In June 2021, the Bank for International Settlements released its working paper entitled "The pricing of carbon risk in syndicated loans: which risks are priced and why?" (the "Study"). A sample of syndicated loans was analyzed in order to answer the question of whether lead lenders price "carbon risk" (described below) into syndicated loans and, if so, how.
The Study concluded that, while lenders have indeed been pricing carbon risk into syndicated loans since the Paris Agreement on climate change in 2015, the evidence suggest that lenders are not fully internalizing the full extent of carbon risk and are only pricing borrowers' Scope 1 emissions,1 thereby failing to price a borrower's complete carbon footprint. These conclusions are noteworthy for the business community generally and, in particular, for the project finance industry. At the same time, they should be viewed in the context of a dynamic and developing field of risk assessment, especially in the field of climate impact analysis.
Carbon risk is a financially material consideration which may manifest directly through an array of regulatory instruments, and indirectly as a result of investor and consumer expectations. A survey of international regulatory developments suggests that increased carbon risk is on the horizon. As the true cost of carbon becomes increasingly clear, it is likely that risk premiums reflecting carbon risk will increase, and that they will capture Scope 2 and Scope 3 emissions,2 including those in the supply chain. Some lenders may choose to avoid high risk firms and projects altogether, while regulators may increase their scrutiny.
For commercial actors, this means an increased focus on carbon risk (including in the supply chain) is imperative, as this risk may implicate everything from cost of borrowing, to access to capital more generally, to access to insurance, to social licence including regulatory barriers.
Carbon Risk: What is it and Why Does it Matter?
The Study broadly refers to carbon emissions that represent a source of financial risk as being "carbon risk". The authors argue that carbon risk may be financially material, as demonstrated by the following example using two key variables:
- Step 1: is to consider the carbon
intensity of a firm, defined as an amount of
emissions per $1 million of revenue.
- Step 2: is to consider a potential
cost of carbon. In this hypothetical, a
direct price on carbon imposed through government policy (i.e. a
carbon tax) is used.
- Result: If a price of $100/tonne CO2 is imposed, then a firm with a carbon intensity of 100 tonnes of CO2 per $1 million of revenue results in a 1% loss of revenue margin (i.e. an increased cost of $10,000 per $1 million) - an amount that is potentially material when it comes to assessing the firm's credit risk and pricing loans.
The example illustrates that even moderately carbon intensive firms face material financial risk where costs are imposed on emissions. Materiality is therefore premised on (a) firm behaviour; and (b) the imposition of a (direct or indirect) cost on carbon through government policy or otherwise. Each factor bears implications for both firms and lenders.
First, with respect to firm behaviour, carbon risk will be more material for firms who do not or cannot, depending on the nature of the project or service or overall business in question, reduce carbon intensity to a level where the effect of the cost of carbon is immaterial to the financial condition of that firm.
Second, a firm's direct and indirect carbon emissions constitute a source of financial risk insofar as a cost is imposed on carbon. Such a cost could be imposed directly, such as through carbon pricing regimes or regulatory initiatives that make carbon-emitting projects otherwise more costly, or indirectly, should climate-conscious investors reallocate resources to less carbon intensive firms, resulting in an increased cost of capital for carbon intensive firms, for example.
A firm's carbon intensity frequently falls into one of the following categories, which are neither exhaustive nor mutually exclusive:
- Ownership of "Stranded
Assets": Stranded assets are physical assets, in
extractive industries for example, whose value declines
substantially due to government policies enacted in respect of
- Direct Emissions: Firms with
relatively high emissions are at a high risk of financial
repercussions if environmental regulations tighten, or in the event
of market responses independent of government, such as customers,
suppliers, or other lenders refusing to do business with them.
Direct loss can result from the imposition of a carbon tax on a
firm's emissions Scope 1 emissions, for example.
- Supply Chain Emissions: Carbon risk is not limited to heavy direct emitters. Even if a firm's own Scope 1 emissions are relatively low, it may face material carbon risk if it has carbon intensive elements in its supply chain. Like other costs, it is reasonable to expect that the cost of carbon will be passed along the chain.
In each case the result is the same: carbon risk, no matter how it manifests, may be financially material to a firm. From a lender's perspective, this financial risk could then be material in assessing the credit-worthiness of the project and the firm.
Contextualizing Carbon Risk: Real World Developments
As noted, the materiality of carbon risk hinges partly on the cost of carbon. An international survey of regulatory developments demonstrates that an increased cost of carbon is likely and, in some jurisdictions, already a reality.
