The term structure of carbon premia

BISWorkingPapers No1045 Thetermstructureofcarbonpremia byDoraXiaandOmarZulaica MonetaryandEconomicDepartment October2022 JELclassification:G12,G30,Q54. Keywords:climatechange,carbonemissions,corporatebondspread,termstructure. BISWorkingPapersarewrittenbymembersoftheMonetaryandEconomicDepartmentoftheBankforInternationalSettlements,andfromtimetotimebyothereconomists,andarepublishedbytheBank.Thepapersareonsubjectsoftopicalinterestandaretechnicalincharacter.TheviewsexpressedinthemarethoseoftheirauthorsandnotnecessarilytheviewsoftheBIS. ThispublicationisavailableontheBISwebsite(www.bis.org). ©BankforInternationalSettlements2022.Allrightsreserved.Briefexcerptsmaybereproducedortranslatedprovidedthesourceisstated. ISSN1020-0959(print) ISSN1682-7678(online) Thetermstructureofcarbonpremia DoraXiaandOmarZulaica1 Abstract Thispaperexploresacarbonpremium–theextrayieldinvestorsdemandtobuybondsissuedbyfirmswithmoregreenhousegasemissions–intheUScorporatebondmarket.Weanalyseacarbonpremiumalongtwochannels,viapanelregression.Oneisthepreferencechannel,underwhichthepremiumreflectsinvestors’preferenceforfirmsthattheyperceiveasbeingmoreenvironmentallyresponsible,allelseequal.Theotheristheriskchannel,whereinvestorsperceivemorecarbon-intensivefirmsasmorepronetodefault.Wetestthepreferencechannelbyinvestigatingtherelationshipbetweencorporatebondyieldsandcarbonemissions,whilecontrollingfortheprobabilityofdefault(PD)andotherbondcharacteristics.WeexaminetheriskchannelbyanalysinghowcarbonemissionsaffectthePD.Wevalidatetheexistenceofcarbonpremiainbothchannels,withthepremiumbeinglargerforfirmsinmoreenergy-intensivesectors.Moreover,thepremiumdiffersacrossmaturities,givingrisetoahump-shapedtermstructureofcarbonpremia,reachingitshighestlevelatthebellyofthecurve(maturitiesof15–20years).Forinstance,a50%reductionincarbonemissionsbyanenergy-intensivefirmcanreducecreditspreadofabondinthebellyissuedbythefirmbyover10basispoints. JELclassifications:G12,G30,Q54 Keywords:climatechange,carbonemissions,corporatebondspread,termstructure 1Theauthors(dora.xia@bis.org,omar.zulaica@bis.org)wouldliketothankPierreCardon,StijnClaessens,IngoFender,MarkMason,FrankPacker,MichelaScatigna,HyunSongShin,IlhyockShim,participantsoftheBISResearchMeetingandtheBankingDepartment’sReserveManagementSeminarforhelpfulcommentsandAdamCapandAlbertoAmericoforexcellentresearchassistance.TheviewsexpressedarethoseoftheauthoranddonotnecessarilyreflectthoseoftheBIS. 1.Introduction Itisanemergingconsensusthattransitioningtheglobaleconomytoalow-carbongrowthpathisessential.Asmoregreenhousegases(GHGs)areaccumulatedintheatmosphere,globaltemperatureswillcontinuetorise,withsomeoftheresultingeffectsbeingirreversible(IPCC(2022)).Globalwarmingcatalysesthefrequencyandintensityofnaturaldisasterssuchasdroughtsandstorms.Indeed,inthepastthreedecades,adverseweathereventshavebecomemorefrequentonthebackofhigherglobaltemperatures.Theseextremeweathereventsoftencausewidespreadlossesanddamagetonature,humankindandeconomicactivities.2 Pricingthistransition,investorswilllikelydemandcompensationforinvestinginfirmswithhighercarbonfootprints.3Why?Investorsseemtoagreeoncarbonemissionsasareasonableproxyforgaugingtheexposuretoclimate-relatedtransitionrisk.4Andtheymaydemandhigheryieldsforfinancingcompaniesthatwillbeaffectedbythetransitionfromfossilfuelstorenewableenergy,forexample,therebygivingrisetoacarbonpremium.5 Anycarbonpremiummayencapsulatethefollowingtwochannelsatwork.Thefirstoneisthepreferencechannel,reflectingthatinvestorscommittedtosupportingsustainablegrowthmighthaveapreference,allelseequal,forfirmsthattheyperceiveashelpingtoachievethisgoal.Seenconversely,investorsmaydislikethesefirmsbecausetheyaremoreharmfultotheenvironment.Thischannelcapturesaspectsoftheinvestmentprocesssuchasnegativescreening,whichexcludesfirmsthatscorepoorlyonenvironmentalfactorssuchasGHGemissions(ElsenhuberandSkenderasi(2019)). Thesecondisthecreditriskchannel(orshorthand,the“riskchannel”),whereinvestorsperceivemorecarbon-intensivefirmsasmorepronetodefault.6Thisisbecausethesefirmsarelikelytofacelargertransitionrisks,whicharerelatedtoregulatorypolicies,advancesintechnologyandchangesinconsumerpreferencesthatmayimpairtheirfinancialhealth.Thischannelcapturespracticesinbanksandcreditratingagencieswhichexplicitlytakeintoaccountenvironmentalfactors–suchascarbonemissions–inassigningriskgradesintheirscorecards. Itisimportanttoexaminehowmuchofacarbonpremiumispricedinfinancialassetsforatleasttworeasons.Ontheonehand,becausefinancialmarketscansupportthetransitiontoamoresustainableeconomybyreallocatingtheirresourcestowardseconomicactivitiesthatfosterit,evaluatingtheextenttowhichthisreallocationhasaffectedassetpricingiscrucial.Naturally,apreconditionforthismechanismtoworkisthatinvestorsdifferentiatebetweenfinancialassetsthatfundactivitieswithdifferentdegreesofenvironmentalimpact.Ontheotherhand,climatechangecanhaveasubstantialimpactonfinancialstability(Boltonetal(2020)).Forinstance,ifcarbonriskisnotsufficientlypricedin,financialassetsarevulnerabletos