By Laura Starks, George Kozmetsky Centennial Distinguished University Chair and Professor of Finance, McCombs School of Business, University of Texas at Austin
Corporate environmental and climate risks are now an important factor in financial decision-making. Bond pricing and credit ratings change in line with evolving environmental risks, particularly climate risks, and portfolio managers, asset owners and corporate managers are paying attention.
In our research, my coauthors, Lee Seltzer and Qifei Zhu, and I wanted to drill down into this area, looking specifically at climate regulatory risks and corporate bonds. Do these risks affect credit ratings and yield spreads, and to what extent?
A deep dive on corporate bonds
We chose to examine the effects on corporate bonds for two reasons. For corporations raising funds in financial markets, the bond market, rather than the equity market, can be considered the marginal source of their financing. In addition, for most firms, climate and environmental risks are fundamentally downside risks, and research has shown downside risk to be the strongest predictor of future bond returns.
We also looked at the relationship between credit ratings and firms’ exposures to climate or environmental regulatory risks. Our evidence suggests that uncertainty about future regulatory actions can motivate investors and other bond market participants to pay more attention and respond to firms’ environmental performance, and particularly to changes in firms’ exposures to climate risks. For example, poor environmental performance or having a more significant carbon footprint is associated in general with lower credit ratings and higher bond yield spreads. Moreover, this correlation is heightened for firms operating in states with stricter environmental regulations.
How the Paris Agreement affected bonds and ratings
To gain a better understanding of how changes in regulatory risk can affect bond credit ratings and pricing, we examined how the Paris Agreement signing in December 2015 acted as a shock to the regulatory risk environment for US corporations and their existing bonds. Achieving the Paris Agreement goals would require new regulations. However, the nature of these regulations was not explicitly determined at the time, which increased uncertainty for corporates regarding their timing and stringency. We also expected that the effects on prices and ratings would be stronger if the firms were in states with stricter regulatory regimes.
We tested whether the Paris Agreement negatively affected the outstanding bonds of issuers with poor environmental profiles. (A poor environmental profile was where the firm had a below median environmental profile, high carbon emissions or high carbon intensity or was in one of the top 15 carbon-emitting industries.) This setting was ideal for mitigating endogeneity in examining the impact of climate regulatory risk on bond ratings and pricing because the Agreement is exogenous to firm fundamentals.
In preliminary analysis, we examined the credit ratings for the top 15 highest carbon-emitting industries, before and after the Paris Agreement. The figure below shows the results, where the bars on the left represent the equal-weighted industry average credit rating from December 2014 through November 2015 and the bars on the right represent the averages from December 2015 through November 2016. The numerical ratings correspond to credit rating quality where a higher number corresponds to a higher credit rating, i.e., the relative credit quality of the bond. A numerical rating of 5 corresponds to a Caa2 rating, a rating of 10 to a Ba3 rating, 13 to a Baa3 rating, and a rating of 20 to a Aa2 rating, where a rating above Baa3 is considered investment grade.
Figure 1: Credit ratings of high carbon emission industries’ bonds before and after the Paris Agreement
As can be seen here, for most of the 15 highest carbon-emitting industries, the average credit rating fell after the Paris Agreement, which is consistent with the hypothesis that credit rating analysts were concerned that the Agreement would result in increased regulatory risk for high-emissions companies.
We found similar results if we used the firms’ environmental scores. As shown below, credit ratings fell for most of the environmental score groups, particularly for those firms that had low environmental scores.
Figure 2: Credit ratings by firms’ environmental scores before and after the Paris Agreement
We also examined yield spreads for the 15 highest emissions-emitting industries before and after the Paris Agreement, as shown in the figure below. Similarly, we found that, for most industries, the average spread increased around the Paris Agreement, and this pattern was repeated if we used the firms’ environmental ratings.
Figure 3: Yield spreads of high carbon emission industries’ bonds before and after the Paris Agreement
To control for other factors that could have affected credit ratings and yield spreads, such as firm profitability or the strength of the economy the firm operates in, we conducted ‘a differences-in-differences analysis’. This approach allowed us to get as close to a lab-experiment as possible, by identifying a group of bonds expected to be especially exposed to the Paris Agreement, and examine how credit ratings and yield spreads changed for them compared to a control group of other bonds during the same time period.
In the below figure, the vertical red line represents the month of the Agreement (December 2015) and the horizontal line spans from December 2014 through November 2016. The higher the numerical score, the better the credit rating.
Figure 4: Bond credit ratings around the Paris Agreement
As the figure indicates, there were no significant differences or trends regarding credit ratings before the Paris Agreement. In contrast, after the Agreement, there was a significant difference between firms in high-emission industries versus other firms: credit ratings dropped by about 0.6 for bonds from the top 15 emitting industries relative to others in the five months after the Paris Agreement. We found the same types of results if we used other measures of firms’ exposure to climate regulatory risk changes caused by the Paris Agreement, such as being a firm with high carbon emissions, high carbon emissions intensity or low environmental scores.
Overall, the Paris Agreement appears to have increased the regulatory risks for firms that are in high-emission industries or have generally poor environmental performance, resulting in negative consequences for their bonds.
Importantly, these effects on bond ratings and yields are observed to be stronger for firms operating in states that enforce regulation more strictly.
Political change affects bond markets
We also found some reversals of these results in 2016 and 2017 when political circumstances in the US changed. Former US president Donald Trump had promised during his presidential campaign that the US would withdraw from the Paris Agreement and after the presidential election there was some reversal in yield spreads. There was further reversal in credit ratings following the official withdrawal announcement in June 2017.
The results suggest that credit rating analysts and bond investors are concerned with issuers’ environmental profiles in part because of potential regulatory costs. Therefore, if bond investors expect an issuer to be punished for poor environmental performance, they are more likely to price those costs into the firms’ bonds.
Climate risks will not be going away. We would estimate that bond prices and spreads will remain sensitive to evolving regulation, and that this sensitivity will increasingly factor into financial decision-making.
Learn more about the PRI’s Credit Risk and Ratings Initiative.
The PRI’s academic blog aims to bring investors insights from the latest academic research on responsible investment. It is written by academic guest contributors. Blog authors write in their individual capacity – posts do not necessarily represent a PRI view.