Bond versus bank finance in the transition to a low carbon economy
Too big to be stranded? Bond versus bank finance 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 market-based and bank-based debt in the allocation of resources to fossil fuels in relation to the risk of stranded assets. The authors show that banks continue to provide financing to fossil fuels that the bond market would not finance as long as they do not price in the risk of stranded assets. In this environment, the risks from stranded assets may have shifted to large banks.
In the ongoing debate about the need for a transition to a decarbonised economy and the actions to be taken by central banks, financial authorities and governments, the role of bank and bond market finance is paramount. Donors could play an important role in diverting funds away from fossil fuels and polluting activities and investing in more environmentally friendly activities (Caselli et al. 2021). However, fossil fuels still dominate energy investments, and banks in particular continue to show an unwavering interest in fossil fuel projects (e.g. RAN 2020, Pinchot and Christianson 2019, Delis et al. 2018). Therefore, a major concern in the transition to a low carbon energy supply is to divert investment away from fossil fuels.
Against this background, there is a real risk that large investments in companies with fossil fuels will lose value and lead to bad loans when climate policy is finally tightened (Löyttyniemi 2021). Stranded asset risk – the risk associated with revaluing high carbon assets as a result of this transition away from a carbon economy – needs to be reflected in fossil fuel companies’ debt costs to offset the increased risk of default.
In a recent paper (Beyene et al. 2021) we examine the potentially different roles of market-based and bank-based credit in the allocation of resources to fossil fuels. To do this, we examine the cost of corporate bond financing for fossil fuel companies versus financing syndicated bank loans and the resulting composition of these two types of debt based on the risk that these companies have of having some of their assets stranded. Following the observation that, on average, bank financing has not decreased with a stricter climate policy, we are investigating the question of whether the stranded assets risk at some big banks is increasingly concentrated on a few large loans?
Our data set consists of corporate bonds and syndicated bank loans issued from 2007 to 2017 by companies that had access to both markets during that period. The risk of stranded assets of companies with fossil fuels is represented by the variable “Climate Policy Exposure”, which is constructed as the product of the strictness of a country’s climate policy and the relative level of a company’s reserves in that country. We collect the relative reserves of companies manually from company balance sheets, and to measure the rigor of a country’s climate policy, we mainly use the Climate Change Policy Index (CCPI) by Germanwatch (Burck et al. 2016). Large energy companies will have reserves in different countries, and these reserves will be subject to different climate policy rigors, which will be captured by Climate Policy Exposure. While the financial literature on carbon emissions has largely focused on corporate-level emissions, the focus on companies’ fossil fuel stocks and the resulting risk is closer to the root of the problem. A large part of global CO2 emissions can be traced back to a small group of companies that mainly use fossil fuels (Ilhan et al. 2020).
The analysis is carried out in four parts. First, let’s consider how the corporate bond market and banks are pricing the risk of fossil fuel companies’ stranded assets. We find that newly issued corporate bonds in the fossil fuel industry have higher returns than syndicated bank loans, and as the exposure to climate change increases, the bond markets deserve a higher premium than the implied credit spread of syndicated bank loans. Second, we show that fossil fuel companies move from issuing bonds to taking out bank loans as their stranded asset risk increases. Third, we show that interbank bond substitution is unlikely to result from differences between banks that write corporate bonds and banks that write syndicated bank loans, and ultimately a resultant difference in the quality of borrowers. To do this, we collect information on lead manager banks, combine the credit and bond subsamples, and create a dataset that observes the same banks taking corporate bonds and syndicated bank loans as lead managers to control for the underwriter. Fourth, we examine whether bank characteristics related to bank size can influence banks’ response to the risk impulses in stranded assets in terms of lending and risk-taking. We find that large banks acting as lead managers charge a lower all-in spread on all syndicated loans than small banks, and consequently there is a migration to the largest lead manager banks along corporate climate policies fossil fuels.
illustration 1 Fossil fuel credit allocation
Figure 1 illustrates some parameters of fossil fuel indebtedness and summarizes our results. We assume that an increase in the climate policy commitment means an increase in the expected loss. Therefore, to cover the expected loss on a debt, the lender must apply a higher interest rate. However, we conclude from our findings that, at least for large banks, the expected gains from an increased investment today can to some extent compensate for the expected loss due to the risk of stranded assets. Therefore, while the corporate bond market requires rBond, which takes into account the risk of corporate stranded assets to some extent, banks only need rLoan. Thus, this difference in pricing stranded asset risk implies that banks will continue to fund fossil fuel projects that the corporate bond market would not fund, as visualized by the red zone. The same figure can be used to illustrate the migration from stranded asset risk to large banks within the banking sector.
Fossil fuel funding from the world’s largest banks remained higher in 2020 than in 2016, the year immediately after the Paris Agreement (RAN 2020) was passed. Our results complement the limited literature on the impact of stranded asset risk on corporate (banks) refinancing costs and provide empirical evidence for this narrative that the risk of stranded fossil fuel assets moves away from markets and towards (large -) Banks are migrating. On the subject of Stranded Assets Risk and Debt, our paper provides the following new insights:
- Market discipline alone appears to be more effective than banks in causing bondholders to price in the negative externalities associated with the risk of stranded assets.
- The ability of large banks to have large exposures to companies at risk for stranded assets can prevent fossil fuel investments from being turned away.
- A substitution mechanism between bond and bank financing, or even within the banking sector, could potentially ease capital constraints on fossil fuel companies imposed by the bond market or some “greener” banks.
Burck, J, L Hermwille and C Bals (2016), “CCPI Background and Methodology”, Germanwatch and Climate Action Network Europe.
Beyene, W., M. Delis, K. DeGreiff and S. Ongena (2021), “Too-big-to-strand? Bonds versus Bank Finance in Moving to a Low Carbon Economy, ”CEPR Discussion Paper 16692.
Caselli, F, A Ludwig and R van der Ploeg (Eds.) (2021), No jokes and no low-hanging fruit in national climate policy, CEPR press.
Delis, M., K. DeGreiff and S. Ongena (2018), “The Carbon Bubble and the Pricing of Bank Loans”, VoxEU.org, May 27.
Ilhan, E, Z Sautner and G Vilkov (2020). “Carbon tail risk”, The review of financial studies 34 (3): 1540-1571.
Löyttyniemi, T (2021), “Integrating Climate Change into the Financial Stability Framework”, VoxEU.org, July 8th.
RAN (2020), Banking on Climate Change, Fossil Fuel Financial Report 2020.
Pinchot, A and G Christianson (2019), “How are banks doing with sustainable finance commitments? Not Good Enough, ”World Resource Institute, Oct. 3.