Collateral climate haircuts: the ECB’s new ‘climate factor’ could reshape bond portfolios

“Corporate bond holdings in the Eurosystem’s monetary policy portfolio will be tilted towards issuers with better climate performance”, wrote European Central Bank (ECB) President Christine Lagarde in a letter
addressed to Irene Tinagli in July 2022. Lagarde’s message to the erstwhile chair of the European Parliament’ economic and monetary affair committee hinted at future changes in the ECB’s musings on climate risk.

Three years later, in July this year, the ECB announced a significant reform to its collateral framework, aimed at improved climate risk management. A new measure, called the ‘climate factor’, will be incorporated into collateral valuations.

The climate factor is significant and consequential. In the long term, it could tilt bond holdings away from issuers with expansive carbon footprints.

Landmark move

Beginning in the second half of 2026, the climate factor will adjust the value of collateral against which the ECB is willing to lend. The factor itself is an ‘uncertainty score’ derived from three components: the first based on sector, the second on the issuer and the third linked to the specific asset in question.

“By directly adjusting collateral valuation for transition risk, the ECB signals that climate exposure is as relevant to creditworthiness as default probability or market liquidity”, says Dr. Scott Kelly, senior vice president at Resilience – a sustainability intelligence firm.

“This makes the ECB’s move a landmark integration of environmental risk into monetary policy infrastructure, one of the deepest structural changes yet from a major central bank”, Kelly told Net Zero Investor.

The ECB’s decision also sets a powerful precedent, one that other central banks will take note of.

“It’s the first time a major central bank has introduced a quantitative adjustment to collateral values explicitly based on climate transition risk”, commented Rémy Estran, CEO of Scientific Climate Ratings, an EDHEC venture.

“Other central banks and financial regulators can now point to a concrete, operational example of integrating climate scenario analysis into lending and market operations”, Estran notes.

Economics of collateral

The climate factor changes the economics of collateral valuation, a critical piece of the puzzle as far as refinancing goes.

“Historically, collateral frameworks have adjusted valuations for factors such as credit quality, maturity, and liquidity, but have generally treated climate risk as either immaterial or too distant”, explains Kelly.

“By directly adjusting collateral valuation for transition risk, the ECB signals that climate exposure is as relevant to creditworthiness as default probability or market liquidity”, he adds.

The change affects the haircut, or the adjustment of collateral valuation, by linking it for the first time, to climate risk.

“The ECB’s climate factor marks a shift to recognising that climate risk is a material financial risk that needs to be priced into monetary policy”, says Estran.

Holdings

In the short term, the climate factor effect is likely to be modest. Both Kelly and Estran noted that corporate bonds account for a small portion of pledged collateral.

The effect of the climate factor then, will play out in the long run. If carbon-intensive assets receive a large climate haircut, one possible consequence is a rebalancing of incentives for financial sector bond portfolios.

“Treasury desks will need to account for the collateral efficiency of their holdings, potentially reducing exposure to high-emitting issuers in favour of those with better climate scores”, Estran told Net Zero Investor.

For asset managers and insurers too, Kelly says the climate factor will have an effect. “The effect is indirect but still material. Bonds with lower collateral value at the ECB may trade at wider spreads in the secondary market”, he explained.

“At a system level, the mechanism creates a price signal. It rewards institutions holding transition-aligned collateral and penalizes those concentrated in carbon-intensive debt”, Kelly adds.

The lesson then, is that in the long run, climate haircuts courtesy of the ECB’s new climate factor, could affect the attractiveness (or lack thereof) of bond issuers. If that is to happen, the change sets a powerful precedent in the broader context of tilting bond holdings away from carbon-intensive issuers.