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The ECB, green bonds and the climate crisis

#wisoidea - WiSo professor Francesco Giovanardi on the preferential treatment of green bonds as a climate policy instrument.

Sprout growing out of a transparent glass flowerpot full of coins

The debate about fighting climate change is one of the most important policy debates of this decade. Lately, there have been calls for action by independent institutions such as central banks and the ECB announced that it “stands ready to support innovation in the area of sustainable finance [...], as exemplified by its decision to accept sustainability-linked bonds as collateral.”  Such bonds, also named “green” bonds, differ from conventional bonds in that their issuers use the funds raised to invest into environmentally friendly technologies. According to Landesbank Baden-Würtemberg, 224 billion euros of green bonds were issued worldwide in 2020, which makes them an important funding source for environmentally friendly technologies.

WiSo Junior Professor Francesco Giovanardi has now investigated, together with Matthias Kaldorf, Lucas Radke and Florian Wicknig, how a central bank could effectively support sustainable finance. In their paper “The Preferential Treatment of Green Bonds” they discuss how the collateral framework of the European Central Bank – which determines those securities that are accepted as collateral to secure borrowing from the ECB – can be used as an environmental policy instrument.  The working paper was published as an ECONtribute Discussion Paper No 098/2021.

Francesco Giovanardi and colleagues evaluate the effectiveness and potential adverse side effects of preferential collateral treatment of green bonds in a quantitative macroeconomic framework. Those models are standard tools to analyse the effectiveness of central bank policies.

The scientists show that, via the collateral framework, the central bank is able to selectively affect security prices, since banks increase demand for securities which are eligible as collateral. By treating green bonds preferentially - either by setting lower valuation haircuts or by increasing minimum eligibility requirements - such a policy can potentially lower the financing costs of low-polluting firms, thus stimulating green investment. At the same time, preferential treatment has adverse side effects on financial stability: it increases risk-taking of green firms and the effect on green investment is therefore quantitatively rather small. The question is then: under which conditions is this policy suitable?

While in theory carbon taxes are the best environmental policy tool, their use remains limited, for example due to political constraints or imperfect international coordination. Their model reveals that collateral policy of central banks becomes important when carbon tax levels are too low. Preferential treatment of green bonds can be used in combination with (low) carbon taxes to significantly reduce pollution.

The result of the paper can be read as a call for (1) central bank action if fiscal policy is not able to adequately address pollution and climate change and (2) a careful assessment of the side effects of central bank preferential treatment on financial stability.


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