Bank of England applies a carbon tilt – can pension funds still justify not doing so?

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The Bank of England has called for input on a discussion paper about ‘greening’ the Bank’s corporate bond purchasing programme, moving away from ‘market neutrality’ to a tilt. The move raises the question of whether other investors should follow, and if they should hold assets the central bank ultimately considers incompatible with net zero. 
In March this year, chancellor Rishi Sunak updated the Monetary Policy Committee’s ‘remit letter’, confirming that the government’s economic strategy – which the MPC is required to support – includes supporting the transition to a net zero economy. The change of remit means the Bank of England now has a mandate to ‘green’ its own investments. 
This includes a corporate bond purchasing programme that was doubled to £20bn last year in light of the pandemic, having originally been set up to support companies after the 2016 Brexit referendum.  
Companies might well need to raise capital in the next few years; in the UK alone, spending on low-carbon technologies and infrastructure will need to rise five-fold, from £10bn to £50bn a year or 2.5% of GDP, Andrew Hauser, executive director of markets at the Bank, said in a speech held last week. Investors will be financing this transition.  
“It’s therefore fair to ask: as an investor in corporate assets in our own right, should we be taking steps to support the achievement of net zero?” he said. 
Although the Bank expects to unwind its stake in corporate bonds at some point, it wants to take a lead in ‘greening’ the issuing companies while it can, and presumably act as a role model for private sector investors. 

Climate risk is ‘mispriced’ 

The Bank has to date sought to replicate the structure of the sterling corporate bond market by dividing up purchases across sectors according to the amount of debt outstanding, and within sectors using competitive reverse auctions. 
“This approach, sometimes called ‘market neutrality’, has obvious attractions for central banks charged with setting monetary policy for the economy as a whole. But it has quite a striking implication for the carbon footprint of the CBPS portfolio,” said Hauser. This is because larger companies – which are more likely to issue investment grade bonds – also tend to be higher emitters. 
The approach also does not work well in the current environment because the cost of emissions is mispriced, he added: “There are increasingly persuasive reasons to believe that financial markets are materially underpricing the cost of emissions, and hence climate risks”, mainly because carbon producers do not generally bear the full cost that their emissions create. 
"A key part of the transition to net zero is to internalise those costs, driving a significant increase in the so-called ‘shadow carbon price’," he argued. “As that happens, it will put downward pressure on the prices of assets issued by companies who have been least successful in transitioning away from high-emissions activities, increasing their cost of finance.” 

Bank takes engagement path 

To reduce its exposure to climate risks, the Bank will seek to adjust the portfolio by tilting future purchases towards issuers which are performing relatively strongly in support of net zero, and away from those that are not. 
“It will allow us to maintain a dynamic engagement with issuers – dialling up those whose strong record improves, and dialling down the laggards,” Hauser said. The Bank will also explore whether it can adjust CBPS eligibility requirements to incentivise timely compliance with requirements to make disclosurs in line with the Task Force for Climate-related Financial Disclosures. 
However, for activities “judged to be fundamentally incompatible with reaching net zero by 2050”, the Bank’s approach is less clear.  
Hauser said that judging whether fossil-fuel related activities other than thermal coal are indeed incompatible and should be excluded was “a complex and technical matter, in which the Bank has no direct expertise”.  
He added: “We welcome input on this question in response to the Discussion Paper, but will need to base our judgments on a combination of robust, broad-based scientific evidence and specific UK government policy.” 
The Bank is proposing a progressive approach, in which the debt of firms that fail to develop and execute credible plans moves down the rungs of a ‘ladder’, flipping first to a negative tilt, then – if poor performance continues – to removal from eligibility, and ultimately active divestment. 

Should pension funds take a lead from the Bank of England’s approach? 

Mike Clark
Nick Spencer