Eco-friendly Central Banks: Toward a Greener Balance Sheet

By | July 20, 2020

This post is the latest in our special issue: “Climate Change and Financial Markets – Risk, Regulation, and Innovation.” To learn more about the special issue and the work of the Global Financial Markets Center around climate change and financial markets, please read the special issue’s introduction here. And to review all The FinReg Blog posts that touch on climate change, go here.

With global warming driving an increase in the frequency and intensity of natural disasters and the COVID-19 pandemic underscoring the world’s unpreparedness to deal with “acts of God,” the need to fight climate change is becoming ever more urgent. One way to move forward is to stimulate the private financing of the climate transition, as emphasized in the launch event of the private-finance agenda for the COP26 Climate Conference, later postponed due to the pandemic. But government authorities that hold significant portfolios of assets, as central banks do, can also help.

Sustainability as an additional investment objective is now a reality for private investors (mainly institutional investors) and for sovereign wealth funds. These investors are increasingly focusing on companies’ adherence to positive environmental, social, and governance (ESG) measures. ESG portfolios, made of stocks and debt issued by ESG-friendly companies, outperformed traditional ones in 2020, taking into account a period that includes the market swings and losses caused by the coronavirus lockdown.

Following this trend, the Network for Greening the Financial System (NGFS) recommends that central banks and monetary authorities integrate sustainability factors into their portfolio management (Recommendation n. 2). The NGFS has even issued a guide containing Sustainable and Responsible Investment principles central banks can follow to mitigate sustainability risks in their investments. The ultimate goal is to make “financial flows consistent with a pathway towards low greenhouse gas emissions and climate-resilient development,” as set in the Paris Agreement, Art. 2(1)(c).

In a previous piece, I discussed how climate change relates to central banks, pointing out that much can, and should, be done within the existent boundaries of their legal authority. Here, I will show how central banks can make “greener,” or more environmentally friendly, their balance sheet by tweaking the two main portfolios they manage when implementing policy: the monetary policy portfolio and foreign exchange (FX) reserves.

Embedding environmental criteria in central banks’ investment decisions may be easier for those central banks with a broader legal mandate, beyond the traditional task of maintaining price stability. This is particularly evident for central banks whose secondary objective is to contribute to the implementation of the economic policy dictated by the government. Article 127(1) of the Treaty on the Functioning of the European Union (TFEU), for example, states that the European System of Central Banks “shall support the general economic policies with the Union with a view to contributing to the achievement of the objectives of the Union (…).” The objectives of the Union, in turn, as defined in Article 3(3) of the Treaty on European Union, include working “for the sustainable development of Europe based on (…) a high level of protection and improvement of the quality of the environment.”

The United States’ Federal Reserve Act (FRA) is much less clear about environmental objectives. But Section 2A assigns a dual mandate to the Fed, requiring it to also envisage broad and long-term economic goals in search of a monetary equilibrium that maximizes the level of employment. The legal question can thus be solved if the Fed can frame the greening of its policy portfolios under Section 2A.

Monetary policy portfolio

Central banks perform the core function of preserving price stability through the formulation and implementation of monetary policy. In general terms, first a monetary policy committee, such as the Federal Open Market Committee in the U.S., sets the target or a target range for the base interest rate that it deems adequate to keep prices stable. The central bank then deploys the tools at its disposal to influence the interest rates used by banks in the short-term transactions among them, aiming to achieve that target.

Traditionally, central banks implement monetary policy through open-market operations (OMOs) in the form of repurchase agreements or the trading of short-term government securities with selected financial institutions (primary dealers). Those traditional OMOs, however, have not been an effective monetary policy instrument since the Global Financial Crisis for central banks that resorted to quantitative easing (QE), inundating the banking system with reserves. In an ample-reserves regime, the central bank may prefer to influence interest rates by remunerating excess reserves instead of conducting traditional OMOs.

OMOs continue to be useful though. In the U.S., the Fed had to resort to traditional OMOs again in reaction to the “repo market turmoil” of September 2019 and to the COVID-19 market scare that took place in March 2020. Traditional OMOs also belong to the monetary toolkit of other central banks, such as the European Central Bank (ECB) and the Central Bank of Brazil, remaining a fundamental tool to the latter.

Another monetary policy strategy is the large-scale purchase of longer-term government securities and private assets, also in the open market. These asset-purchase programs, known as QE programs, try to reverse deflationary pressure by increasing the money supply to lower long-term interest rates and prop up prices. Large-scale asset purchases by central banks were initially seen as an unconventional tool, to be phased out once the crisis ended, and central banks’ balance sheets returned to “normal” levels. Those programs have, however, become a permanent feature of monetary policy implementation in jurisdictions around the world.

