In his thesis, student Max Vullinghs studied the effect of enterprise carbon intensity on cost of debt, and tested whether forward-looking indicators are incorporated by lenders – and how lenders are encouraged to think sustainably. His study suggests that climate risks like over-reliance on fossil fuels, newly imposed regulations and changes in consumer preferences are indeed priced in by lenders.

Enterprises play a pivotal role in the transition towards the low-carbon sustainable economy that is needed to address climate change driven by excessive carbon emissions – which has become one of societies’ most urgent problems. Currently, the 100 most polluting enterprises are responsible for over 70 per cent of global emissions, and the top 20 polluters are accountable for more than a third of global emissions.

The 2015 UN Paris Agreement formed a framework for a collective approach to undertake the biggest threats the climate is facing, and 196 parties adopted it. However, their intentions have not yet led to the desired results.

Extra incentives needed?

It’s thought that enterprises need extra incentives to overcome the prevalence of short-termism and actively contribute to a greener world. Academics conducted research on the effects environmental performance could bring for investors and enterprises and found it can positively impact stock market performance, enterprise value and operating performance. Intuitively, as a result of better financial performance and less exposure to environmental risks, cost of capital should also benefit from becoming based on a more sustainable footing.

However, past research does not consistently confirm this belief. Max Vullinghs’ thesis investigated whether lenders incorporate carbon intensities into their lending decisions. He measured this as Scope 1 carbon emissions (direct emissions from owned or controlled sources),  and Scope 2 carbon emissions (indirect emissions from the generation of purchased and consumed power), divided by total sales.

More interestingly, Max’s study extends the literature on possible mitigating factors affecting this relationship by testing whether a carbon policy can benefit enterprises’ cost of debt because it demonstrates awareness and commitment of carbon risk mitigation that’s not visible in historic emissions. His study found that carbon intensity positively impacts the cost of debt for enterprises. The results suggest that climate risks such as over-reliance on fossil fuels, newly imposed regulations and changes in consumer preferences are priced in by lenders.

Max’s second finding in the study is that the penalty of an organisation’s historic emissions performance can be effectively mitigated by the demonstrated use of a carbon reduction policy. Consequently, implementing carbon reduction policies is encouraged by lenders, so it is important for enterprises to effectively channel incremental information to investors about their future carbon risk profile – this information needs too beyond their historical carbon intensity level. The benefits for financing costs for heavy emitters seeking to adapt their operations to a carbon-constrained future can be substantial. But replacing carbon policy for a carbon target, makes the mitigating effect disappear because lenders interpret carbon targets as not a viable action to reduce their climate risk exposure.

For further analysis and robustness of the results, Max examined sub-samples of enterprises separately. The results showed that carbon risks were only priced in after the Paris Agreement and not before. A result of the Paris Agreement was that (Dutch) governmental climate policy became stricter. It is estimated that implementation of the proposed climate policies will leave fossil fuel reserves ‘stranded’, leading to a loss in their economic value and increasing enterprises’ risks. The trend of internalisation of climate risks by lenders and enterprises in Europe is increasing, but the effect remained invisible in the USA, even after the agreement. This could be partly explained by the presidency of Donald Trump, who is very sceptical of the human role in climate change, so the risk of governmental intervention was substantially smaller in the USA than it is in Europe. With new leadership in the USA, it will be interesting to test whether this will favourably influence lenders and enterprises.

The other tested sub-samples are based on the emissions profiles of the enterprises and the industry in which they operate. Testing the sub-sample of enterprises operating in high-emitting industries results in a significantly positive relation between carbon intensity and cost of debt that can be mitigated by carbon policy. This effect is invisible for enterprises in low-emitting industries. These samples therefore indicate that investors and enterprises should focus on issues material to the industry.

Not triggered

But Max’s study found that the opposite was true. His study found that carbon intensity does not increase cost of debt in a sample of the top 100 emitting enterprises. He says this is unfortunate because these are the enterprises which should be triggered to reduce their emissions as they are responsible for nearly 75 per cent of the total emissions. Debt markets can play an important role in the transition towards a more sustainable world by allocating its capital to the most efficient needs. A more widespread awareness by investors of the risks associated with heavy emissions, like stranded assets and physical risks, will be key to rightly incorporate these risks into future financing decisions.

Green Bonds

Lastly, Max’s study found a similar significantly positive effect between carbon intensity and the way that investors spread their bond investments in a sample of conventional and bonds that raise funds for projects that deliver environmental benefits, known as ‘green bonds’.. Interestingly, the ‘green’ label on a bond can mitigate this positive effect, similar to the effect of a carbon policy So carbon intensity has no effect on green bond spreads, and lenders perceive the issue of a green bond as a signal of commitment towards a more sustainable future instead of an attempt at greenwashing.

Issuing a green bond can be extra beneficial for enterprises that have relatively high historic carbon intensities. However, the results do not inevitably conclude that green bond issuers will benefit from reduced financing costs, because there are additional costs associated with their issue. Although the proceeds of the bonds are devoted to sustainable projects, they are not ring-fenced, and what’s more, undertaking a sustainable project does not mean that the overall enterprise becomes more sustainable, so it is still uncertain whether issuing a green bond effectively reduces exposure to climate risks.

More information

This is a blog from the Erasmus Platform for Sustainable Value Creation at Rotterdam School of Management, Erasmus University (RSM). The Platform aims to enhance knowledge and debate on sustainability in the financial sector. Curious to learn more? Please see our webpage.

Platform for Sustainable Value Creation blog