The European Central Bank regularly justifies the mis-alignement of its policies with the EU’s climate goals by claiming it must respect the “market neutrality” principle. However our research shows this principle is more the result of arbitrary choices by the Governing Council than a well-defined legal requirement. As Christine Lagarde hinted to, now is the time to revisit this approach to address the climate emergency.
Nicolas Hercelin is a Research Assistant at Positive Money Europe
Cross-posted from Positive Money Europe
Credit picture: CC Deutsche Bank
For the last four years, Positive Money Europe has been voicing criticism against the fact that the ECB’s policies are highly biased in favour of multinationals responsible for most of the pollution and carbon emissions. For example, a report of Positive Money Europe demonstrated how more than 63% of the portfolio of the ECB’s Corporate Sector Purchase Programme (CSPP) was directly financing the most carbon-intensive sectors.
In response, the European Central Bank has kept repeating that its monetary policy must be “neutral” with respect to the functioning of financial markets and can’t therefore expressively make the choice to support the transition toward a low carbon economy. This “market neutrality” principle appears to be the main, if not unique, reason why ECB refuses to adopt green criteria in the design of its asset purchase programmes.
Benoit Cœuré, board member of the ECB, acknowledged and justified this fact when he met the members of the French Parliament’s finance committee in May: “In the framework of our current policy, we are neutral regarding the market’s structure which lead us to buy bonds from corporations whose carbon footprint are not good”.
Since the market neutrality principles is presented as an insurmountable obstacle to the alignment of the ECB policies with climate and environmental goals, we wanted to explore deeper to see what this concept means in practice, and its justifications. The purpose of this article is to share our findings. We show that despite having the shape of an insurmountable constraint, the market neutrality principle can and need to be adapted to the new challenges brought by climate change.
What is market neutrality?
Curiously, the market neutrality principle is mentioned in the documentation of the ECB, but almost never in other central banks. We found more than 70 occurrences of “market neutrality” on the ECB websites, and more than 80 for “market neutral”. On the contrary, the Bank of England and the Federal Reserve have less than 10. Moreover two later central banks mainly refer to market neutrality in the context of non-monetary portfolio while the ECB mainly refers to their QE programmes. This seems to indicate that no other central banks are as much concerned than the ECB by the neutrality of their monetary policies.
When implementing its policies in a “market neutral” way, the ECB claims it wants to “minimize the impact on relative prices […] and unintended side effect on market functioning”. Furthermore, by doing so the idea is to “preserve the price discovery mechanism and limiting distortions in market liquidity.” Additionally, ECB’s Yves Mersch justify the market neutrality approach because it is a way to ensure the apolitical position of the bank: “Deviating from market neutrality and interfering with economic policy risks exposing the ECB to litigation. It is not up to the central bank but to elected governments to decide which industry is to be closed and when.”
As a result, the market neutrality principle is concretely implemented by following the distribution of assets on financial markets. For example, the composition of the CSPP portfolio is decided proportionally with the market capitalization of the different eligible parties – leading this portfolio to be very carbon intensive.
The partiality of the ECB’s market neutrality approach
The aversion against any distortion of the “functioning” of the market is a strong feature of the ECB’s policy design. However, despite being recurrent in the ECB’s publications, the way in which the neutrality principle is put into practice is not as obvious and consistent as one may expect.
For example, a paper from the Dutch National Bank highlighted that “the design of the QE policy of the Eurosystem as a ‘market neutral’ buyer is rather different than the policies implemented by the Federal Reserve, the Bank of England and the Bank of Japan.”
Pierre Monnin goes further, by arguing the CSPP, by solely targeting bonds – and not equity shares – is by itself the result of non-neutral choices. The Bank of Japan and the Bank of Swiss are for example buying shares in the course of their corporate purchase.
Clément Fontan and Jens van’t Klooster recently published a paper describing the distortive distributional impact of the ECB’s market neutrality. In particular, they point out that the difficulties for SMEs to finance themselves from bond markets prevents them from benefiting from the CSPP. They conclude that “no attempt to replicate market structure will ever succeed in removing the political dimension from security purchases and ‘offset’ distributive consequences.”