In its highly anticipated March 2021 decision, References re Greenhouse Gas Pollution Pricing Act, 2021 SCC 11, the Supreme Court of Canada (the "SCC") upheld the federal Greenhouse Gas Pollution Pricing Act ("GGPPA"), which sets national minimum standards of greenhouse gas pricing across the country. Pursuant to the GGPPA, the price of carbon emissions will progressively rise from CAD $40 per tonne in 2021 to CAD $170 per tonne by 2030, setting a clear floor on which carbon risk in Canada may be assessed. For more information on the SCC decision and Canada's carbon pricing regime, see our previous update here.
The EU has a "cap and trade" system (the "EU ETS"), under which a cap is set on the total amount of certain greenhouse gases that can be emitted by the installations covered by the system. Within the cap, installations buy or receive emissions allowances, which they can trade with one another. In such a system, the price of carbon necessarily fluctuates according to supply and demand.
The market price for carbon under the EU ETS has steadily risen to its current 2021 level and a recent survey of industry participants indicates an expectation that prices will rise significantly in the next decade due to more aggressive EU emissions targets and a lower cap on total permitted emissions. This expectation aligns with a sweeping ETS reform package proposed by the EU Commission in July 2021 as part of the European Green Deal.3
Also in July 2021, the EU announced details regarding its proposed Carbon Border Adjustment Mechanism ("CBAM"), a tariff designed to target imports from countries with less stringent environmental standards. The CBAM can be expected to impose a carbon-related cost on firms (including Canadian businesses) which sell affected products in the EU. This is likely to include commodities like steel and aluminum, as well as specific manufactured products, with the idea of maintaining an even playing field for EU firms subject to higher input costs resulting from higher domestic carbon prices.
Whether the United States will implement a price on carbon is less clear. Despite support from prominent Democrats including Janet Yellen, the Treasury Secretary, who stated during her Senate confirmation process that "[w]e cannot solve the climate crisis without effective carbon pricing", the Biden administration has not expressed a clear position one way or the other.
Nevertheless, a direct carbon price is not the only mechanism through which carbon risk can materialize. Any regulatory mechanism which directly or indirectly makes carbon emissions more expensive would pose a similar risk for lenders and would likely be reflected in a firm's cost of borrowing. For instance, vehicle emission standards impose an incremental cost of compliance. Another example is climate and other "ESG" disclosure, which is a current focus of the Securities and Exchange Commission (see our previous update on ESG and securities disclosures here).4 By requiring firms to report more transparently on carbon-intensive activities, avoiding the risk of negative investor or lender response (for instance, by finding ways to lower emissions) may also impose carbon-related costs.
In each of the above surveyed jurisdictions, it appears inevitable that the cost of carbon will increase, which, in turn, is likely to impact borrowers' carbon risk across industry sectors, and therefore the responses of lenders to these risks.
Carbon Risk as a Material Consideration in Syndicated Lending
Given that lead banks in a lending syndicate have an incentive to consider all relevant risks when pricing a loan, and given that carbon risk is expected to be financially material for many firms, lenders should be expected to price such risks. This hypothesis was tested by the authors of the Study.
Using carbon intensity as a proxy for carbon risk, the authors reviewed a sample of firms and analyzed the relationship between those firms' carbon intensities and the margin (the difference between the amount borrowed and the value of the collateral offered as security) contained in its syndicated loans. Several notable conclusions are reached:
- Carbon risk has been "priced in" to
syndicated loans since the Paris Agreement: Since the
Paris Agreement was signed in 2015, there is an observable and
statistically significant positive relationship between a
firm's carbon intensity and the margin contained in its
- Premiums are not industry driven: The study
suggests that lenders price carbon risk based on firms' actual
carbon emission intensities and not based on the perceived risk
facing the industry in which those firms operate.
- Current premiums are low relative to materiality of carbon risk: Current carbon risk premiums do not appear to fully internalize the risk of realistic carbon pricing regulations.
- Premiums are Limited to Scope 1 Emissions:
Potential financial risks from carbon emissions are not limited to
a company's direct emissions. For example, if a company uses
carbon intensive inputs in its supply chain, then an increase in
the cost of carbon and a resulting increase in the cost of a
firm's inputs would negatively impact the financial condition
of that firm. Despite this fact, the Study suggests that carbon
emissions indirectly caused by production inputs were not priced in
the studied loans, implying that lenders have not yet internalized
risks posed by firms' overall carbon footprint.
- "Green banks"5 do not price differently: The authors of the Study found no evidence that "green banks" put a higher price on carbon, though they do suggest that there is evidence showing that green banks screen out companies with high carbon exposure.
Implications for Project Finance
Given the evidence that carbon risk is now being priced into syndicated loans across all sectors, any firm that utilizes syndicated lending for financing purposes should be cognizant of this development. Further, we would expect that this trend will apply to unsyndicated loans as well.
In terms of specific commercial implications, the evidence to date indicates that:
- Because carbon risk is related to regulatory intervention,
existing risk premiums reflect anticipated regulatory developments.
