Central banks are increasingly incorporating climate change and environmental, social, and governance (ESG) considerations across their mainstream activities – from bank supervision to monetary policy and financial stability; according to a recent report by Invesco.
More than one-third of the world’s central banks are linking policies and reserve asset management to the environment as membership of the Network for the Greening of the Financial System (NGFS) multiplied 10-fold in the last three years to over 80 central bank members. NGFS membership also includes supervisory authorities, of which Abu Dhabi Financial Services Regulatory Authority and Dubai Financial Services Authority are members.
“Institutional investors and asset managers globally have been integrating ESG objectives into investment management since the issuance of the UN Principles for Responsible Investment (UNPRI) in 2006,” said Zainab Kufaishi, Head of Middle East and Africa, Invesco. “From a financial perspective, we have seen that incorporating ESG considerations has the potential to improve risk-adjusted returns by identifying medium-to-long-term exposures that could impact a company’s fortunes.”
The One Planet Sovereign Wealth Fund Coalition, of which the Abu Dhabi Investment Authority, Kuwait Investment Authority, and Saudi Arabia Public Investment Fund are founding members, has assisted SWFs looking to integrate policy and ESG factors into the investment management process since 2017.
Central banks’ investment activities are gradually following suit. In the Invesco 2020 study of global sovereign asset managers, about a quarter of the central banks surveyed responded that central bank balance sheets should be used to mitigate climate change. The central challenge of climate risk and potential disruption to domestic commerce, international trade, and global financial markets as the result of rising global temperatures has been a factor considered by central bankers and reserve managers. As much as monetary policy is becoming increasingly concerned with the growth and financial stability risks posed by ESG challenges, central bank practices are still evolving.
Central banks have moved more slowly as they face some distinct challenges while seeking to incorporate ESG factors, depending on reserve management objectives, policy framework, or asset class composition. Central banks that hold foreign currency reserves to mitigate the impact of economic shocks will have less leeway due to liquidity and capital preservation requirements, whereas other central banks may have more degrees of freedom.
“The principles and practice of reserve management are evolving as reserve managers have been working to overlay ESG objectives onto traditional investment objectives of capital preservation, liquidity and return,” said Arnab Das, Global Market Strategist at Invesco EMEA. “Incorporating ESG considerations into investment criteria can play an important part in the prudent protection of a country and economy from potential ravages of climate change, loss of biodiversity and other natural resources that form the wealth of nations.”
Central bank strategies to incorporate ESG criteria have fallen into three categories – exclusionary screening, investment integration, and impact investing. Exclusionary screening is the most widely used because of its simplicity to screen and exclude sectors or companies from the investment universe based on ethical, moral, or scientific beliefs. Investment integration seeks to incorporate ESG considerations to improve risk/adjusted returns as well as societal benefits. Impact investing places policy outcomes alongside financial outcomes.
Fixed income securities issued by sovereigns, government agencies, and supra-nationals constitute the greater part of central bank reserves. Though the size of the sustainable bond market, including green bonds, has grown rapidly in recent years, the investable universe for central banks is generally smaller as only about half of the market would fall into “traditional” reserve asset classes including sovereigns, government agencies, and multilaterals.
Growth is expected to continue as many sovereigns announce plans to increase issuance in the coming years, which will help improve liquidity – a key factor in central bank reserves. While the market is developing, Invesco’s study found that central banks invest simply through a green “tilt” by replicating risk characteristics of an underlying sustainable benchmark, or by incorporating ESG factors into an external manager dedicated mandate with a socially responsible investment monitoring process.
“In many ways, central banks are now in a position to take the lead in setting the ESG agenda, the standards, and enforcement mechanisms,” Das continues. “Both through monetary policy decisions and policy portfolios, central banks can focus as much on reducing national and global climate risk as they seek to regulate, manage or reduce the risks of economic and financial instability. Incorporating ESG considerations into investment criteria can play an important part in the protection of a country and its economy.”