Winta Beyene: University of Zurich, Manthos D. Delis: Montpeillier Business School, Kathrin de Greiff: Swiss Finance Institute, Steven Ongena: University of Zurich
Fossil fuel investments over the past few years are at the centre of political debates about climate change policy. This article explores the role market- and bank-based debt play in the climate transition process. It presents evidence that fossil fuel firms increasingly substitute bonds for syndicated bank loans, when banks price the risk of stranded assets less than the bond market.
Capital investment decisions are critical in shaping the nature and pace of the climate transition and the role of the financial sector is central to the process. Fossil fuel resource extraction is capital intensive and firms in the energy industry traditionally run highly leveraged balance sheets. The two primary sources of debt for firms are public bonds and private bank loans. Hence, bond markets and banks can either play an important role in facilitating continuing fossil fuel investments or, contrarily, play a decisive role in channelling funds away from the fossil fuel sector.
The transition to a low-carbon economy creates credit risks for the financial sector because it limits the extraction and use of fossil fuel resources by companies to which banks and bondholders may have credit exposures. As governments move to more strictly control carbon emissions and fossil fuel divestment campaigns gain traction, the partial stranding of oil, gas, and coal assets becomes increasingly likely. With this growing risk, lenders are expected to first respond by requiring a higher interest rate – to compensate for the increased risk of default – and eventually to exclude the riskiest fossil fuel sector borrowers.
The relevance of debt financing for the fossil fuel sector and the imminent risk of stranded assets suggests that both bond and bank financing would be directing investments away from fossil fuel. However, market-based finance might be better placed than bank-based finance to facilitate this climate transition. Literature shows that bank sector development does not spur growth in innovative-intensive industries, but it has a significant effect on growth in industries with high external financing dependence (Brown et al. 2017). Furthermore, the greater cyclicality of bank lending compared to bond financing, and their high leverage, makes banks more prone to systematically mispricing credit risk before financial crises (Langfield and Pagano, 2016).
Similarly, banks may be less likely to cut fossil fuel financing compared to bond markets as long as the value of carbon assets does not sharply slump; either because existing fossil fuel exposures incentivise banks to delay the liquidation of fossil fuel loans or because banks are less sensitive to stakeholder pressure to account for environmental issues.
We investigate fossil fuel firms’ composition of external financing alongside their risk of stranded assets. We use firm-level data that includes fossil fuel firms raising new corporate bond or syndicated bank loan financing from 2007 to 2016 with maturity of at least one year and look at the bond-over-total debt ratio, which compares the total amount raised through bonds in a given year to the total amount of syndicated bank loan and bond funds borrowed in that year. The measure is organised as a panel of firm-year observations and captures firms’ partial substitution from bonds to syndicated bank loans and vice versa. Firm-year observations, where neither syndicated bank loans nor bonds were issued, are excluded to rule out lack of demand for either type of credit (Ruggiero, 2018; Becker and Ivashina, 2014). Since a fossil fuel firm’s stranded assets can’t be observed, we follow Delis et al. (2019) and substitute the risk of stranded assets through a firm-level risk measure – climate policy exposure. This is based on the quantity of fossil fuels a firm holds within a specific country and this country’s potential willingness to implement stricter climate policies. To measure a country’s climate policy stringency, we mainly use the Climate Change Policy Index (CCPI) by Germanwatch (Burck et al., 2016).
Conditional on the issuance of new debt, firm-level controls and aggregate loan supply indicators, we interpret firms’ (partial) switching from bonds to loans with the increasing risk of stranded assets as a contraction in bond supply relative to syndicated bank loan supply.
In Figure 1 we illustrate along the left y-axis the predicted average marginal effect of climate policy exposure on firms’ choices between bond and syndicated bank loan financing. The bar figure shows that fossil fuel firms can substitute between bonds and loans as a response to changing climate policy exposure. The average bond-over-total-debt ratio of firms across all sectors, as illustrated by the horizontal red line in the figure, is at approximately 21%.
The choice between bond and bank debt is a function of supply. We find that changes in the credit supply to fossil fuel firms are reinforced by the pricing of climate policy exposure in bonds and syndicated bank loans. This is consistent with previous literature, which suggests that changing relative costs between different forms of financing require a rebalancing of the firm’s debt structure (e.g. Rajan, 1992).
Figure 1 also illustrates on the right y-axis the average marginal effect of climate policy exposure on bond and syndicated bank credit (AISD) spreads from 2007 to 2016. Newly issued bonds in the fossil fuel industry have higher yields than syndicated bank loans, and with increasing climate policy exposure, bond markets earn a higher premium relative to the syndicated bank loan-implied credit spread.
This differential in the pricing of climate policy exposure attracts fossil fuel firms with climate policy exposure to pursue syndicated bank loans rather than bonds. However, data that focuses on the post-2015 period—after the Paris Agreement, when climate issues became more acute—suggests that banks have started to price the risk of stranded assets, possibly diminishing the bond-to-loan substitution effect (Delis et al. 2019).
The monitoring role of banks, generally, should be rewarded in more precise expectations embedded in loan prices. Despite this, the differential in the pricing of climate policy exposure implies that banks have been disregarding the actual likelihood that environmental policies will lead to assets being stranded to a larger extent.
The substitution from bonds to syndicated bank loans indicates the relative extent to which banks are a source of misallocation during the climate transition. We draw two conclusions. First, market discipline, on its own, seems to be more effective in driving bondholders, rather than banks, to price the negative externalities associated with the risk of stranded assets. Second, it is important to recognise debt heterogeneity when looking at how to reduce the financing of carbon-intensive activities. A substitution mechanism between bond and bank financing, or even within the banking industry, between financing by banks with different stances towards the climate transition, could potentially mitigate the capital constraints on fossil fuel firms imposed by the bond market or some environmentally friendly banks.
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Becker, B., & Ivashina, V. (2014). Cyclicality of credit supply: Firm level evidence. Journal of Monetary Economics, 62, 76 - 93.
Burck, J., Hermwille, L., & Bals, C. (2016). Ccpi background and methodology (Index Methodology). Germanwatch and Climate Action Network Europe.
Brown, J.R., Martinsson, G., & Petersen, B.C. (2017). Stock markets, credit markets, and technology-led growth. Journal of Financial Intermediation, 32, 45–5.
De Haas, R., & Popov, A. (2019, September). Finance and carbon emissions (Working Paper Series No. 2318). European Central Bank. Retrieved from https://ideas.repec.org/p/ecb/ecbwps/20192318.html
Delis, M., Greiff, K. D., & Ongena, S. (2018). Being stranded on the carbon bubble? Climate policy risk and the pricing of bank loans (SFI Research Paper 8-10). University of Zurich.
Langfield, S., & Pagano, M. (2016). Bank bias in Europe: effects on systemic risk and growth. Economic Policy,31(85), 51-106.
Rajan, R. G. (1992). Insiders and outsiders: The choice between informed and arm’s-length debt. The Journal of Finance, 47 (4), 1367-1400.
Ruggiero, F. (2018). Loan to bond substitution: An empirical analysis on the functioning of the substitution channel for Eurozone firms (Working Paper. Available at SSRN: https://ssrn.com/abstract=311816