Disclaimer: Views in this blog do not promote, and are not directly connected to any Legal & General Investment Management (LGIM) product or service. Views are from a range of LGIM investment professionals and do not necessarily reflect the views of LGIM. For investment professionals only.

The Bank of England’s plan for greener bond buying

As COP26 took place in November, the Bank of England fleshed out how its corporate bond purchases will reward companies taking action to make the economy greener. We think the BoE has taken a balanced approach to incentivising company behaviour, utilising a mixture of carrots and sticks, allowing a gradual phase-in of rules, and aligning with other areas of policy. Despite the small size of the programme overall, investors should still keep an eye out for how this might impact credit spreads in the sterling corporate bond market.

 

Since 2016, the Bank of England (BoE) has been purchasing corporate bonds to drive yields down and stimulate the economy in a programme known as the Corporate Bond Purchase Scheme, or CBPS. And for about as long as the CBPS has existed, central bankers have been thinking about how their institutions can incorporate climate risk management and contribute to the overall climate transition.

Applying ‘greening’ criteria to the CBPS

The November market notice from the BoE detailed more mechanics of how the CBPS would evolve, building on the central bank’s May discussion paper and the mandate given to the central bank by the government in March.

‘‘Greening’’ the CBPS involves principles that commit to changing the behaviour of companies whose debt is held by the Bank of England, rather than simply reducing the carbon footprint of the central bank’s portfolio. The BoE has set out the tools it will use for doing so, which we also summarise in the table below.

Source: this table is a summary of the information made available by the Bank of England on their website – for more information, please visit this page: Greening our Corporate Bond Purchase Scheme (CBPS) (Nov. 2021)

 

Below, we highlight what we believe to be five key strengths of the tools set out by the BoE:

  1. It encourages issuers in high-emitting sectors to adapt – we believe encouraging companies to eliminate existing activity by adopting science-based pathways can have more impact than outright exclusions
  2. Green bond purchasing is not included – we’re glad that the BoE hasn’t adopted the overly simple approach of allocating more funds to labelled bonds, which was something we discouraged in our feedback. We think the BoE is right to instead focus on the ESG performance at issuer level
  3. The BoE is prepared to pay a higher price for better climate performers – we believe that this is a critical point in terms of impacting valuations.
  4. Scorecard is forward looking – incorporating backward and forward-looking metrics, absolute carbon reduction targets, and sector-specific weighting reflects a detailed approach to the tilting methodology which also solves for some of the shorter-term data challenges
  5. Escalating engagement – the BoE will disclose information on the scorecard incentivising companies to perform and may escalate engagement including using divestment

It’s a start, but a small one

There are a couple of reasons why climate watchers might want to curb their enthusiasm. CBPS as it currently stands is small: just £20 billion[1]. That’s less than 7% of the total sterling-denominated corporate bond market. By contrast, the ECB holds approximately €304 billion of corporate bonds under the Corporate Sector Purchase Programme[2].

Furthermore, the ‘tilting’ will only be applied to periodic re-investment, starting this month.  And currently, the eligibility criteria will not have a significant impact on the investment universe (for example, there’s a low level of coal exposure in sterling credit).

Finally, data availability remains an issue. For example, Scope 3 (indirect) emissions have been excluded for now given the difficulty of obtaining fair and accurate measurements.

The BoE’s purchasing patterns should therefore not change materially in the short term but will start to shift more significantly from 2022 when mandatory climate disclosures and the BoE’s scorecard come into effect.

Watch the spreads for climate leaders and other central banks to follow suit….

Despite some limitations, we believe that the Bank of England’s move to green the CBPS is an important moment for credit markets and has implications for sterling credit investors.

Unlike in the euro market, sterling bonds held by the BoE do not currently trade at a significant premium versus peers. However, in times of market stress or volatility – such as when the CBPS was introduced in 2016 – the BoE’s actions can act as an important signal to the market and create a meaningful dispersion between the valuations of issuers included in the list and those that aren’t. We therefore believe that the BoE framework paves the way for green issuers to outperform climate laggards in the sterling bond market over the medium term.          

We also think that the BoE has set the standard for other central banks. The ECB’s ‘roadmap to greening monetary policy’ already contains a commitment to make asset purchases greener, and considering the size of its corporate holdings, whatever approach is adopted here could have significant implications for valuations in euros.

 

[1] Source: Bank of England speech – “It’s not easy being green,” Andrew Hauser, May 2021

[2] Source: ECB statistics as of Nov. 5, 2021.

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