principles, it must start actively reshuffling its portfolio (so-called stock-based approach). This implies substituting bonds from ‘non-green’ companies with bonds from greener companies. The important message for the covered bond market was that Ms. Schnabel also indicated that the ECB wants to decarbonise (or green) its covered bond portfolio, which currently has an outstanding amount of EUR 304bn. But it first needs a framework to do so. Therefore, it seems likely that the ECB is now working on a framework that it can use to decarbonise its CBPP3 portfolio. In this note, we will discuss how such a framework might look like.
The framework that the ECB uses to decarbonise its corporate bond holdings consists of three pillars: (1) backward-looking emission performance of corporates; (2) forward-looking emission targets, and (3) the quality of climate disclosures. The backward-looking emission performance includes a time series of a company’s carbon emissions, based on scope 1, 2 and 3 emissions (with the latter assessment using sector-level data), while the forward-looking measure assesses the level of ambition of companies’ climate strategies. The final pillar judges the quality of climate-related data that companies publish and whether these are, for example, checked by third parties. Hence, the best scores are for companies with the lowest emissions, the clearest and most ambitious decarbonization strategies as well as those that provide the most transparent climate-related insights in their reporting.
The big question is how the central bank will apply such a framework to covered bond issuers. Complicating factors in this respect is that covered bonds are backed by collateral (mostly mortgages, but also public sector loans and shipping loans), which could be included within the framework as well. As a starting point, we expect that it is likely that the central bank will look at the issuer level. Most banks already report scope 1 and 2 emissions, and have emission targets as well. However, the quality of reporting varies widely. Moreover, scope 3 emissions from their lending portfolios (i.e., the carbon emissions of companies that banks lends to) are the most important element in assessing how carbon-intensive banks are within their lending operations. Currently, several banks only report scope 3 emissions restricted to their indirect business operations (e.g., business travels).
Still, the ECB’s recent publication of climate-related data could provide insights in a methodology that it will probably use to measure the carbon footprint of banks. Indeed, the ECB has published a set of climate-related statistical indicators, which offers insights in issuance and holdings of sustainable bonds as well as exposures of the financial sector to physical climate risks and transition risks (see and ). Transition risks are mainly captured by the ECB’s indicators about carbon emissions, which are based on two indicators. The first focusses on capturing the banks’ financing towards carbon-intensive activities, and includes for example, the total amount of carbon emissions from companies financed by the bank (absolute emissions). The second focusses on more directly capturing exposures to transition risks through relative metrics, and includes for example, the weighted average of the carbon-intensity of bank loan portfolios.
This information is something the central bank could use in its calculations of the first pillar, which would imply that the more carbon-intense the loan book, the lower the score. However, the central bank acknowledges that there are still quite some challenges related to the quality of the data, which is why the recently published data on the carbon intensity of banks’ portfolios is based on data from non-financial counterparties., Furthermore, the ECB acknowledges that the data is subject to various methodological and data-related limitations, including limited data coverage over time and across regions. For example, emissions and balance sheet information are jointly available for only about 47% of outstanding debt, which gives therefore only a partial view over the emissions of banks’ portfolios. As a result, it could be that the central bank will give this pillar a lower weight in its framework initially, given a higher weight to, for example, the third pillar, which is related to the quality of the disclosures. This would incentivise banks to be more transparent on the carbon footprint of their portfolio. Once data quality improves over the years, the central bank could put more focus into this pillar.
The second pillar is likely to be assessed on an issuer level as well. To do so, the ECB needs to look at whether banks have climate strategies in place, and if so, what the level of ambition is compared to peers. We think that this pillar will likely mirror the approach it will use to assess targets and decarbonization strategies of the companies that issue the securities in its corporate bond portfolio. To assist with this assessment, it could for example consider whether the strategies have been published and whether they have been incorporated in banks operations as well. A starting point could be whether banks are member of the Net Zero Banking Alliance (NZBA), which also keeps track if banks have in place decarbonisation strategies (see ). Signatory banks of the NZBA are required to set intermediate targets to reduce emissions of their lending and investments portfolio for 2030 or sooner using robust, science-based guidelines, and must commit to net-zero emissions by 2050. A quick look shows that most large eurozone banks that issue covered bonds are indeed part of the NZBA, but also that covered bond issuers from some euro area countries are missing (e.g., Belgium, Slovakia). Currently, the below euro (benchmark) covered bond issuers are members of the NZBA:
Unsurprisingly, banks that have clear strategies in place, with targets aligned with the Paris Agreement, which are verified by a third-party will likely be the ones that score best for this pillar.
The third pillar is about the quality of climate-related disclosures, which is somewhat related to the first pillar. The ECB will check what level of data banks are reporting when it comes to their carbon emissions, so banks that currently do not report emissions of their lending portfolios will likely score lower on this pillar. A big difference in this respect is that the ECB already has access to a lot of information because it is the bank regulator. As such, it demands from banks that they are taking steps in terms of climate strategy, governance, risk management, etc. and that banks also provide it with information about these. Furthermore, the ECB already uses data for its climate indicators, which it can use. Having said that, this pilar (data disclosures) will likely be more related to the data that banks make publicly available and whether this data is being checked by third parties. In this case, the higher the quality and level of detail of publicly available data, the better the score.
This brings us to the question of whether the central bank will also consider climate-related information on cover pools backing the covered bonds that banks issue. The new Covered Bond Directive that came into force on 8 July 2022 does include reporting requirements for covered bond issuers, although these do not (yet) include data disclosures related to climate (risks). The ECB indicated last year in a speech (see ) that it would appreciate banks to start disclosing more climate-related data on all covered bonds and not only sustainable covered bonds. This likely implies that the central bank prefers to see banks reporting climate-related data on all assets included in cover pools. For mortgages, this could, for instance, consist of information about carbon emissions of the properties and/or energy labels. This, however, could lead to some ‘greenwashing’ as banks could reserve mortgages on most energy-efficient buildings for their cover pools, keeping least-energy performing mortgages out. As such, it would be better if the ECB would look at the total mortgage portfolio of covered bond issuers rather than only the cover pool (hence also an issuer-level analysis). This, in turn, would be rather closely related the first pillar (i.e., the carbon-intensity of a bank’s loan book). It therefore remains to be seen whether the ECB will add a fourth pillar to covered bonds, although it might separate carbon emissions related to banks’ mortgage lending and that related to other lending. Having said that, data issues are likely to pop up among countries in this respect as well.
Finally, as with the corporate bond holdings, the ECB could favour green covered bonds over regular covered bonds, as these have already the green label being also subject to reporting requirements. However, the universe of eligible green covered bonds remains limited, implying that the central bank needs a broader framework to materially decarbonise its covered bond portfolio. Indeed, currently, the share of green covered bonds in the euro benchmark index is roughly only 5% (EUR 39bn).
Overall, we expect the ECB to establish a framework for greening its CBPP3 portfolio that would be roughly similar to the framework it uses for corporate bonds, with the difference being that there are still some considerable data issues that need to be solved. Having said that, the central bank as regulator has already access to quite some data, while it also has started to compile climate-related statistics, which it is likely to use for this framework. Therefore, the central bank will probably publish such a framework sooner rather than later. The end of APP reinvestments, which we expect in July, might be a good starting point to start actively decarbonising its CBPP3 portfolio.