Market neutrality is a doctrine, not a legal requirement
The fuzziness around the implementation of the market neutrality doctrine is certainly explained by the fact that no explicit legal framework consecrates this principle. In fact, one important case law of the European Court of Justice (ECJ) about the ECB actually nuances the preeminence of the market neutrality principle.
Nothing in the EU Treaties nor in the ECB’s statutes mentions the market neutrality principles. On the side of the ECB’s legal literature, there is only one occurrence where “market neutrality” is clearly mentioned, but this appearance has nothing to do with the core policies of the ECB.
In the absence of any concrete legal dispositions, ECB officials have repeatedly referred to article 127 TFEU to justify the market neutrality approach. In the April 2017’s economic bulletin – which have been released before the opinion of the ECJ – the bank claims it “is mandated to act in accordance with the principle of an open market economy with free competition, favoring an efficient allocation of resources. Consequently, the ECB aims for a market-neutral implementation of the APP and therefore CSPP (…)”.
Not only is the “market approach” not clearly justified nor explained in European law, but ECJ’s OMT judgement of 2015 is even directly weakening the scope of the principle. Indeed; the points 72 to 76 of the Court’s ruling highlights that the ECB launched the OMT program because it judged financial markets were mispricing some government bonds during the sovereign debt crisis. At this time financial markets were requiring “excessive […] interest rates” provoked by “unjustified fears about the break-up of the euro area”. In its final judgement the ECJ endorsed the choices made by the ECB, creating therefore a legal precedent where the ECB is able to judge the “neutrality” of the market itself and to intervene by correcting, through monetary policy, the bad functioning of markets when the bank judges so.
Revisiting market neutrality
Far from being set in stone in the EU’s rigid legal framework, the market neutrality concept appears to stem from a specific interpretation of the ECB’s mandate by the Governing Council. If the market neutrality principle is not such a static concept, this also means the ECB’s Governing Council has the power to offer and implement a new revised definition of the market neutrality principle. In light of our current and urgent challenge, now would be a good time to adjust its definition and implications.
It is today a matter of consensus that climate change, if not mitigated, will have a disruptive effect on the financial system and on the economy. Climate change will then disturb, or even prevent, markets from functioning normally. And in the words of the ECB this is exactly what the market neutrality approach is supposed to avoid.
The ECB, like most central banks, are increasingly concerned that “climate related financial risks are not fully reflected in asset valuations”. This would mean that markets are mispricing certain assets by disregarding the future impact of climate change for the economy. Jean Pisani-Ferry brilliantly pointed out the contradiction that this analysis entails for the ECB: “is it consistent to tell the private sector you should not invest in such asset because it involves a risk that this asset becomes stranded because of climate change […] and at the same time saying that in the monetary policy operations the asset purchase of the ECB, you are perfectly neutral and you don’t distinguish between those type of assets?”
There are therefore two reasons for the ECB to adapt its market neutrality design to climate change issues, especially through monetary policy. Firstly monetary policy need to stop aggravating financial stability by financing activities that fuel climate change. Secondly monetary policy should intervene to restore the proper conditions for the markets to function under the climate change context. Restoring the functioning of the markets and reduce systemic risks can be done by integrating green factors or climate-related risks in the collateral eligibility criteria (as advocated by Villeroy de Galhau) and by excluding highly pollutive assets from the CSPP.
In this regard, the unprecedented remarks of Christine Lagarde during her confirmation hearing as next ECB president are quite encouraging. She notably endorsed “a gradual transition to eliminate carbon assets” from ECB’s portfolio.
Moreover, in her response to MEPs, Lagarde did allude to the possibility that a robust environmental framework as defined the upcoming EU’s sustainable finance taxonomy could “superimpose to market neutrality”. Although it is not clear at this stage what Lagarde exactly means, it is a positive sign that the future ECB president may be willing to shift away from the blunt and strict application of the market neutrality doctrine.