11 June 2024
Many countries are attempting to reach net-zero targets through carbon pricing measures, such as taxes on carbon emissions or cap-and-trade systems, which can add significant financial pressures on businesses. As such, this transformation will involve significant costs, which could substantially impact businesses' financial health. Specifically, the costs associated with this shift could negatively affect firms' cash flows and valuations, thereby undermining their ability to service and repay their debts. This could affect the credit risks and the likelihood of defaults among affected firms.
Climate change poses two main types of risks to businesses: physical and transition risks. Physical risks arise from direct damage caused by extreme weather events to infrastructure, property, and business operations. Transition risks, on the other hand, result from the changes in climate policy regulations, advancements in technology, and shifts in consumer and market sentiment as the economy adjusts to a lower-carbon model. We focus on the second risk.
Previous studies have shown that climate regulation risks, as indicated by firms' carbon emissions data, influence credit risk. However, these studies often do not clarify whether and how these emissions are regulated by carbon policies. Our research (link below) documents that the impact of carbon regulations on firms' credit risk is determined by the policies' scope, stringency, and the pace at which they mandate carbon transformation. These factors collectively shape the actual financial implications of carbon pricing policies, extending beyond mere emission levels or emission intensity of firms.
Understanding the drivers of carbon risk exposure is crucial as it directly influences how lenders assess and re-evaluate firms' creditworthiness. Firms perceived as more exposed to carbon risk tend to see their valuations decrease, whereas those deemed less exposed might witness an increase in their valuations. Qualifying and quantifying the effect of these drivers form the core of our analysis in “Carbon Default Swap – Disentangling the Exposure to Carbon Risk Through CDS”.
Building on the understanding that firms may adapt to regulatory and transition changes at different times and at varied paces, we posit that lenders incorporate these differences into their valuation of firms. To explore this premise, we employ the daily spreads of Credit Default Swap (CDS) contracts to construct a market-implied, high-frequency, and forward-looking carbon risk (CR) factor.
The CR factor is constructed as the difference between the daily median CDS spreads of high-emission-intensity (polluting) firms and low-emission-intensity (clean) firms. This difference helps identify how the lenders' market perceives the differential exposure of polluting and clean firms to carbon risk. When policy events, such as the announcement of tightening regulations, trigger a rise in carbon risk, lenders to more exposed firms demand increased protection, widening the CDS wedge—the distance between the price of default protection for polluting and clean companies. Conversely, if a loosening of regulation is expected, there is a narrowing of the wedge. The CR factor thus captures the perceived general carbon risk. By construction, the financial performance of this factor mimics the dynamics of a lending portfolio in which default protection is bought for a polluting firm and sold for a clean firm.
We then introduce a series of hypotheses aimed at identifying the drivers behind the impact of carbon price regulation, assessing their relevance, and quantifying their influence. Using daily CDS data for more than 280 firms in Europe and North America from 2013 to 2019, we investigate how firms' CDS spread returns change in response to variations in the CR factor. We find that an increase in the market's perception of carbon risk leads to an increase in CDS spread returns. For instance, considering a European 5-year CDS contract with a notional value of USD 100 million and a spread of 100 basis points (equivalent to a yearly premium of USD 1 million), a one standard deviation increase in carbon risk exposure results in lenders demanding an additional USD 0.21 million annual credit protection on this CDS contract.
We find that increased perception of carbon risk exposure generally leads to higher default protection costs, yet the magnitude of this effect varies significantly by region. Specifically, the influence of carbon risk on CDS spread returns is more pronounced in Europe compared to North America—a disparity attributable to the distinct carbon pricing regulations in each area. Europe employs explicit carbon pricing mechanisms, such as the European Union Emission Trading System (EU ETS), whereas North America has largely utilized non-pricing emissions regulations. Nevertheless, a firm's carbon risk exposure is not solely determined by where it operates. Our findings show that the impact of carbon risk on CDS spread returns is also affected by the precise scope of the regulation. Firms subject to direct carbon pricing face an estimated additional annual cost of USD 0.35 million for a one standard deviation increase in carbon risk—almost thrice the impact on firms outside direct carbon pricing frameworks. This holds across both Europe and North America, underscoring the influence of direct carbon pricing on perceived exposure to carbon risk. The lending market, with its inherently forward-looking approach, shows a keen sensitivity to these substantial regulatory differences, adapting its assessment of carbon risk based on the nature of firms' regulatory exposure.
Our analysis also reveals that the impact of carbon pricing on perceived carbon risk exposure is influenced by the share of a firm's direct emissions regulated by carbon pricing—the stringency of the carbon policy in question. Firms with a significant portion of their emissions covered by carbon pricing show a heightened responsiveness to changes in the CR factor. This is observable in both Europe and North America, with the effect being notably stronger in Europe. A 1% increase in the proportion of emissions under regulation translates to an estimated additional annual cost of USD 0.24 million for every USD 100 million of exposure in Europe, and USD 0.11 million for every USD 100 million of exposure in North America. These findings highlight the critical role of carbon policy stringency.
The literature finds that the effect of carbon risk becomes more pronounced when considering exposures that are specific to certain industries. Consequently, we explore whether the regulatory coverage of a specific sector’s emissions amplifies the effect of carbon risk on CDS spread returns. Our findings suggest that lenders consider firms within the carbon-intensive sectors of Basic Materials, Utilities, and Energy as carrying increased risks. As carbon regulations become more stringent, these sectors are likely to face rising operational costs, adversely affecting their financial stability and credit ratings. Indeed, our findings show that a one standard deviation rise in the CR factor equates to an additional estimated financial impact of USD 0.23 million for European firms in Basic Materials, with this impact being more than two times higher for Utilities and more than eight times greater for Energy. This underlines the escalating financial implications that tighter carbon regulations, aimed at achieving net-zero ambitions, would have for these sectors.
Finally, we find that carbon risk is influenced not only by the scope and stringency of regulations but also by the expected speed of the transition towards a low-carbon economy. By analyzing the relationship between the term structures of CDS spreads and carbon risk, we show that an increase in carbon risk leads lenders to foresee higher costs for short-term transitions. This expectation is manifested through a more pronounced rise in CDS spreads for shorter tenors relative to longer ones, signaling a market anticipation of immediate financial implications stemming from increased carbon regulation. Such findings carry profound policy implications for central banks, particularly in relation to monetary strategies aimed at cushioning the potential negative impacts of a disorderly transition. A disorderly transition is characterized by abrupt repricing of risks and the risk of assets becoming stranded. Our analysis suggests that re-pricing activities, spurred by the anticipated quickening pace of carbon reduction initiatives, are expected to occur predominantly in the near future.
Read the full paper: Carbon Default Swap – Disentangling the Exposure to Carbon Risk Through CDS