The CO2 Content of the TRLTRO III Scheme and Its Greening

Banks participating in the European Central Bank’s (ECB) targeted refinancing schemes “disproportionately” lend to more polluting sectors, according to this paper from the Grantham Institute at the London School of Economics. The authors explore how to design green targeted longer-term refinancing operations (TLTROs) to address the refinancing “carbon bias” and support price stability.

The ECB’s TLTRO programme aims to increase private lending to the real economy by offering banks long-term funding at favourable rates. The programme is executed by national central banks and applies better rates in proportion to the extent of lending to non-financial businesses and households. This paper focuses on the emissions profile of the second tranche of the third series of TLTROs, referred to as TLTRO III, in the period March 2020-2021.

The results show that existing TLTROs promote carbon-intensive lending which is misaligned with the ECB’s monetary policy objectives and “neglects” transition risks. Approximately 80% of loans went to high-emitting firms, while loans granted over the reference period funded 151 megatons of CO2, or 8% of the EU’s overall emissions in 2019. While TLTROs successfully increase lending to the real economy, this carbon bias exposes the ECB to substantial climate-related risks.

The authors – Chiara Colesanti Senni, Maria Sole Pagliari and Jens van ‘t Klooster – explore how the ECB can mitigate this through a precautionary green TLTRO programme. They use a general equilibrium model to analyse the effectiveness and financial implications of green credit easing.

The results show that central banks can effectively steer lending behaviour and support the low carbon transition by setting differentiated cost factors on bank loans that redirect funding towards less polluting activities. The authors say rates should be determined by the share of high-polluting firms in bank portfolios and the likelihood attached to transition by private agents.

The authors argue that, given the possible impact of green monetary policy on financial stability, the policy should be carefully designed to not prejudice the ECB’s flexibility in responding to changing inflationary conditions. They explain that higher interest rates for polluting sectors can go together with low rates for the rest of the economy, while a TLTRO programme can be implemented in concert with rising interest rates to “shield green investments” from higher financing costs.

The authors say that green TLTROs are “clearly permissible” within the ECB’s primary mandate, as climate shocks undermine monetary and financial stability. To ensure TRLTROs align with the ECB’s narrow mandate, they should support existing policies rather than engage in “autonomous policymaking”.

TLTROs should, they add, refer to the EU’s green taxonomy and disclosure regulations, and link funding to existing targeted financing, such as the REPowerEU action plan.

Finally, the authors propose three options for evaluating the climate-alignment of bank lending:

1. an EU policy-based design, based solely on existing EU criteria such as the EU Taxonomy
2. a bank-based design, where banks would decide on how green investments are
3. a supervisory expectations-based design, where central banks determine eligibility.