If the rising temperatures, ongoing loss of biosphere, and wildfires are not crystal-clear evidence of the dreadful worsening of climate change, perhaps hearing the economic impact of climate change will finally convert the most skeptical of you out there. According to a recent analysis, in the past forty years only, extreme weather cost $1.9 trillion to the insurance sector, making health coverage a luxury good that only a few can afford. Moreover, looking at the gross domestic product (GDP), a Stanford research has found out that, due to the shortening of primary resources in the supply chain, there is a 51% of chance that GDP would reduce permanently by 20% in the years to come. If these data are not disturbing enough, the World Employment and Social Outlook 2018 projected that 1.2 billion jobs are on the brink of unemployment as they are directly linked to the environment’s sustainable management.
By mobilizing the necessary capital on the sustainable policies carried out by the European Green Deal as well as by the UN’s commitment to sustainable goals, the financial world has an outstanding share of responsibility in confronting climate change. The idea of establishing a green economy has become a cardinal point under the 8th UN’s Sustainable Goal ever since the Conference on Environment and Development (UNCED) in 1992. Although the term encompasses a variety of meanings, according to the UN’s Environment Programme (UNEP), it can be defined as part of a broad economic, social and environmental agenda that “results in improved human well-being and social equity, while significantly reducing environmental risks and ecological scarcities.” In short, a green economy can be seen as a framework of economic policies intended to mitigate the sustainable transition while taking into account the climate-related investment risks with a high degree of transparency.
The European Union has welcomed and enhanced the “will of greening” its monetary policy as part of its pioneering European Green Deal’s agenda to make Europe the first climate-neutral continent by 2050. The strategy was kick-started in 2019 by the Commission. However, financial considerations were only recently started to be included within the plan. The latter is expected to mobilize €1 trillion of sustainable investments over the next ten years as part of the sustainable financial framework to assist public and private investments required in the agreed terms of the UN 2030 agenda.  This strategy’s ultimate objective is to help achieve a climate-neutral, green, competitive, and inclusive economy. In line with the long-waited European Green New Deal’s goals, in 2018, the Commission designed a new comprehensive policy agenda on sustainable finance. The latter delineated a new plan of action on financing sustainable growth as well as nurturing a renewed sustainable finance strategy. Indeed, great attention is drawn to the financial sector, which arguably is among the key players for such an all-around environmental transition. Precisely as it takes place at the micro-level, policy-makers have to craft an attractive agenda for external investors who, attracted by the foreseeable profits, invest part of their assets.
Similarly, although at a much greater level, with much higher investments and detaining greater market credibility, central banks have the same crucial role for the transition to a low-carbon economy. By influencing capital allocation through affective monetary policies, central banks move quite important strings of the financial market. Among these invisible economic powers, central banks can subtly and yet radically shape both the speed and extent of the transition towards low-carbon technologies through their monetary policy operations. 
Nevertheless, from great powers come even greater (green) responsibility, and it seems that behind the sustainable progressive mask, it hides an outdated carbon-driven villain. As a matter of fact, despite the rosy targets that the Commission has agreed on, such as tilting investments towards more sustainable technologies and business or contribute to the thriving of a climate-resilient and circular economy, recent data displays a ‘browner’ carbon-driven attitude by the EU. Today, financial markets are persistently underestimating climate risks and indirectly supporting high-carbon companies. Indeed, a good share of them is turning a blind eye to the long-term implication of climate change on their assets.
Despite being overlooked now, this carbon bias is hampering the achievement of the Green New Deal’s target of net zero-emission and will most likely impart huge economic losses in the long run. How is it possible that the EU is setting its house in order to successfully become the leading country in the green marathon while deliberately slowing itself with a financial carbon bias? Simply put, a brown collateral framework. Indeed, as argued by a wide number of financial experts and NGOs, in its current form, the Eurosystem’s collateral framework is “not only at odds with democratically defined goals of the Paris Agreement and the EU’s Green Deal, but it also actively underpins financial market failures and reinforces the carbon lock-in.” The link between greening the monetary policy and collateral framework is perhaps only indirect. Nonetheless, it underlies how all market sectors are tightly intertwined in a seeming system of chain reaction. As the main goal of the Eurosystem is to avoid any potential losses stemming from defaults of issuers, such as private businesses or commercial banks, in monetary operations, a climate-aligned collateral framework may seem to seize a vital role in maintaining the European Central Bank (ECB)’s primary objective: market stability. 
