NGFS publishes first green investment handbook for central banks

The network for greening the financial sector published what it calls the first ever handbook for central banks on ecological investment today (October 18).

The NGFS was set up in December 2017 as a consortium of central banks and regulators aiming to make finance more ecologically-minded. It initially had eight central banks and regulators as members. Membership has now grown to 46 official bodies, with a further nine as observers.

The new handbook is the work of the third of the NGFS’s three “workstreams”. Each workstream comprises central bank and regulator officials carrying out research on how to reform significant ways that the financial sector works. Workstream three, headed since April 2019 by the Deutsche Bundesbank’s Sabine Mauderer, is examining how to bring green finance into the mainstream.

Mauderer and the Netherlands Bank’s Frank Elderson, who is the NGFS’s chairman, said the handbook was based on a “comprehensive portfolio-management survey among our members on how they integrate sustainability factors”.

The handbook offers various approaches to Sustainable and Responsible Investment, or SRI, for central banks. It argues that central banks face restrictions that other large investors do not, including their need to stick to policy mandates. “It is up to each central bank to determine whether an SRI objective could be adopted without prejudice to its mandate”, the handbook says.

In order to preserve liquidity, central banks, largely buy supranational and high‑grade sovereign debt with short duration. Sustainable investement “is less straightforward for these asset classes”, the handbook notes.

Central banks seeking to run an SRI regime may also face challenges from their need to preserve independence and maintain confidentiality, the handbook says. Transparency is seen as a key factor in building up a green portfolio, but many central banks are limited in what information they can disclose.

But despite these pressures, many central banks have already built up strong SRI portfolios, the handbook argues. The network’s survey shows “shows that 25 out of the 27 respondents have already adopted SRI principles in their investment approaches, or are planning to do so”.

The survey’s results indicate that there is some way to go before even most of the more environmentally aware banks that have joined the NGFS make specific commitments on climate change. The principles adopted by the NGFS members that responded to the survey “range from broad environmental, social, and governance (ESG) considerations (60% of the survey respondents) to climate‑specific focuses (16%)”, the handbook says.

The handbook takes a detailed look at five possible SRI strategies. Negative screening is the exclusion of companies or entire sectors which are responsible for negative environmental or social impacts.It is often seen as a first step towards a full SRI portfolio, the handbook says. But it cautions that excluding all companies from a sector may prevent investors from engaging with firms and moving them away from their bad practices.

A “best in class” strategy involves selecting assets either on the basis of positive screening or via the creation of weightings to judge how much an asset is compatible with ESG goals. This kind of strategy “offers a relatively easy  SRI solution for central banks”, the handbook notes, but is also highly dependent on ESG ratings. “This could be a drawback as long as issues with ESG data persist,” the handbook notes, and details a number of problems with such ratings.

A strategy of “ESG integration” involves the inclusion of “all financially material ESG-criteria” to a central bank’s investment analysis. But the handbook notes that identifying “financially material ESG criteria is not straightforward, as these tend to vary across industries, geographical locations and over time.

These strategies are quite common among investors in shares. But for fixed income investors, “ESG integration is still in its infancy, partly because the extent to which ESG criteria impact credit ratings is not straightforward”.

Impact investing sees investors trying to generate positive, quantifiable environmental and social impacts alongside their financial returns. Some parts of central banks’ portfolios are better suited to this kind of strategy than others, the handbook says.

Finally, a voting and engagement strategy involves an investor using its voice to push the firms it has invested in towards environmentally and socially desirable policies. Such a strategy “may be feasible as long as it does not undermine the central bank’s independence or lead to a conflict of interest”, the NGFS notes. The handbook includes a case study showing how the Bank of Switzerland used a proxy voting policy to purse environmentally and socially responsible goals without compromising its independence.

Most of the central banks of the world’s largest economies’ have joined the NGFS, with the notable exception of the Federal Reserve and other US regulators. Other countries’ central bank officials who work on NGFS initiatives have said that they understand that Fed officials face strong political pressures not to engage with the network.