Unintended Consequences?
This note examines the ECB's initiatives to combat climate change and examines whether monetary policy is the right tool to achieve this important goal.
William J. Adams
CHIEF INVESTMENT OFFICER - GLOBAL FIXED INCOME MFS
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The European Central Bank (ECB) has announced a wide-ranging initiative to combat climate change. We argue that the best way to address this challenge is through marketbased capital allocation mechanisms, not monetary policy.
Everyone in the investment industry is aware of the growing attention paid to environmental, social and governance (ESG) themes. Asset owners and investment managers have been quick to incorporate sustainable investment factors into research and practice. ESG rating agencies and data sources have become firmly planted in our lexicon, investable asset restriction lists are more commonplace and the Green bond marketplace continues to increase in size and popularity. The marketplace also includes regulators in various geographies, clarifying investment styles, implementing guidelines, and enforcing disclosure transparency and manager best practice.
These developments portend a positive trend in investment management and for society as a whole. Active investment management and capital allocation can be constructive and influential forces acting on corporate decision-makers and debt-issuing entities. Trends like these, however, also create risks. ESG is a worthwhile development, but investors must be wary of misplaced marketing efforts and asset- gathering activities that come in an “ESG wrapper,” or regulatory and policy oversight that may create unintended consequences.
A new actor
A new actor recently entered the ESG marketplace: the European Central Bank (ECB). Its intent and influence should be a focus for investors, in my opinion.
The recent press release and strategy discussion from the ECB was clear and leaves little to interpretation: Climate change considerations will be included in the bank’s monetary policy strategy and framework.1 I am interpreting nothing here; the commentary and quotes come directly from the bank itself.
Specifically, The ECB said, “The Governing Council of the ECB has decided on a comprehensive action plan, with an ambitious roadmap to further incorporate climate change considerations into its policy framework. With this decision, the Governing Council underlines its commitment to more systematically reflect environmental sustainability considerations in its monetary policy.”
Under the heading: “Macroeconomic modelling and assessment of implications for monetary policy transmission,” the ECB says it will accelerate the development of new models and conduct theoretical and empirical analyses to monitor the implications of climate change and related policies for the economy, the financial system and the transmission of monetary policy through financial markets and the banking system to households and firms.
ESG is a worthwhile development, but investors must be wary of misplaced marketing efforts and asset- gathering activities that come in an “ESG wrapper,” or regulatory and policy oversight that may create unintended consequences.
Further, under “Statistical data for climate change risk analyses,” the ECB says it will develop new experimental indicators, covering relevant green financial instruments and the carbon footprint of financial institutions, as well as their exposure to climate-related physical risks.
Finally, and perhaps most interestingly, under “Corporate sector asset purchases,” we can see that the ECB has already started to take relevant climate change risks into account in its due diligence procedures for its corporate sector asset purchases in its monetary policy portfolios. Looking ahead, in line with its mandate, the ECB will adjust the framework guiding the allocation of corporate bond purchases to incorporate climate change criteria. This will include, at minimum, the alignment of issuers with EU legislation implementing the Paris agreement through climate change-related metrics or commitments of the issuers to achieving its goals.
Investors skeptical
These are powerful statements, which asset owners, investors and corporate decision-makers need to consider. I commend the ECB’s recognition of the risks inherent in climate change and the attempts to use its influence to exert pressure and create change. That said, investors are justified in viewing this initiative through a jaundiced eye. Are new models, theoretical analyses, and experimental indicators appropriate means of conducting monetary policy? Should climate change even be in the realm of consideration for monetary policy?
This is the same ECB that is in the process of adopting a new strategy around “symmetric” inflation targeting, the same ECB introducing owner-occupied housing price data for multiple countries — many lacking the actual data for input — and the same ECB that continues its “short-term” emergency negative interest rate policy. The recent press release describes much experimenting, potentially resulting in social policy practiced through a monetarist’s lens or an even larger ECB footprint in the marketplace.
Engagement on climate change
Again, I don’t want to understate the importance of addressing climate change. Ignorance and inactivity are unacceptable; the risks are real and must be addressed — through empirical research and science-based action, and importantly, via the capital allocation decision-making process. Access to capital and long-term capital allocation decisions can help drive companies and sovereign debt-issuing entities toward positive outcomes on the climate change front. Over the longer-term, this should create alpha opportunities for investors and reduce downside climate risks. It all feels like a mammoth undertaking for monetary policy, and not one we recommend.
Rather, this is a moment for active investment managers to shine. In our view, engaging with portfolio companies has a markedly better outcome than an exclusion list; this is a definitional characteristic of active ownership. If the objective is improving corporate behavior, then we must engage with issuing entities, not just sell to a marketplace that might simply ignore the issues.
Solutions to complex issues are themselves complex and require significant analyses and investment judgment. Simply stated, the engagement and insight integral to capital allocation decisions and prudent risk management allow for climate change risks to be considered, unlike with passive investment vehicles. And the market pricing and allocation mechanism can be productively employed to address climate change.
Endnote
1 ECB Press Release, July 8, 2021.
The views expressed are those of the author(s) and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation to purchase any security or as a solicitation or investment advice from the Advisor. No forecasts can be guaranteed.
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