The interplay between sustainability and the monetary policy portfolio becomes more relevant when the central bank is allowed to buy private assets to implement policy. The purchase of private assets for monetary policy purposes is legally available, for instance, to the ECB, the Bank of England, the Bank of Japan, and, while the COVID-19 national emergency period lasts, the Central Bank of Brazil. Environmental criteria for the purchase of corporate bonds by central banks have been object of debate. Christine Lagarde, the president of the ECB, has declared that the on-going review of the ECB’s monetary policy strategy will take into account climate change issues, while the European Parliament has adopted a resolution calling on the ECB to redesign its corporate asset purchase programs in a socially and environmentally sustainable manner.

The Fed, on the other hand, is legally constrained in that aspect: it can only buy, in the open market, U.S. government bonds and debt issued or fully guaranteed by government agencies, according to Section 14(b)(2) of the FRA. In any case, to provide liquidity and preserve stability during the COVID-19 crisis, the Fed has created emergency lending facilities under Section 13(3) of the FRA and Section 4003(b)(4) of the CARES Act, which enable it to purchase private assets, like corporate bonds and loans, and corporate bond ETFs.

Against this backdrop, should central banks prioritize the acquisition of green bonds to make their monetary policy portfolio eco-friendlier when purchasing private assets, either in normal or exceptional times? The proposal of purchasing green bonds—or excluding dirty (also called “gray”) bonds—arguably faces two obstacles in the context of monetary policy.

The first is the principle of market neutrality, which, in a monetary policy context, dictates that central banks must not interfere with price-formation when they buy or sell assets. The Bank for International Settlements, in its recently published book “The Green Swan,” refrains from recommending asset-purchase programs focused on green assets, arguing that this kind of central-bank intervention can “distort markets.”

The second obstacle is the insufficient size of the green bond market compared to the volume of assets traded in a QE program. According to Fabio Panetta, a member of the Executive Board of the ECB, the central bank would swallow up the green bond market if it decided to buy only green bonds as part of an asset-purchase program in the European Monetary Union.

Still, as the market for green bonds matures and debt securities issued by carbon-intense economic sectors fall out of favor, central banks will need to purchase more green bonds and divest from dirty bonds. Additionally, research has demonstrated that, because some central banks are lagging behind private investors in acknowledging this type of financial risk, their asset purchases may be contributing to the mispricing of high-carbon assets.

On the other hand, when central banks start to allocate resources based on considerations that go beyond the narrow sense of monetary and financial stability, they become more exposed to political, corporate, and public pressure. By getting involved in government policies designed for prompting non-financial companies with a greener profile, central banks will inevitably pick winners and losers, moving closer to the fiscal realm. And once the line that separates monetary and fiscal policy grows more blurred, the survival of central bank legitimacy will necessitate a long-overdue revamp of central banks’ legal mandate and role in the government, as well as a reformulation of the concept of central bank independence.

FX reserves

FX reserves are central banks’ assets denominated in foreign currency. Central banks hold FX reserves mainly as insurance against extreme currency volatility that can end up causing financial and economic instability. The signaling effect to foreign investors matters here —a central bank that holds FX reserves in significant amounts indicates to foreign investors that it has sufficient funds to face increased demand for foreign currencies.

FX reserves kept by central banks are, in general, state-owned assets. Much like a private asset manager in relation to its clients, central banks have a fiduciary duty, owed to the sovereign state, to minimize the assets’ exposure to financial risks. In Brazil, for example, the idea that the reserves are merely “entrusted” to the central bank is explicit in the Central Bank Act (Law 4,595, of 1964), which declares that the Central Bank of Brazil is the “depository of the government’s gold and foreign currency” (Article 10, VIII). In the European Union, the Statute of the European System of Central Banks and of the European Central Bank states that the ECB “shall have the full right to hold and manage the foreign reserves that are transferred to it and to use them for the purposes set out in this Statute” (Article 30.1), as does Art. 127(2) of the TFEU, indicating that the reserves belong to the Member States.

Reserve management focuses on three basic objectives: liquidity, safety, and return. Balancing these objectives involves trade-offs since more safety or liquidity, for example, means less return. Central banks can also favor one objective over the others depending on the primary intended use for the FX reserves, such as intervention in FX markets, emergency liquidity assistance, or execution of payments for the government.

To comply with their fiduciary duty, central banks should incorporate environmental criteria in the reserve management framework they use to maintain a safe and stable portfolio of foreign assets. Climate change affects financial risk assessment because it carries physical risks (impact on asset values derived from climate-related events) and transition risks (reassessment of asset values due to the process of adjustment toward a low-carbon economy). As green bonds acquire “investment grade” quality, allocating part of the FX reserves to ESG investments can minimize the financial risks without compromising safety or return. This kind of investment can also bring diversification to central banks’ FX portfolio, making it more resilient.