In other words, the extent to which carbon risk is internalized
reflects the firm's and/or the market's current expectation
of what regulators will do; and
- The risk premiums which lenders can realistically charge are constrained by the fact that the market for debt (i.e. attracting business from borrowers) is a competitive industry. Lenders cannot be expected to internalize significantly greater levels of risk than their competitors will. However, assuming lenders become increasingly sensitive to rising carbon risks, one might expect premiums to rise in the market generally.
When viewed through this lens, some further implications for business can be drawn:
As the price of carbon increases, risk premiums should increase: Lending is a competitive market. Competition drives down the cost of capital, and necessarily the risk premiums that may be charged. However, when carbon risk and its price increase, all lenders and syndicates can be expected to increase their associated risk premium floors.
Lenders may move to internalize the risk of Scope 2 and 3 emissions: Currently, it may be difficult for lenders to price Scope 2 and 3 emissions in a competitive market for debt, as the potential impact of these emissions on the bottom line is less clear. Nevertheless, the financial materiality of Scope 2 and 3 emissions will likely present itself as the cost of carbon rises, suggesting that firms with carbon intensive supply chains will face increased carbon risk moving forward, even if their own practices are carbon-light.
Lenders may choose to avoid high carbon risk projects entirely: The Study revealed that "green banks" sometimes screen out high-intensity borrowers altogether. Moving forward, some mainstream lenders may also decide that reputational risks and pressure from activist shareholders and other sources (e.g. government, employees, lawsuits) are not worth the premiums which can be obtained on the market with respect to certain carbon intensive projects and firms.
Hesitancy by lenders to finance environmentally harmful projects is increasingly observable in practice. For example, Industrial and Commercial Bank of China, China's largest bank, recently abandoned a plan to finance a $3 billion coal-fired power plant in Zimbabwe, citing "environmental problems". Chinese lenders had already been seen as the last resort to secure funding for coal-plants in the region, as South African and European banks have come under increasing pressure from shareholders not to fund such developments.
Similar instances have become increasingly prevalent in the insurance industry. In Canada, a number of insurers refused to insure the Trans Mountain pipeline altogether,6 and those that had signed on to the project later opted to withdraw after pressure from climate activists.
As a result, even where firms may choose to absorb the cost of carbon through higher borrowing premiums, this will not compensate for scenarios where the project itself is deemed by lenders (and insurers) to be too risky.
Regulators may get (more) involved: Market forces constraining the ability of lenders to internalize material risks may be addressed by regulatory intervention. Should policymakers decide that lenders are not routinely pricing-in risks associated with the loans they originate, these regulators may seek to mitigate this potential risk to the financial system. Given that the risk is driven primarily by regulators themselves (i.e. through the imposition of carbon pricing and potential increases to the price), regulators may be eager to ensure that any resulting risk to the financial sector is alleviated. Should regulators act to mandate increased internalization of risk by lenders, borrowers will probably bear the associated increase in costs.
Arguably, the current widespread movement of requiring climate-related risk disclosures is one such intervention, albeit indirect. Greater disclosure allows the market, including lenders, to assess borrowers' carbon risk, enabling better calculation and internalization of that risk.
Existing evidence suggests that carbon risk is a financially material consideration to many firms, and that the manifestation of this risk is largely a function of public policy. As the Study demonstrates, the Paris Agreement ushered in a new era of public awareness related to climate change which has not gone unnoticed by the market. In anticipation of a regulatory response to the ambitious goals set by the Paris Agreement, the market has begun to price carbon risk into syndicated loans. As public and regulatory awareness of this risk continues to grow, commercial entities should expect a further and stronger response from the market.
This means an increased focus on firms' carbon risk (including in their supply chains) moving forward, which may implicate everything from cost of borrowing, to access to capital more generally, to access to insurance, to social licence for projects and investments. While the Study suggests that carbon risk is currently underpriced, businesses should bear in mind that carbon pricing in lending is a new development, and the ability to fully-price carbon risk is currently constrained by market forces along with regulatory uncertainty.
Market actors should not expect premiums to remain static, and should stay attuned to both regulatory developments and further shifts driven by changing consumer and investor expectations. As carbon risk is demonstrably not limited to firms in extractive industries with a number of "stranded assets", it should be on the minds of firms across all sectors, especially those seeking significant project financing.
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1 Scope 1 emissions are direct greenhouse gas emissions that occur from sources that are controlled or owned by an organization (e.g., emissions associated with fuel combustion in boilers, furnaces, vehicles). (U.S. EPA)
Scope 3 emissions are the result of activities from assets not owned or controlled by the reporting organization, but that the organization indirectly impacts in its value chain. (U.S. EPA)
5 "Green banks" are classified as those that have signed the Equator Principles or the United Nations Environment Programme - Finance Initiative (UNEP FI).
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