7 January: In March 2021, the UK Government explicitly included the support for the transition to a net zero economy in the mandate of the Bank of England. In response, the Bank announced it would green its Corporate Bond Purchase Scheme (CBPS) and by November 2021 it provided details about the greening framework. The Bank plans to use a climate scorecard that evaluates the bond issuers’ climate performance and tilt purchases towards companies that are stronger climate performers within their sectors.
The new environmental mandate has created a unique opportunity for the Bank to play a leading role in the decarbonisation of monetary policy. However, the approach that the Bank has taken to green the CBPS lacks ambition. The Bank’s greening strategy has two fundamental limitations. First, it relies on a ‘carrots first, sticks later’ principle that precludes the introduction of substantial penalties for poor climate performers, at least at a first stage. Second, the Bank remains committed to the principle of ‘market neutrality’, despite having recognised its inherent carbon bias. This restricts the Bank’s ability to reduce subsidies it extends to carbon-intensive activities in the CBPS.
We explore these limitations through a quantitative analysis that replicates the tilting of CBPS holdings as proposed in the Bank’s approach, and we show the following:
- The Bank’s tilting framework cannot reduce the representation of carbon-intensive activities in the CBPS and can paradoxically lead to some carbon-intensive companies getting better treatment than environmentally friendly companies. This is a consequence of the Bank’s continued adherence to the market neutrality principle, which leads to the tilting of CBPS holdings within sectors so that the scheme continues to reproduce the underlying sectoral composition of the bond market.
- The Bank’s tilting approach is not going to substantively reduce the Weighted Average Carbon Intensity (WACI) of the CBPS portfolio. In our replication, the WACI would only decline by 7%. Thus, the Bank will find it challenging to achieve even its own target of 25% reduction in WACI by 2025.
To help the Bank of England genuinely lead by example on the decarbonisation of monetary policy, we propose two alternatives: Strong Tilting and Strong Tilting+Exclusion. The Strong Tilting option adds activities-based taxonomies into the tilting strategy and reallocates purchases across different sectors without being restricted by the market neutrality principle. In the Strong Tilting+Exclusion option, we additionally exclude from the Bank’s holdings the bonds of fossil fuel companies and the bonds issued by non-renewable electricity utilities with a poor climate performance. Our quantitative analysis shows the following:
- Our proposals would substantially reduce the subsidies that the Bank of England extends to companies engaged in carbon-intensive activities. Under the Strong Tilting option, the proportion of carbon-intensive bonds in the total CBPS holdings declines from 54% to 48%. In the Strong Tilting+Exclusion option, this proportion declines even more to 36%.
- Under the Strong Tilting option, the WACI of the CBPS portfolio declines by 11%, while Strong Tilting+Exclusion leads to a decline of WACI by 39%, allowing the Bank to achieve its 2025 target right now instead of waiting for three more years.
Importantly, the Strong Tilting+Exclusion option will likely have the strongest impact on the decarbonisation of the UK economy. It would directly penalise those companies that have done nothing or too little to address the climate crisis. Excluding these companies from CBPS would not just increase their cost of borrowing through bond markets. It would entail adverse reputational effects by sending a strong signal to markets that companies which fail to contribute to the achievement of the Paris targets can suffer financially. Such reputational consequences can increase the pressure on companies to decarbonise their activities and fundamentally change their business models. In comparison, such pressures are minimal under the Bank’s tilting option, whereby some carbon-intensive companies could even benefit from the incorporation of climate criteria into the Bank’s monetary framework.
Our proposals remain applicable should the Bank decide to taper its corporate asset purchases in the coming months. For example, the Bank can implement tapering by excluding from the eligible universe, or reducing the holdings of, those bonds that have been issued by poor climate performers. A green tapering would give a powerful signal to financial markets.
The climate emergency cannot be addressed through economic policies that simply tinker around the edges. A sharp reduction in emissions requires bold changes in the design of economic policies and the implementation of unprecedented measures that will transform the structure of our financial systems. As a powerful policy institution with a new environmental mandate, the Bank of England should take up the challenge, lead by example, and contribute decisively to the fight against climate change.