Investors can go further than the ECB on climate change

The European Central Bank (ECB) is going to change its monetary policy to favour companies that have "better climate performance"

The European Central Bank (ECB) is getting ready to shift its approach to monetary policy in the direction of corporate bond issuers with "better climate performance." That's a good goal, but it will be hard to reach. Even though simple decision rules may seem useful, we think investors need a more complete understanding of climate issues to deal with the causes and effects of climate change.

Last month, the ECB set October 2022 as the official start date for making climate change a part of its monetary policy. The ECB's programmes to buy corporate bonds, as well as its policies on disclosure, risk assessment, and collateral, will all be affected by the change in policy. Under the plan, companies that do a better job of taking care of the environment will have a bigger share of the assets on the Eurosystem's balance sheet than companies that do a worse job. Even though it seems simple, this plan has a lot of big problems in the real world.

Climate issues are complex. We think there are four main areas where investors who care about climate change need better data, expert insights, and a more nuanced approach to make good decisions.

Learn about Emissions: Most likely, a selection process based only on numbers that rewards companies with lower carbon emissions will not be enough. Today, most companies only report and account for their Scope 1 and Scope 2 emissions, but Scope 3 emissions are also important. Emissions are the biggest problem for the environment for many industries.

Since scope 3 emissions haven't been widely reported yet, investors often use estimates from third-party providers. But their estimates will always be limited in ways that may be important. Investors can learn and figure out how big scope 3 emissions really are by talking to companies directly.

While the European Union (EU) is still working on making disclosure practises mandatory through the proposed Corporate Sustainability Reporting Directive, the ECB may try to deal with the lack of scope 3 data by giving more weight to companies that disclose indirect emissions information voluntarily.

We think this approach could be a good way to speed up climate disclosures because companies would be rewarded for being more open. But the results might not be final, and there wouldn't be any good ways to compare them because third-party industry estimates aren't always accurate.

Taking a look at transition plans: The past is not a good way to predict the future. Reducing carbon emissions in a sustainable way means that companies' long-term plans should aim to cut their emissions. So it's very important to find companies with long-term climate commitments that can be trusted. Using independent sources of expertise and clear climate pledges like the Science Based Targets initiative (SBTi) and the Net-Zero Banking Alliance (NZBA) can help separate companies with long-term commitments from those who are not yet ready to walk the walk.

How the ECB will judge long-term commitments is still not clear. For example, the EU does not yet directly back the SBTi. Without an active engagement programme, the ECB won't be able to tell how a company is doing over time.

Appreciating Climate Innovation: Some industries that put out a lot of pollution now will be very important in solving climate problems in the future. For example, the auto industry is making technologies and products to move away from high-emitting internal combustion engine technology. Several original equipment manufacturers (OEMs) and suppliers in the automotive industry have long-term climate goals and high capital expenditure (capex) commitments that could really change the industry. This means that a single emissions metric may not be enough to understand the companies' strategies.

Encouraging Climate Resilience: Even if we manage to keep global warming to 1.5 degrees Celsius, as the Paris Agreement calls for, we will still need to improve our infrastructure and societies to deal with the effects of climate change that can't be changed. Extreme weather is likely to keep getting worse, putting stress on our buildings, transportation, and health care systems. For example, the construction industry, which uses a lot of energy, must play a key role in making sustainable technologies, structures, and materials better, such as by making better insulation for buildings.

To stop climate change from happening, it is important and urgent to move toward a low-carbon economy. We are very supportive of climate action and people who work to stop global warming.

But it's important to make sure that any actions are well thought out, based on a full understanding of the problems, and give credit to companies whose work is important for a smooth transition.

We think the ECB's plan is a step in the right direction, and we're excited to see how its policy guidelines will change over time to better reflect how complicated climate issues are.