This framework lies at the heart of the Union’s monetary policy system. It sets up the rules and criteria for the economic transactions between central banks and both financial and non-financial investors. It is important to mind that the eligibility criteria and rules enlisted within the collateral framework are largely based on information and analysis, which actively disregard climate-related risks while favoring the fossil fuels’ big capital profits. A lack of consistent and transparent data on climate-related risks sends a clear signal to the market: sustainable transition is still a risky investment. Without the right information, investors and non-financial players may incorrectly assess the value of assets. For this precise reason, a reallocation or consideration of climate change within the collateral framework is of primary importance right now. According to several analyses, this misperception can cost trillions to the financial world and is likely, if not surely, to have catastrophic impacts upon all sectors in the long run. If the sub-prime crisis in 2008 felt like a hard punch to swallow, the yet-to-come climate-related financial crisis will be the unrecoverable kick for Europe and the world.
Collateral frameworks and carbon bias
Global markets perceive collaterals as necessary elements for the well-functioning of the economy. In short, for the least expert of you on the topic, collateral is the condition in which central banks accept bonds or loans issued by commercial banks, which in turn lend part, if not all of them, to non-financial actors. Moreover, collaterals constitute a core element for implementing EU’s monetary policy and play an important role in avoiding rampant fluctuations of market prices. In other words, they contribute to the most important task of central banks: maintaining price stability. The example of house mortgages is incredibly suitable to have a clearer picture of what a collateral is. When an individual files a mortgage with a private bank, the latter uses the house as assurance. Therefore, if the issuer will not be able to pay back the debt, the bank will then be entitled to sell his property on the market to avoid economic losses. The concept of collaterals works exactly in the same terms; however, since it perhaps involves far larger capitals, central banks, such as the ECB, use financial assets in the form of governments or corporate bonds as security. A key role here is played by the list of eligible criteria that defines the type of assets the ECB deems as acceptable. The latter, despite being regularly updated, still inherently holds a carbon bias. Drawing attention to the data, it can be argued that the ECB’s eligibility criteria are disproportionally buying assets from high-intensive carbon companies compared to low intensive ones. Although this bias may seem to be done indirectly, as fossil-fuels companies issue loans from private banks, it is hard to believe that a competent institution as the ECB is unaware of the nature of the collaterals. This argument is even harder to buy if we look at the huge numbers of eligible bonds coming from carbon-driven companies accepted by the same central bank. According to a recent study carried out by Greenpeace, which relies at large on the work of several financial advisors, the ECB accepted over 756 corporate bonds by 61 fossil fuel companies for a net-worth value of EUR 300 billion on 26 November 2020.
The implication of such outstanding support creates advantageous financing conditions for the same companies responsible for the climate crisis. The assets deemed eligible as collateral by the Eurosystem, gain value and credibility among the market, thus becoming significantly attractive for other investors. As a consequence of this collateral supply chain, as the demand for these assets increases, so do their prices. Eventually, this will cause the interest rates and borrowing costs to drop for the government or corporate that issued the asset. In simple terms, most bonds accepted by the ECB stem from fossil fuel companies that enjoy a privileged spot within the collateral framework as they have almost insignificant borrowing costs and higher credit. Therefore, the Eurosystem is proactively picking a side in the fight against climate change. However, as things stand now, it seems to stand shoulder to shoulder with the perpetrator of such climate catastrophe, turning the EU into an enemy rather than a pioneer for sustainability. Shedding light on the numbers, as shown in the figure below, 59% of corporate bonds that the ECB accepts as collateral are based on carbon driven companies while their overall contribution to EU employment and Gross Value Added (GVA) is less than 24% and 29%. In other words, despite still being a cardinal element in the financial sector in the form of collateral and haircuts, carbon-intensive companies do not bring any drastic positive change to the European employment rate or production, thus underlying how, despite the obvious evidence, fossil fuel companies remain among the most powerful and influential lobbies at the international tables.
