Climate risk is already priced in bank loans

In Europe and the United Kingdom, regulators are demanding from banks and insurance companies to include climate-related risks when assessing their business risks. I have mentioned before that in the green bond market, the evidence is lacking that green bonds trade at different yields to traditional bonds – at least in the secondary market.

But it seems that while bond markets don’t reflect climate risks, banks giving loans to businesses already make sure they cover the excess risk from a borrower exposed to higher climate risks. And this is not happening in Europe where the adoption of the recommendations of the Task Force on Climate-related Financial Disclosures are becoming mandatory for banks and insurers, this is happening in the United States. 

Most people know that in the United States there is a large group of people who do not believe that climate change is real or that it poses a significant threat to society. With the last administration, this climate change denial was going all the way to the White House. Yet, at the same time, the Pentagon calls climate change a “catastrophic national security threat” and prepares its troops for a world severely impacted by climate change.

And when it comes to their own money, banks across the United States prepare as well. A study by two researchers from the University of Texas showed that bank loans given to businesses all over the country differentiate between companies with different climate risks. Businesses that are more exposed to the impact of climate change like floods, droughts, and windstorms pay a premium of roughly 14bps per year on their bank loans compared to businesses that are less exposed to climate risks. Compared to the average interest for businesses with low climate risk that is about a 10% premium on the interest demanded by banks on loans to businesses exposed to climate risks. Banks do that because they know that climate change makes loans to businesses in certain areas riskier and no matter what your local politician or the bank’s lobbyist may say, these risks are real and they don’t want to lose money over it.

If American banks can include climate risks in their business practices, then I would say every company around the world needs to get to terms with its exposure to climate change and the risks and opportunities that come with it. Not doing so, is kind of a dereliction of duty, in my view. Meanwhile, investors who pay the same price for a conventional bond as for an otherwise identical green bond are likely overpaying for the conventional bond.

Climate risk premium in US bank loans

Source: Masum and Javadi (2020).