Central banks are finally putting their money where their mouth is when it comes to sustainable financing, opening up a new source of demand for the budding asset class.

The European Central Bank has been buying the debt as part of its asset repurchase programme. Hungary and France’s central banks have each created funds dedicated to ecological investments. Now Peru is considering buying green bonds, too, central bank President Julio Velarde said in an interview in Washington earlier this month.

While many central banks offer incentives to lenders to finance environmentally sustainable projects, they’ve hesitated to buy the debt amid liquidity concerns and vague guidelines as to what makes a bond truly green. Those hurdles are falling as issuance ramps up and market participants increasingly collaborate on standards, making the asset class ripe for investment by reserve managers overseeing nearly $12 trillion.

“Central banks are important institutional investors, and the fact that they are participating in this market, it gives the market almost like a seal of reliability and maturity,” said Christian Deseglise, global head of central banks and global sponsor of sustainable finance at HSBC Holdings Plc, the biggest underwriter of the bonds this year.

“It’s not so much about adding demand, because we already have demand,” he said. “It’s the quality of that demand that’s really important.”

Most major central banks have signed on to promote sustainable growth, offering incentives that encourage green financing. While the Federal Reserve, with nearly $4 trillion on its balance sheet, is notably absent from the Network for Greening the Financial System, regional branches have published research on the topic, and Chairman Jerome Powell maintains that it’s a “longer-run issue.”

However, central banks have been slower to incorporate climate-change risks in their investment frameworks, partly because there aren’t many specific policies that discourage the buying of non-eco-friendly assets, according to ECB Chief Economist Philip Lane.

But there are signs that central banks are warming up to the idea of buying green bonds, the largest category of sustainable debt by dollar volume. The Bank for International Settlements, often referred to as the central bankers’ central bank, started an open-ended fund for central bank investments in green bonds last month. That could help set more uniform standards for the investments, the BIS said.

It already seems to be working. A recent survey of central banks showed that almost all of the 27 respondents said they have already adopted sustainable and responsible investment principles in their portfolio management or are planning to do so. The ECB may embrace the idea even more under incoming president Christine Lagarde, though there’s not enough eligible debt to make much of a meaningful near-term impact, according to Mahesh Bhimalingam, chief European credit strategist at Bloomberg Intelligence.

Three central banks have approached Morgan Stanley in recent weeks and asked the New York-based lender to find securities for them in both the primary and secondary markets, according to Navindu Katugampola, Morgan Stanley’s head of green and sustainable bonds.

In Peru’s case, the central bank said it will look to buy green bonds that the country’s government is preparing to issue for the first time.

Going mainstream

However, pricing and liquidity are still limiting factors. As green bonds become more mainstream, investors are offered little additional incentive to buy them as they price comparably to non-green debt. Also, with sustainable bonds making up just a fraction of the broader fixed-income market, that could be a concern for central banks, which look for easily tradeable investments, according to Massimiliano Castelli, head of sovereign strategy at UBS Asset Management.

“As soon as the green-bond market becomes sizeable you’ll see central banks investing more in green bonds,” Castelli said earlier this month as part of a panel called Greening the Financial System and Monetary Policy, hosted by UBS in Washington.

While still small, sustainable financing is growing. There’s been $165 billion of green-bond issuance from companies and countries this year — more than double 2016’s total — according to data compiled by Bloomberg. And with new entrants like PepsiCo Inc. and Verizon Communications Inc. popping up, the market for environmentally and socially responsible debt will grow to about $1 trillion by the first half of 2021, according to HSBC.

“Central banks are already buying green bonds and they should be buying more,” said Ulrich Volz, Director of the SOAS Centre for Sustainable Finance in London. “But at the end of the day, we need a mainstreaming of responsible investing across all assets.”

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