From ambition to action: How to improve the ECB’s climate factor

On June 15th, the European Central Bank (ECB) will integrate climate considerations into its collateral framework, further enshrining the importance of climate change in its activities. But while it is a step in the right direction, the flaws in the design of the measure and the restrictive perimeter could weaken its impact. As a result, the ECB should consider several improvements to ensure the climate factor delivers on its objectives.

The launch of the ECB’s climate factor is a significant moment for green monetary policy. For the first time, it will take climate change into account in its collateral framework – the set of rules that determines which assets banks can use as guarantees when borrowing from the ECB and under what conditions.

Until now, climate change was overlooked in the collateral framework, and, as a result, it was biased in favor of carbon intensive companies (1). By introducing the climate factor, the ECB is implicitly acknowledging that traditional risk assessment methods do not adequately capture the risks associated with climate change and that carbon intensive assets may be riskier than previously considered.

But beyond the symbolic importance of the climate factor, the crucial question is whether the factor will deliver on its promises.

The climate factor is designed to account for the potential financial impact of climate transition risks (2), that is to say the risks associated with the shift to a lower-carbon economy (i.e. repricing of assets, changes in consumer preferences, regulatory developments…). The factor is calculated at the asset level, meaning it is assessed for each asset based on three components:

1. How exposed the sector is to climate transition risks. This sector-specific stressor is derived from climate stress tests and is identical for all assets within the same sector.
2. How exposed the company is to climate transition risks. This issuer-specific stressor is determined by the company’s greenhouse gas emissions, decarbonization pathway and climate disclosures (3). It is the same for all assets issued by a given company.
3. How long will the asset be exposed to these risks, or its vulnerability, measured by the residual maturity of the asset.

Together, these components produce an “uncertainty score”. This score is then incorporated into a formula set by the ECB to calculate the final climate factor. A higher uncertainty score leads to a low climate factor, which in turn leads to a stronger penalty for the asset (4). In theory, this factor should penalize assets tied to carbon intensive activities such as fossil fuels, although uncertainty on the overall impact of the factor remains.

The climate factor can be a powerful tool to tackle the carbon bias in the collateral framework and restrict indirect support to the worst polluters. However, to achieve this, the ECB should consider the following improvements to the design of the factor.

• Automatic calculation: the climate factor for each asset is not generated automatically when they become eligible. Instead, the climate factors of all asset are calculated at the same time once a year. Assets that become eligible between two annual updates are assigned a median climate factor instead (5). This can misrepresent climate-related risks, with some assets receiving a more favorable climate factor than they should (and vice versa). This limitation is also unnecessary. When the issuing corporation has already been assessed – that is, when the sector-specific and issuer-specific stressors have already been calculated – the climate factor for a newly eligible asset could be generated automatically. The ECB should therefore calculate climate factors by default and only apply the median for assets whose issuer or sector has not been assessed.
• More transparency: the ECB will not publish the climate factor for each asset, nor will it publish key parameters such as the minimum value of the factor. This makes it difficult for external stakeholders to evaluate the measure, and it weakens its signaling effect. The decision to maintain a high level of opacity is surprising given the ECB already publishes information on corporate assets eligible as collateral, including assessments of their conventional financial risk (6). The ECB should increase transparency regarding the climate factor and its underlying components.
• Maximum penalty for the worst polluters: the climate factor may not be strong enough to fully address the carbon bias and end the ECB’s indirect support to the worst polluters (7). It is expected that the climate factor will remain relatively high, even for the worst polluters, thus imposing only small penalties. The factor also does not go as far as excluding some assets (by giving them a factor of 0) (8)

For now, the climate factor applies only to assets issued by non-financial corporations and their affiliated entities, which together account for less than 5% of pledged collateral. This focus can be explained by two factors: straightforward link with climate-risks and availability of data. However, the ECB should work towards integrating climate change beyond this restricted scope and across the entire collateral framework. Extending the climate factor to other asset classes, each with their own specificities, will require adjustments but is in no way impossible.

In particular, the ECB should work on extending the factor to credit claims as this would be relatively easy and impactful. Indeed, this type of asset is one of the most used as collateral by bank – representing nearly 30% of collateral pledged. The ECB should easily be able to collect data on the corporations tied to the loan (i.e. the debtors) as it already collects information to allow banks to use these loans as collateral. Even with this information, it may not be possible to calculate the equivalent of the issuer-specific stressor since small corporations are not required to publish climate-related data. However, this should allow the ECB to at least determine the sector of activity of the debtor, from which the ECB can derive a sector-based climate factor.

With the implementation of the climate factor, the ECB is taking an important step forward in integrating climate change into its monetary policy. As this is the ECB’s first attempt to incorporate climate considerations into its collateral framework, it should continuously evaluate the measure and refine it where necessary. 

Based on our analysis, some improvements could already be made. In particular, the ECB should automatically calculate the factor for newly eligible assets and increase transparency. It should also investigate ways to extend the climate factor beyond its current scope, especially to credit claims.