Figure 1: Contribution of carbon-intensive sectors to the ECB list of eligible corporate bonds in the collateral framework (outstanding amount), EU-28 employment and EU-28 Gross Value Added (GVA).
These concerns were echoed by Former Executive Board Member Benoit Cœuré at the French National Assembly in May 2019. In this speech, he outlined that ‘in the framework of our current policy, we are not neutral regarding the market’s structure, leading us to buy bonds from corporations whose carbon footprints are not good.’ The statement, which raised the alarm across the financial world, was backed the same day by De Nederlandsche Bank President Klaas Knot, who challenged the meaning of neutrality in a capital market driven by fossil fuels. Controversy apart, the Dutch Bank President invited central banks to design, within the limits of their mandates, new policy instruments that would take climate-related risks into deep consideration while unlocking sustainable investments’.  The picture above serves to visibly outline how, despite carbon-driven companies argue that the ECB’s collateral framework stimulates employments and GVA, data prove them wrong. In fact, there is disproportionality between incentives received by the ECB and the contribution to employment of these businesses, suggesting once again the need to green the financial system and its monetary policies.
When it comes to exploring new ways of aligning the existent monetary policy tools to climate-related risks throughout financial disclosures and assessments, haircuts play a critical role. Haircuts are risk management tools that reflect the perceived risk of the asset dropping in value in case of liquidation. It follows that the higher the haircut, the riskier the investment, making central banks or investors less inclined to accept or invest in these companies’ assets.
Beyond the technical use of such monetary instruments, they do have an outstanding implication for allocating resources and movements of capital over the assets. As mentioned before in the case of collaterals, bonds issued by high-intensive carbon companies share an almost insignificant haircut, meaning that they have rock-solid credibility by central banks. Therefore, these companies are likely to overly benefit in terms of borrowing costs and asset valuations compared to low-carbon ones. If words are not convincing enough, let’s have a look at the data. The current monetary strategy of the Union, as shown by a group of researchers of the Grantham Research Institute on Climate Change and the Environment, the average haircut of carbon-intensive sectors, which include fossil fuel companies (13.33%), carbon-intensive transportation (10.27%), non-renewable energy (13.36%), is actually lower than non-carbon-intensive sectors (13.93%). Nonetheless, haircuts and eligible criteria rely on outdated data that weigh more the short-term economic benefits over the long-term ones. Unfortunately, though, if this misconception will last, the ECB risks a painful exposure to the credit risk of fossil fuel companies’ collateral which is expected to suffer from transitional climate risks.
As high carbon-intensive means high capital-intensive companies, how will the ECB be able to replace the profound void left by carbon-related bonds when the green transition will finally reach a point of no return? Financial systemic change may be the way to shift a carbon-biased market towards a more sustainable endeavor radically. For such transition to be of any grasp, the ECB will have to enforce a few changes within its eligibility criteria. This suggests that the institution’s role as a neutral, independent agent would have to acquire a greater degree of policy-making power. Indeed, the ECB is required to break the whip now and adopt a new general approach that favors low-carbon assets if it wants to respect its legal mandate and enhance the Union’s sustainable development. Greening the monetary policy suggests tilting the eligibility criteria towards low-carbon businesses to increment the inflow of liquidity in this changing market. However, by enforcing a policy that would smooth the climate-related mitigation and assist businesses into their sustainable transition, some argue that the ECB will likely create a temporary shakeup upon the market. Such ‘intrusive’ but necessary action has sparked much contestation among financial regulators who argue that it stands at odds with the central bank’s mandate of maintaining price stability and market neutrality. If doing nothing is no longer an option, we need to explore new ways for the Eurosystem, particularly concerning its collateral framework, to align with the European Green New Deal’s objectives without undermining the rule of law.
