Carbon risks and credit spreads

I have reported before that there is a bit of a conundrum in fixed income markets when it comes to the influence of greenhouse gas emissions and climate change risk. On the one hand, banks include climate change risks in the cost of loans to different firms. On the other hand, green bonds trade at the same price as conventional bonds in secondary markets. It seems as if bond markets are not differentiating between “green” and “brown” companies. This is all the more surprising because equity markets seem to make just that differentiation.

But it could be that we just measured the wrong thing in bond markets. Instead of looking at the difference between green bonds and conventional bonds of the same issuer, Huu Nhan Duong and his colleagues looked at the differences in CDS spreads between companies. Looking at issuers in the United States that were increasingly being asked to comply with state-specific greenhouse gas emissions regulations, they could track which issuer at what time actively engaged in reducing their greenhouse gas emissions. More broadly, they measured the ability of a company to manage its carbon risk in light of increasing regulation and the possibility of being subjected to a carbon tax.

The result of their study indicates that with changing regulation companies start to take their climate risks more seriously. Introducing tighter regulation and reporting requirements around climate-related risks forces companies to improve their risk management and monitoring around these risks. And that in turn reduces the CDS spread of these companies as investors price in a lower default risk. The study found that improving the carbon risk management typically reduces the CDS spread by c10bps in the next quarter. That may not sound like much but it is a roughly 7% reduction in credit spreads and for a 5-year corporate bond boosts bond prices in the secondary market by 0.5%.

It seems then that fixed income markets do price climate risks after all. They are just not very discerning and stick essentially to the climate risk of the issuer, without any differentiation between the type of bonds or projects used to finance with the proceeds.