The pricing of carbon risk in syndicated loans: which risks are priced and why?

Summary

Focus

Do banks price the risks of climate policy change? We combine syndicated loan data with carbon intensity data (CO2 emissions relative to revenue) of borrowers across a wide range of industries. With this data, we study whether banks charge a "carbon premium". Firms with higher carbon intensity are at risk to suffer penalties if stricter climate policies, such as carbon taxes, are introduced. Hence, banks should be charging higher rates for firms with a higher carbon intensity.

Contribution

The pricing of "stranded assets" in the fossil fuel industry has received early attention in the literature. We argue that carbon risks go beyond stranded assets and apply to firms in all industries with a carbon footprint. We analyse emissions directly attributable to the firm (scope 1), those more broadly measured to include indirect emissions from consumed energy (scopes 2), as well as those including emissions from production inputs ("upstream" scope 3).

Findings

We find that carbon risks in the syndicated loan market are priced consistently both across and within industry sectors – after the Paris Agreement. Our results suggest that banks have started to internalise possible risks from the transition to a low-carbon economy – but only for the risks captured by the narrowly defined scope 1 carbon emissions. The overall carbon footprint of firms (including scopes 2 and 3) has not been priced. Further, the price of risk we find for scope 1 emissions is low relative to the expected financial hit to firm revenues from an introduction of carbon prices at plausible levels. Neither do banks that signal they are green nor do de facto green banks appear to charge a higher carbon premium.

Abstract

Do banks price the risks of climate policy change? Combining syndicated loan data with carbon intensity data (CO2 emissions relative to revenue) of borrowers across a wide range of industries, we find a significant "carbon premium" since the Paris Agreement. The loan risk premium related to CO2 emission intensity is apparent across industries and broader than that due simply to "stranded assets" in fossil fuel or other carbon-intensive industries. The price of risk, however, appears to be relatively low given the material risks faced by borrowers. Only carbon emissions directly caused by the firm (scope 1) are priced, and not the overall carbon footprint including indirect emissions. "Green" banks do not appear to price carbon risk differently from other banks.

JEL-classification: G2, Q01, Q5.

Keywords: environmental policy, climate policy risk, transition risk, loan pricing.