Working Paper Series no. 790: Climate-related Risks and Central Banks’ Collateral Policy: a Methodological Experiment

Central banks increasingly acknowledge that climate change is a source of financial risks, which will also impact their conduct of monetary policy. Against this backdrop, the aim of this paper is to explore one potential approach to factoring climate-related transition risks into a central bank’s collateral framework. Given the radical uncertainty associated with measuring such risks, the methodology explored in this paper relies on so-called climate “alignment” methodologies, which enable us to assess the consistency of eligible and pledged marketable assets with specific climate targets. While such methodologies yield non-financial metrics that do not strictly measure climate-related risks and are also subject to uncertain assumptions, this paper considers that they can be used by a central bank as a relevant gauge of transition risks when managing its collateral framework.

Moreover, this paper proposes a “climate-hedging portfolio approach”: instead of seeking to “align” the collateral on an asset-by-asset basis, central banks could aim for “alignment”, in aggregate, of the collateral pools pledged by their counterparties with a given climate target. The rationale for this choice is that assessing climate-related risk at the pool level avoids the central bank having to decide on which assets/issuers in the pools should be excluded or capped, and is therefore more compatible with a market neutral approach.

The numerical experiment using Eurosystem marketable collateral data suggests that, in aggregate and despite some differences across methodologies and metrics, neither the Eurosystem eligible collateral universe nor the collateral pledged is “aligned” with the climate targets of the European Union. Hence, the Eurosystem marketable collateral can be considered to be exposed to climate-related transition risks.

However, more work will be needed to account for potential unintended aggregate effects or determined impacts on counterparties in specific countries. More work is also needed to test current results through additional “alignment” methodologies and metrics, and to better capture the “alignment” of asset classes that were not covered properly by this study .