To act or not to act: the ECB’s legal mandate dispute
Although being an independent brunch that operates through its own judgment in monetary implementation and control over the market, the EU commitment to the Sustainable Goals agreed in the Paris Agreement is pressuring the ECB to promote a sustainable framework throughout its policies. As argued in the paragraphs above, there are quite a few obstacles that hamper the development of a transparent and consistent green monetary policy. First and foremost, the Eurosystem’s collateral framework and list of eligible criteria are hard-wired with a carbon bias that supports the carbon-lock in. Secondly, there is a controversy between the various rules that define the ECB’s mandate, leaving its objective and means of achievement open to debate.
- Paragraph 1 of Article 127 of the Treaty on the Functioning of the European Union (TFEU) states that “the primary objective of the European System of Central Banks (hereinafter referred to as ‘the ESCB’) shall be to maintain price stability. Without prejudice to the objective of price stability, the ESCB shall support the general economic policies in the Union with a view to contributing to the achievement of the objectives of the Union as laid down in Article 3 of the Treaty on European Union”.
- Paragraph 3 of the abovementioned Article 3 of TFEU outlines that the EU “shall work for the sustainable development of Europe based on balanced economic growth and price stability, a highly competitive social market economy, aiming at full employment and social progress, and a high level of protection and improvement of the quality of the environment.”
The terms of the mandate leave its interpretation relatively broad, underlining a certain dispute between enhancing sustainable development while maintaining price stability. As agreed by a wide number of financial advisors, the ECB can foster the EU’s climate policy framework through a transparent and coherent readjustment of its collateral portfolio and eligibility criteria. In fact, as outlined by Cœuré, a former member of the ECB’s Executive Board, “by doing this, the ECB would support the EU’s environmental goals while staying true to its price stability goal.” Despite noticing that climate change has, and will further have, a dramatic impact on the ECB monetary policy, a reassessment of the eligibility portfolio and allocation of assets by the institution has been persistently overlooked. There cannot be a green development without a green financial system that doesn’t trade off climate risks assessment for market neutrality. As emphasized by Executive Board Member and Network for Greening the Financial System Chair Frank Elderson, this principle undermines the ECB’s primary objective of price stability.  There is a direct link between climate risks and inflation if we look at this situation in the long run. Moreover, the ECB’s mandate of enhancing environmental protection and sustainable development, which is often named after the central bank’s secondary objective, is not an option but a duty.
ECB’s experts have proved that the effectiveness of monetary policy could be curbed by the climate-related structural change, which would likely lead to a disruption of the financial system. Nevertheless, as reflected throughout several types of research on the topic, if the ECB fails to implement climate-related considerations within its collateral framework, climate change will impart an unrecoverable punch to the world economy. Furthermore, the EU Court of Justice confirmed that the pursuit of the primary objective of the ECB, that be price stability, is required by all means. Thus, if, on the one hand, greening the collateral framework will likely result in a temporary fluctuation of prices in the market, on the other, though, if actions do not move forward, the ECB will eventually face tremendous repercussion for not having taken a step in time. This sounds as ironic as a revelation; who would have ever thought that nature and economics are interdependent? This question does not longer surprise the world economists or environmentalists that for so long have tried together to voice how financial institutions would better stop underestimating the benefit of sustainable development.
When the ECB’s mandate was first outlined, climate change was not a heated topic on the negotiation table. However, as the discourse today has promisingly changed into a far more inclusive view of the environment, central banks are now demanding financial advisors to deliver a list of actions to include climate change into the EU’s new financial and economic policies without impacting price stability. In a newly published policy recommendation, Green Peace has worked shoulder to shoulder with several other social movements and think tanks, such as Inspire and the Sunrise Project, to outline three policy scenarios that would allow the ECB to green its collateral framework significantly.
