When green meets green: Environmental risk-pricing by banks

Climate change is threatening the future of the globe. Extreme weather conditions have attracted the interest of policy makers, who urge the need to take action. The UN Climate Change Paris conference in December 2015 put forward a limit of a 1.5°C increase in average global temperatures relative to those prevailing before the Industrial Revolution. This limit can only be reached by drastically cutting carbon emissions. The transition to a carbon-neutral economy requires raising the environmental consciousness of firms and banks. We therefore ask how bank financing can contribute to reaching the global climate objectives.

In our recent paper (Degryse et al. 2021), we investigate whether and how the environmental consciousness (“greenness,” for short) of firms and banks is reflected in the pricing of bank credit. Using a large international sample of syndicated loans, we find that firms are indeed rewarded for being green in the form of cheaper loans — but only when borrowing from a green consortium of lenders and only after the ratification of the Paris Agreement . Hence, we find that environmental attitudes matter when “green meets green.”

Our empirical analysis requires proxies for the greenness of banks and firms. We classify a firm as green if it voluntarily reports to the Carbon Disclosure Project, an investor-oriented nonprofit initiative to facilitate and standardize disclosure of a firm’s environmental impact. Firms reporting to the Carbon Disclosure Project are expected to have better in-house capabilities to measure and manage their exposure to the green transition of the economy, which can be viewed as evidence of their environmental consciousness.

Banks are classified as green if they are members of the United Nations Environment Programme Finance Initiative, which aims to “mobilize private sector finance for sustainable development.” Since its creation in 1991, more than 160 banks have joined the Initiative. There is evidence that the Initiative’s signatory banks can issue green bonds with a premium because they can more clearly signal their environmental attitudes in lending (Fatica et al. 2019).

Using these proxies, we analyze the price information of syndicated loans using a comprehensive international syndicated loans database for 2011–19. Our results suggest the presence of a statistically and economically significant “green meets green” effect. We estimate that green firms enjoy an additional discount of 35-38 basis points when borrowing from green banks rather than from nongreen (“brown”) ones.

We further examine whether the Paris Agreement, which was reached on December 12, 2015, affected the relationship between the banks’ and firms’ environmental attitudes and loan credit spreads. While the green-meets-green effect is insignificant before the Paris Agreement, it is statistically and economically significant after the agreement.

In particular, the “after the Paris Agreement” subsample shows that green banks offer green firms a discount of about 60–69 basis points relative to brown firms . Overall, the green-meets-green effect is intimately linked to the changes brought about by the Paris Agreement. We further confirm this with a difference-in-difference-in-differences regression model.

Why would the Paris Agreement have such a large indirect impact on lending terms, and why is this restricted to green banks? The Paris Agreement can be interpreted as a shift in the perception of climate transition risks, both by firms and by banks. Much of the difficulties in managing risk related to climate change are attributed to the highly uncertain real impacts of climate change and the endogenous nature of future policy shocks that affect the transition to a low-carbon economy (Campiglio et al. 2018). However, shifts in public opinion could lead to political pressure to strengthen environmental regulation, which could harm firms that do not anticipate such shocks.

For example, in May 2021 Royal Dutch Shell, a major player on the oil and gas market, was ordered by a Dutch court to cut its carbon emissions faster, overruling the firm’s own transition plans. This signaled to the market an increased likelihood that the judiciary system would become involved in climate issues in the future.

We develop a stylized theoretical model to explain why a robust green-meets-green pattern has emerged after the Paris Agreement. We argue that heightened perception of the carbon transition risk — following the world leaders’ resounding commitment to a carbon-neutral future — may have incentivized a subset of banks (green banks) to engage in third-degree price discrimination with regard to firms’ greenness, resulting in an equilibrium in line with our estimated green-meets-green pricing patterns.

As the expectation of a regulatory shift — and the probability of a negative shock — increases, so does the firms’ and banks’ equilibrium environmental attitudes. In an uncertain environment prone to sudden equilibrium shifts, there is a strong emphasis on public events that anchor expectations and coordinate the behavior of economic agents.

The Paris Agreement, as the world’s first comprehensive climate agreement, raised public awareness of climate-related risks and increased policy makers’ commitment to stricter enforcement of climate policy. This shifted investors’ perception of climate transition risk, therefore materially influencing equilibrium prices.

Recent research argues that countries that rely on capital markets more than on banking are more forthcoming in dealing with climate change (De Haas and Popov 2018). Our findings, however, show that (at least parts of) the banking systems may also be conducive to the transition as banks are favorably pricing loans to green firms relative to brown firms. This holds when banks have a similar environmental consciousness — our “green-meets-green effect.” Putting climate change on the agenda through the Paris Agreement has fostered this attitude.

References

Campiglio, E, Y Dafermos, P Monnin, J Ryan-Collins, G Schotten and M Tanaka (2018), “Climate change challenges for central banks and financial regulators,” Nature Climate Change 8(6): 462–68.

De Haas, Ralph and Popov, Alexander A., Finance and Green Growth (July 12, 2018), EBRD Working Paper No. 217.

Degryse, H, Goncharenko, R, Theunisz, C and Vadasz, T (2021), “When green meets green,” SSRN Working Paper.

Fatica, S, R Panzica and M Rancan (2019), “The pricing of green bonds: Are financial institutions special?” JRC Working Papers in Economics and Finance.