The Bank for International Settlements (BIS), in its role of assisting central banks in the management of FX and gold reserves, created in 2019 a green bond cooperative initiative offering a green bond fund for central banks. The initiative is part of the BIS’s efforts to promote green finance by deepening the green bond market and stimulating the development of safer standards for green investment, using the joint investment power of central banks. The BIS green bond fund is an alternative for central banks to invest in green bonds with the support of a trustworthy agent.

During the COVID-19 pandemic, the issuance of coronavirus bonds has partially replaced the issuance of green bonds. The proceeds of the coronavirus bonds are earmarked to fund initiatives that soften the effects of COVID-19, such as activities to combat the disease itself and provide financial assistance to businesses. This shift may come as a blessing in disguise for green bonds, as the increased demand for coronavirus bonds can help build a more robust market for all kinds of ESG bonds. Evidence of that trend came when the reopening of the European economy after the lockdown was accompanied by some recovery in the sales of green bonds.

Moving forward

Such a change of approach in central banks’ investment choices cannot take place without sufficient and credible information about the green securities. Who will define which assets are green or dirty? As revealed by an NGFS survey published in May 2020, financial institutions find that the absence of harmonized data is the principal obstacle for defining the greenness of an asset, and most of them use a voluntary classification or principle for their investment decisions.

It all starts with private companies’ appropriate—and uniform—disclosure of environmental risks. Industry-led initiatives like the Task Force on Climate-related Finance Disclosures (TCFD) aim to propose standards for consistent corporate transparency in this regard. The UK Financial Conduct Authority has recently released a consultation paper proposing to require companies listed on the London Stock Exchange premium segment to disclose their compliance with TCFD recommendations.

Government regulations, such as Article 173-VI of France’s Law on Energy Transition for Green Growth (Law 2015-992) and the taxonomy under development in the EU’s Green New Deal might help with disclosure and standardization, by making environment reporting mandatory, and providing companies with an official taxonomy to be followed. Governments can start by issuing non-binding guidance, which can later take legislative form—the EU Green Bond Standard guide is an example of this kind of initiative.

The lack of uniformity in the classification of bonds as green can occur even inside the same jurisdiction. In China, for example, different parts of the government, like the People’s Bank of China, the National Development and Reform Commission, and the China Securities Regulatory Commission, have different rules as to the definition of green bonds. China has recently presented a plan to unify government standards and to prevent projects related to coal from obtaining funding through green bonds. Some projects that envisage a so-called “clean use” of coal, such as coal washing plants and technologies to cut pollution during coal combustion, are presently eligible to be considered sustainable investments in China. This approach seems to be in contrast with international practices, such as the taxonomy set by the Climate Bonds Initiative (CBI) and the Green Bond Principles from the International Capital Markets Association (ICMA).

Central banks’ investment choices are presently guided by traditional credit ratings, which haven’t yet fully incorporated climate exposures in their assessments. However, the rating agencies are beginning to gather more environmental data and downgrade companies based on ESG reasons. In this process, rating agencies may conclude that bundling environmental, social, and governance evaluations in one single rating is inappropriate. An issuer, for example, may get high marks for how well it treats its employees and, simultaneously, display a bad record in adopting green practices in its business model.

To overcome the standards gap, central banks have to complement the traditional ratings with their own evaluation of the assets’ “color.” Some central banks, such as the Bundesbank, already have internal credit-rating systems that incorporate climate financial risks. While assessing investment risks internally, central banks must follow clear parameters to assure equal treatment to issuers. Internal standards are also essential to avoid legitimation of “greenwashing,” providing central banks with mechanisms to identify false or misleading environmental information about the use of the proceeds of the bonds.


In a 2019 survey conducted by the NGFS, 25 out of 27 central banks or regulators reported the adoption of sustainable and responsible practices in their investment approaches or a plan to do so. The results of the survey show that central banks have started to protect their portfolios against the financial effects of climate change. But central banks’ acquisition of green bonds or disinvestment from dirty bonds is not equivalent to the government’s direct funding of green initiatives. The central banks’ move is instead primarily motivated by the need to improve their portfolios’ risk-return profiles.

By following the growing demand for ESG-compliant investments, moreover, central banks communicate their belief that the private sector is adequately pricing risks when financing corporations committed to environmentally friendly practices. With that, central banks can, within their legal authority, enhance the positive effects of government initiatives aimed at a sustainable transition to a greener economy.

Central banks, therefore, can be a part of the public policy action against climate change and in favor of environmental progress. As a first step, they must acknowledge that sustainability concerns are now inseparable from all investment decisions, including those regarding their asset portfolios.


Juliana B. Bolzani is a lawyer at the Central Bank of Brazil and an SJD student at Duke Law School. The views and opinions expressed here are hers and do not reflect the position or policy of any of the institutions with which she is affiliated. For comments, please contact

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