Climate Disclosures Heighten The Risk To Companies That Aren’t Planning Financing For Their Transitions Today

A new paper written by researchers at the Bank for International Settlements suggests that even before the Paris Agreement, banks provided less financing to companies with high emission volumes and emissions intensity. Their investigation focuses on Japanese banks, but provides an interesting comparison of the possible channels through which action on climate change influences financial markets, which is only expected to expand as emissions become more visible and as climate-related risks begin to impact the financial strengths of financial institutions.

The analysis looks at bank loans provided to listed Japanese firms and whether the degree of emissions or emissions intensity impacted the amount of loans they received. The impact was seen as being strongest in companies’ direct (Scope 1) emissions, where an increase of emissions by one standard deviation led to a 3% reduction in bank loans. For emissions intensity, the impact was similar, and in both cases this shows an economically meaningful reduction in access to finance for companies with higher emissions.

From this point, the authors try to identify what is driving the reduction of loans to higher-emissions companies. They look and find no evidence that the reduction is driven by the demand side, where higher-emissions companies demand less in loans. Often when they are increasing debt levels, they are replacing financing from banks with bonds instead. Another idea that is checked and discarded as lacking evidence is that companies with higher emissions require less debt to finance growth in fixed assets or rising sales.

The analysis continues to look at the factors motivating the banks themselves in how financing is offered. One of the most interesting conclusions is that banks with higher leverage and lower returns on assets are more sensitive to emissions than their stronger counterparts. This would suggest that decisions are being driven by credit risk concerns that are more acute for higher-emissions companies. This finding is reinforced by analysis that found no difference between the degree of sustainability disclosure at a bank and the reduction of loans to higher-emitting companies.

The backwards-looking view is of interest in highlighting that emissions have been considered an element of credit risk for a long time – certainly before the Paris Agreement was adopted in 2015. However, this viewpoint is only part of the interest in the research findings. Although the research included consideration of direct (Scope 1), purchased energy (Scope 2), and other value chain emissions (Scope 3), data have been more widely and consistently available for Scope 1 and Scope 2 emissions, at least within many developed markets.

Therefore, it is reasonable to conclude that even though Scope 2 and Scope 3 data were considered (only the latter were found to have an impact on loan volumes), it was easier to measure customer Scope 1 emissions data, which were driving most of the impact. That is relevant to Islamic markets for a few reasons.

First, despite companies having generally less data available, it is likely that high-emissions and emissions-intensive companies already face some headwinds, particularly from international banks, if their experience is similar to Japanese banks. For domestic banks, which have often begun considering climate change as a source of risk, they may already have more risky assets because of adverse selection, whereas international banks have focused their loan growth on companies with less climate risk.

Second, as stock exchanges and regulators increase their sustainability disclosure requirements, the full emissions picture will become clearer. This is a mixed bag for companies, some of whom may see benefit from transparency if it shows them as relatively lower emissions or less emissions intensive compared to their peers. The effect will likely be magnified by the new ISSB climate disclosure standard coming into effect starting next year, which will bring a substantial degree of new data about both direct, indirect and value chain emissions for companies.

There will be some catch-up where the ease, cost and access to finance for companies is repriced by greater clarity about the emissions embedded in companies. This will be an ongoing process because it will take a long time to get the type of data available that would be needed for banks to directly evaluate the climate risk of their customers. However, in the meantime, the process identified by the researchers will continue to advance.

Companies that are higher emissions or more emissions intensive will get benefit from showing how they are mitigating their risk (primarily through reducing future emissions, such as by developing transition plans for decarbonization). Companies that are reliant on more leveraged banks or those generating lower returns on their assets will be at the front of the line of those facing repricing risk associated with having to fill a gap when it comes time to refinance their existing loans.

The process is unlikely to overlook any company or financial institution. If the evidence found in the paper continues to drive financial sector activity, then the cost of continuing the status quo will continue to rise. Rising financial impacts on banks from materialization of current climate risks will weaken their returns on assets and push them towards more leveraged business models to try and generate better returns for equity.

The result of the pressure on the banking system will further accentuate the effects of higher climate risk, leading to lower or more costly access to finance for higher-emissions companies or those that are more emissions-intensive. The broadening of climate disclosures will allow some companies that are taking steps to mitigate their emissions footprint to snap out of the cycle. Companies that are less nimble will face a future of higher climate risk, more expensive financing, and ultimately a more challenging competitive environment.

The speed at which these changes are happening will continue to accelerate, especially for companies whose emissions footprints are concealed within their supply chains or primarily embedded in their purchased energy (including electricity), where electricity suppliers will in effect pass through the impact of their own climate risk to their customers. The outcome for companies, banks and the broader economy will be improved by opening more avenues to finance transparent and credible transition plans.