Banks underpricing carbon risk in syndicated loans

IFR 2386 - 05 Jun 2021 - 11 Jun 2021
5 min read
Americas, EMEA, Asia
Tessa Walsh

Banks are massively underestimating the carbon risk in syndicated loans as they only consider direct Scope 1 CO2 emissions rather than looking across companies’ whole carbon footprint, according to research from the Bank for International Settlements.

Scope 1 and 2 emissions cover assets that companies own or control directly plus their own energy consumption and are a fraction of each company's totals. Most emissions come from indirect Scope 3 emissions arising from companies’ value chains and how customers use their products.

The research finds that banks have been including a "carbon premium" in loans since the 2015 Paris Agreement to limit global warming to 2 degrees or less, but that that premium is relatively small and would not cover the hit to company revenues if a carbon tax is introduced.

“Banks' view on carbon risk is still relatively narrow,” the report said.

The report doesn't say so directly but implies that a move to price-in broader CO2 emissions to more accurately reflect reality could further affect the availability and cost of credit – and even create issues of financial stability for banks exposed to borrowers with high emissions.

The analysis calculates that banks have priced in a carbon risk premium of 3bp–4bp since 2016, rising to 7bp for high-emitting companies (those with a carbon intensity of more than 1,000 tonnes of CO2 per US$1m of revenue).

“The price of carbon risk in the syndicated loan market since 2016 is low relative to the material risks,” the report said.

Pressing issue

The most pressing risk is the potential introduction of carbon taxes. The report finds that carbon emissions are material, or even severe, for around 30% of companies with high carbon intensity, and a carbon price of US$100 per tonne of CO2 (as a result of the introduction of a carbon tax) could knock 1 percentage point off their revenue margins. Around 10% of companies have ultra-high emissions intensity, and the same level of carbon pricing could account for at least 10% of their total revenues (possibly much more), which is unlikely to be covered by the current 7bp premium.

The report also finds that banks that describe themselves as green do not yet appear to be pricing risk differently from other banks, although there is some evidence that they are screening out companies with high carbon exposure.

The research measures carbon intensity – carbon emissions relative to revenue as a proxy for carbon risk – and has combined annual emissions carbon data with syndicated loan data from 2005–2018.

The data set covers US$1.4trn of loans from 567 companies in 31 countries that finance new investments or projects and excludes loans for refinancing and buyouts. It analyses all-in pricing, including fees, on loans with maturities of more than a year, excluding financial institutions.

The report calls on regulators to redouble their efforts to ensure institutions are prepared for the higher levels of carbon pricing implied by the Paris emission reduction goals, and central banks to take the risks into account in their own monetary operations, such as credit provision, collateral policies or asset purchases.

“Regulators and supervisors of financial institutions should design incentives to ensure regulated participants fully internalise the environmental impact of their activities,” the report said.

Opaque pricing

Loan bankers IFR talked to about the report questioned whether the pricing data used could be skewed by a relatively high proportion of emerging markets borrowers (which have higher loan pricing), particularly as lower European investment-grade loan pricing is usually not disclosed.

They also said that investment-grade loan pricing does not directly reflect credit as banks effectively use relationship lending as a loss-leader to win more lucrative business.

“I’m a bit nervous of how this is extrapolated; it’s dangerous to draw conclusions as investment-grade pricing in Europe now is almost opaque. I’m just a bit cautious,” a senior loan banker said.

Bankers point to a general tightening of bank capital rules since the financial crisis of 2007–08 and questioned whether the post-2015 effect could be attributed more to the oil price crash of 2014–16 rather than the Paris Agreement, although the BIS research says it has ruled that out. “The main results did not change when controlling for oil prices,” the report said.

Most banks are currently assessing prospective lending clients from a more general sustainability point of view, and are asking internally whether they want to bank those industries and sectors, rather than analysing individual companies' footprints directly, in part due to a lack of information.

That conversation is just beginning, but is expected to accelerate as banks and companies are forced to disclose more information, which will make banks pay greater attention to environmental considerations.

“Today, I don't see anyone going to credit and asking what the carbon footprint of a credit is. We don’t know a company’s CO2 footprint and whether to charge 5bp more – yet,” the senior loan banker said.

Distribution of carbon intensity