Too big to run aground? Bond financing versus bank financing in the transition to a low carbon economy
One of the concerns in the climate change debate is whether financial flows help reduce emissions. This column examines the role of bond and bank debt in allocating resources to fossil fuels in the context of stranded asset risk. The authors show that banks continue to provide financing to fossil fuel companies that the bond market would not fund until they assess the risk of stranded assets. In this context, the risks associated with stranded assets may have shifted to the big banks.
In the ongoing debate on the need for a transition to a low-carbon economy and the actions that should be taken by central banks, financial authorities and governments, the role of bank and bond financing is paramount. Financiers could play an important role in diverting funds away from fossil fuels and polluting types of activities and investing in greener activities (Caselli et al. 2021). However, fossil fuels still dominate energy investments, and in particular, banks still show an unwavering interest in fossil fuel projects (e.g. RAN 2020, Pinchot and Christianson 2019, Delis et al. 2018). A major concern in the transition to a low-carbon energy supply is therefore to steer investments away from fossil fuels.
In light of this, there is a real risk that large investments in fossil fuel companies will decline in value and lead to bad debts when climate policies finally tighten (Löyttyniemi 2021). Stranded asset risk – the risk of revaluing carbon-intensive assets as a result of this transition to a carbon economy – needs to be reflected in the cost of debt of fossil fuel companies to offset the risk. increased default.
In a recent article (Beyene et al. 2021), we examine the potentially different roles of market-based credit versus bank credit in the allocation of resources to fossil fuels. To do this, we study the cost of financing corporate bonds by fossil fuel companies versus financing syndicated bank loans, and the resulting composition of these two types of debt based on the risk of these fossil fuel companies. to see part of their assets blocked. Following the observation that bank financing on average has not decreased with stricter climate policies, we study the question of whether the risk of stranded assets is increasingly concentrated on a few large risks for some large banks?
Our dataset consists of corporate bonds and syndicated bank loans issued from 2007 to 2017 by companies that gained access to both markets during that time period. The risk of stranded assets of fossil fuel companies is represented by the variable ‘climate policy exposure’, which is constructed as the product of the stringency of a country’s climate policy and the relative amount of a country’s reserves. business in this country. The relative reserves of companies that we collect manually from company balance sheets, and to measure the stringency of a country’s climate policy, we mainly use the Germanwatch Climate Change Policy Index (CCPI) (Burck et al. . 2016). Big energy companies are going to have reserves in different countries, and those reserves are going to be exposed to differential stringency in climate policy, which the exposure to climate policy captures. While the financial literature on the subject of carbon emissions risks has largely focused on company-level emissions, focusing on the holdings of fossil fuel companies in fossil fuel reserves, and the risk thereof. follows, is closer to the root of the problem. . Much of the global stock of carbon emissions can be attributed to a small set of fossil fuel companies (Ilhan et al. 2020).
The analysis takes place in four parts. First, we examine the pricing of the risk of stranded assets of fossil fuel companies by the corporate bond market and by banks. We find that newly issued corporate bonds in the fossil fuel sector have higher yields than syndicated bank loans, and with increasing exposure to climate policy, bond markets earn a higher premium over the spread. implicit credit union bank loans. Second, we show that fossil fuel companies shift from issuing bonds to obtaining bank loans as their exposure to stranded asset risk increases. Third, we show that bond-bank substitution is unlikely to result from differences between banks that underwrite corporate bonds and banks that underwrite syndicated bank loans, and ultimately from a resulting difference in the quality of the borrower. To do this, we collect information on lead banks, combine the loan and bond sub-samples, and construct a dataset in which we observe that the same banks engage in corporate bonds and corporate bonds. syndicated bank loans as a lead in order to control for the underwriter. Fourth, we examine whether banking characteristics related to bank size can influence banks’ response to risk impulses from stranded assets in terms of lending and risk taking. We find that for all syndicated loans, the large lead banks charge a lower overall spread than the small banks, and therefore there is a migration to the larger lead banks alongside the lending. exposure to climate policies of fossil fuel companies.
Figure 1 Credit allocation towards fossil fuels
Figure 1 is an illustration of some parameters of fossil fuel debt and summarizes our findings. We assume that an increase in exposure to climate policies implies an increase in the expected loss. Therefore, to cover the expected loss on a debt, the lender must charge a higher interest rate. However, we conclude from our findings that for at least the big banks, the expected gains from increased investment today may still, in some ways, outweigh the expected loss due to the risk of stranded assets. Therefore, while the corporate bond market requires rBond, which to some extent represents the risk of stranded corporate assets, banks only require rLoan. Therefore, this differential in pricing stranded asset risk implies that banks will continue to fund fossil fuel projects that the corporate bond market would not fund, as the red zone shows. The same figure can be applied to illustrate the migration of risk from stranded assets to large banks within the banking industry.
The level of fossil fuel financing by the world’s largest banks remained higher in 2020 than in 2016, the year immediately following the adoption of the Paris Agreement (RAN 2020). Our findings add to the limited literature on the impact of stranded asset risk on the cost of (banking) financing of businesses and provide empirical evidence for this narrative that there is a migration of stranded asset risk. fossil fuels from markets to (big) banks. Regarding the risk of stranded assets and debt, our article provides the following new information:
- Market discipline alone appears to be more effective in inducing bondholders, rather than banks, to assess the negative externalities associated with the risk of stranded assets.
- The ability of large banks to hold large exposures to companies with stranded asset risks may prevent investments from being diverted from fossil fuels.
- A substitution mechanism between bond and bank financing, or even within the banking industry, could potentially ease the capital constraints imposed on fossil fuel companies by the bond market or some more “green” banks.
Burck, J, L Hermwille and C Bals (2016), “CCPI Context and Methodology”, Germanwatch and Climate Action Network Europe.
Beyene, W, M Delis, K DeGreiff and S Ongena (2021), “Too big to be stranded? Bond financing versus bank financing in the transition to a low carbon economy”, CEPR Working Document 16692.
Caselli, F, A Ludwig and R van der Ploeg (eds) (2021), No headache and fruits at hand in national climate policy, CEPR Press.
Delis, M, K DeGreiff and S Ongena (2018), “The Carbon Bubble and Bank Lending Pricing,” VoxEU.org, May 27.
Ilhan, E, Z Sautner and G Vilkov (2020). “Carbon tail risk”, The Financial Studies Review 34 (3): 1540-1571.
Löyttyniemi, T (2021), “Mainstreaming Climate Change in the Financial Stability Framework”, VoxEU.org, 08 July.
Pinchot, A and G Christianson (2019), “How Are Banks Performing on Sustainable Finance Commitments? Not Good Enough, ”World Resource Institute, October 3.