ECB introduces climate risk overlay for bank collateral framework

The European Central Bank (ECB) has introduced climate related risk adjustments into its collateral framework.

This marks the first time climate transition uncertainty will influence how much banks can borrow against corporate bonds pledged in monetary policy operations.

The new 'climate factors', which took effect on June 15, are designed to protect the ECB's balance sheet from potential losses arising from the transition to a low carbon economy by reducing the vale assigned to corporate bonds issued by companies deemed more exposed to climate related risks.

The changes complement the ECB's existing collateral risk controls, including the valuation haircuts, by incorporating forward-looking climate risks that may not be captured in historical market data.

"Climate factors complement existing risk control measures by protecting the ECB's balance sheet against unexpected climate transition shocks," ECB economists Dirk Broeders and Daniel Gybass said.

The central bank said climate change presents unprecedented financial risks, with shifts in climate policy, technology and consumer behaviour capable of rapidly affecting companies' profitability and asset values.

Under the revised framework, bonds issued by companies with higher greenhouse gas emissions, weaker decarbonisation strategies or less comprehensive climate disclosures will receive larger valuation reductions. Longer-dated securities will also attract higher adjustments because they are considered more vulnerable to future transition risks.

The ECB said the framework uses a two-step methodology, assessing each issuer's exposure through a combination of sector-level transition risks, company-specific emissions and disclosure data, and the remaining maturity of the bond before converting those assessments into a climate adjustment factor.

For example, a corporate bond valued at €100 with a standard 10% haircut and a climate factor of 0.987 would allow a bank to borrow €88, instead of the €90 under the previous framework.

The central bank said the immediate impact on banks is expected to be limited because borrowing levels remain low and corporate bonds account for a relatively small share of collateral pledged in refinancing operations.

The ECB said sectors including utilities, materials and transportation are expected to receive the largest climate-related adjustments due to their greater exposure to transition risks, while software and consumer services are generally expected to attract smaller reductions.

The Governing Council will review the climate factors regularly to reflect improvements in climate data, regulatory developments and advances in risk assessment methodologies.