The recommendations are:
– The climate-aligned haircuts (conservative): maintaining the existing list of eligible bonds but adjusting the haircuts on collateral according to the bonds’ climate footprint. Through this approach, the ECB can offer incentives and market signals to issue green bonds and improve their climate performance.
– The lower-carbon, climate-aligned haircuts: excluding dirty bonds issued by fossil fuel companies and adding climate-friendly bonds that meet the ECB’s eligibility criteria.
– The low-carbon, climate-aligned haircuts: Banks are no longer allowed to post dirty bonds issued by either fossil fuel companies or other carbon-intensive companies as collateral. This would reduce the weighted average carbon intensity (WACI) to 71.
Although, as stated throughout the research, these three scenarios do not erase entirely carbon-intensive companies from the list of eligible issuers, they do indeed restrict the eligibility of their debt in the ECB’s collateral list to green bonds.  This encourages companies to accelerate the transition to low-carbon activities and incentives banks to invest in green, thus helping non-financial companies align their agenda with the Paris Agreement’s resolutions. Shifting the worldwide economy to renewable energy may have sweeping consequences for all those businesses which are still heavily relying on coal, oil, or natural gas. Nevertheless, despite acknowledging the risks of the green transition in terms of adjustment costs, it does indeed offer a window of opportunity to design new solutions and mitigation strategies that will hopefully have to be taken into account and implemented sooner than later. Thus, instead of denigrating the run to sustainability, financial institutions should share their information to enable policymakers to design a consistent framework that would finally better off the environment. After all, by actively supporting the EU’s commitment to the UN’s Sustainable Development Goals, the ECB is not only undergoing something ecologically just for once, but it would indeed avoid unrepairable economic losses altogether.
“A well-designed financial system is not a silver bullet to fix all our economy’s flaws, but it is one of the most important things to get right if we are to genuinely build back better.”
 Kimberly Amadeo, Climate Change: Facts and Effects on the Economy, the balance, February 11 2021, https://www.thebalance.com/economic-impact-of-climate-change-3305682
 UN Economic and Social Council, Greening the economy: mainstreaming the environment into economic development. 7 July 2011 sustainabledevelopment.un.org.
 United Nations, Green Economy, Department of Economic and Social Affairs: Sustainable Development, https://sdgs.un.org/topics/green-economy
 European Commission, Overview of Sustainable Finance, https://ec.europa.eu/info/business-economy-euro/banking-and-finance/sustainable-finance/overview-sustainable-finance_en.
 Pierre Monnin. “Central Banks should reflect climate risks in their monetary policy operations.” Council on Economic Policies, September 2018, suerf.org.
 Martina Anzini et al., A Green ECB Collateral Policy: A proposal for a minimum green share collateral policy. 2020, CepInput, cep.eu.
 Daniela Gabor et al., Greening the Eurosystem collateral framework. How to decarbonize the ECB’s Monetary Policy”. Greenpeace, March 2021.
 Sini Matikainen, Emanuele Campiglio and Dimitri Zenghelis “The climate impact of quantitative easing”, Policy Paper May 2017
 Danae Kyriakopoulou, ECB market neutrality crumbling, 16 February 2021, Official Monetary and Financial Forum, omfif.org
 Tucker, P., Pristine and parsimonious policy: Can central banks ever get back to it and why they should try’, in P.Hartmann et al. The Changing Fortunes of Central Banking, 2018, pp. 48-64
 Dirk Schoenmaker, Greening the Monetary Policy, 19 February 2019, Bruegel.org
 TFEU Article 127(1).
 TFEU Article 3(3).
 Cœuré,‘Monetary Policy and Climate Change’, speech to the NGFS Conference ‘Scaling up’ Green Finance: The Role of Central Banks at the Deutsche Bundesbank, 2018, Berlin, November.
 Frank Alderson, Greening Monetary Policy, ECB’s Blog, https://www.ecb.europa.eu/press/blog/date/2021/html/ecb.blog210213~7e26af8606.en.html
 Positive Money, Sustainable Finance and Central Banks, positivemoney.eu.