How can we better understand the threat that climate risk poses to financial stability?
This commentary explains a new way to measure how the scope and speed of the economic transformation needed to mitigate climate change and the associated credit risk vary across sectors, jurisdictions and time.
The question of how exactly climate change will impact banks has been a contentious issue. Certainly, the economic transformation required to achieve net zero targets will be profound and could generate sizable costs for unprepared sectors and companies. These costs could significantly affect firms’ cash flow and valuations, undermining their ability to service and repay their debt, and eventually leading to higher probability of defaulting and greater credit risk. There is already some evidence that credit risk is influenced by transition risk – i.e. the risk that results from changes in climate policy, technology and consumer and market sentiment during the adjustment to a lower-carbon economy.
However, whether climate risk is actually a threat to financial stability has been subject to ongoing debate. Findings from a regulatory report published by the European Central Bank in 2021 suggest that banks’ probability of default will likely see only a mild climate-driven increase over the long haul. And in the ECB’s report on ‘good practices for climate stress testing’ of December 2022, it highlighted the magnitude of credit risk impact must be measured at the most granular level to account for the varying impact of climate-related transition risks, reflecting how exposure to climate risk varies significantly from region to region, from industry to industry, and from year to year.
Establishing how lenders differently perceive polluting and clean firms’ exposure to ‘carbon risk’
We have developed a way to use Credit Default Swap spreads to examine these issues. A Credit Default Swap (CDS) is a type of derivative that transfers the credit exposure of fixed income products. We have used CDS spreads to construct a forward-looking, market-implied carbon risk factor. We study how, where and when carbon risk will affect firms’ creditworthiness by examining whether firms’ exposure to carbon risk is reflected in the market price of their CDS contracts.
CDSs offer several advantages over other commonly used credit risk measures, such as corporate bonds (or ratings). First, CDSs respond more quickly to changes in market conditions than alternative financial debt and credit products, because CDS contracts are traded on standardised terms. Second, CDSs are usually more liquid than corporate bonds. The third crucial advantage is that, since there are CDS contracts with varying tenors up to 30 years, using them enables us to incorporate lenders’ collective forward-looking considerations into our analysis. As such, CDS spreads provide a unique window for viewing the effect of carbon risk through the lens of lenders’ perceptions of carbon risk.
Looking at daily median CDS spreads, we identify how the lenders’ market perceives the differential exposure of polluting and clean firms to carbon risk – i.e. the impact of unexpected changes in the scope, timing and speed of greenhouse gas emissions mitigation policies. When a rise in carbon risk is triggered by a policy event (e.g. an announcement that regulations are to be tightened), lenders to more exposed firms demand more protection, i.e. their demand for CDS increases. In contrast, those that lend to less exposed firms demand less CDS because these firms’ credit exposure decreases. This widens the gap between the price of default protection for polluting and clean companies. Conversely, if a loosening of regulation is expected, the distance narrows or may even close up. The carbon risk factor thereby represents changes in perceived exposure to carbon risk on a very granular level.
Variations in risk exposure across regions, sectors and time
Our study bears out the fact that exposure to climate risk varies significantly from region to region. We find that lenders’ perceived exposure to carbon risk and firms’ cost of default protection is significantly stronger in Europe – which is notably pro-carbon regulation – than in North America.
We also find that exposure to carbon risk varies substantially across industries. There is a high sensitivity to carbon risk in the CDS spreads of the classic carbon-intensive sectors (e.g. energy, basic materials and utilities), while the market seems to regard other sectors (industrials, technology and healthcare) as capable of making the necessary adjustments to facilitate a low-carbon transformation. These latter sectors therefore suffer less from a surge in carbon risk.
On the temporal dimension, we examine how a rapid acceleration of the transformation is likely to have significant financial impacts in the near future and, consequently, a faster decline in credit quality in the nearer versus longer term. In Europe, our findings suggest that the market perceives carbon risk to be a short- to medium-term risk – i.e. over the next four years. This result is of particular relevance for central banks and speaks to the debate about carbon risk and its time horizon, and the pertinence of monetary policy adjustments. Collateral in monetary policy operations is generally pledged for short periods only. Authorities have been debating a lot whether and how they should adjust their monetary policy strategy to take climate risks into account. In this context, if carbon risk is exclusively a long-horizon issue, central banks might be less concerned with carbon risk and associated consequences, such as stranded assets. Our results suggest something different: through the critical credit risk channel, climate-related transition risk can have short-term consequences.
While there is a growing consensus among policymakers and supervisors that climate change poses real financial risks, the adequate quantification of physical and transition risks remains a major challenge due to an unprecedented combination of impacts in the short- and medium-to-long-term horizon inherent in climate risk.
Our findings complement and extend the initial work from the Basel Committee on Banking Supervision, which concluded that transition (and physical) risks can be captured in traditional financial risk categories such as credit risk.
We hope our results on how carbon risk varies in time can contribute to the current debate on how to close gaps in the regulatory framework and address systemic aspects of climate risk. This might result in the need to introduce possible adjustments to cater for the special features of transition risks: for example, to require banks to estimate Probability of Default, taking into account future changes in the expected temporal materialisation of carbon risk.
Read more about the authors’ research in the new Grantham Research Institute working paper ‘Carbon default swap – disentangling the exposure to carbon risk through CDS’.
The views in this commentary are those of the authors and do not necessarily reflect those of the Grantham Research Institute.