An effective environmental policy must take into account the behavior of the financiers of polluting companies. In 2013, the EU Emissions Trading System implemented a reform that resulted in higher compliance costs for producers. This column explains that, contrary to the possible intentions of the program, credit spreads fell on average by 25% from 2013, and this dynamic partly compromised the expected reduction in CO2 emissions. It identifies a key role of permit storage in lowering credit spreads for the companies concerned.
By Fabio Antoniou, Manthos Delis, Steven Ongena and Christos Tsoumas *
According to the World Wide Fund for Nature (WWF 2020), the momentum around climate change is now positive. Polluting companies must be directly discouraged from releasing CO2 emissions, so that the social costs of carbon are reflected in prices. A widely implemented policy instrument is cap and trade (ICAP 2020). Interestingly, a recent debate calls for higher indirect costs through increased spreads on loans or bonds from banks and other financial institutions to polluting companies and sectors. Most anecdotal evidence suggests that, at least until recently, this has not been the case, with the banking industry continuing to fund heavily polluting activities (e.g. RAN 2020, Financial Times 2020, Guardian 2019).
The best-known fully operational cap-and-trade system is the EU Emissions Trading System (EU ETS), launched in 2005. In 2013, alongside the launch of phase III, significant structural changes have been made to the system. In particular, emission permits (allowances) were offered at a decreasing rate of 1.74% per year and participating companies were given a lower proportion of free allowances, while the rest had to be bought on the market or through auctions with few exemptions (Europe Commission 2015). This reform aimed to increase the cost of carbon for polluters so that they reduce their carbon footprint. As the regime and regulatory framework have become more stringent, implying higher costs for polluting companies, we believe that the corresponding financial conditions reflected in credit spreads must have internalized this risk after 2013.
However, anecdotal evidence of credit spreads around Stage III of the EU ETS shows a different picture. Figure 1 shows regression lines for syndicated loan spreads (DealScan) among the treated group (EU ETS participating companies) and the control group (non-participating companies), before and after the launch of the phase III in 2013. The figure shows parallel trends in credit spreads between treated and control groups before the program. This is consistent with the flexibility of the syndicated loan market, as the lending terms of a loan facility can be easily readjusted. The upward trends of the two lines until 2013 are mainly due to the higher financing costs induced by the global crisis and the European debt crisis. From 2013, credit spreads narrowed for processed companies, while remaining approximately at their 2012 level for untreated companies.
Our recent study (Antoniou et al. 2020) shows that a company is encouraged to act proactively to deal with potentially stricter future regulations. To this end, the processed companies can store permits or hold offsets with a similar role, in order to facilitate future regulatory compliance. Then, when processing materializes, the stored permits decrease the demand for expensive quotas and therefore decrease the cost of compliance. This, in turn, reduces the risk faced by the lender, leading to a smaller loan spread in the second period. In addition, a collective result is obtained once the individual decisions are aggregated. The excess supply of permits during the post-processing period lowers the price of permits, which also leads to lower compliance costs. The risk is lower and the credit spread decreases.
Figure 1 Loan variance for processing and control groups
We empirically examine these theoretical propositions, using a new manually matched dataset that brings together data on syndicated loans to European firms (DealScan), firm year characteristics (Compustat), Pollution permits to specific companies (EU ETS) and carbon emissions. EUA price allocations (EEX market). Our identification strategy examines the behavior of credit spreads before and after the implementation of phase III of the EU ETS system in 2013 for treated companies (those participating in the program) and non-treated companies (those that do not. not participate). Phase III of the EU ETS program is the most important for lenders as it introduced expensive permits for most polluters (until then the lion’s share of permits were freely allocated to specific companies).
We find that credit spreads decline by 25% on average from 2013, which equates to a reduction of 25.4 basis points. To give a prospect of reducing the total cost of the loan, the 25.4 basis points correspond to a reduction in interest charges of 5.56 million euros for the loan of medium size and maturity. Notably, we also collect data on corporate bond yields (from SDC Platinum) and show that bond spreads also decreased for traded companies from 2013. Thus, bond markets are also aligning their incentives with those of banks, giving an overall picture of more competitive financing costs for polluting companies after phase III of the EU ETS policy.
We then identify the main reasons for the reduction in credit spreads due to the EU ETS policy. We find that the effect is most negative when the price of the EUA is particularly low, which is the case over the period 2013-2017 (Figure 2). In addition, the decline in credit spreads is much smaller for those firms processed that are net buyers of permits in the current year or the previous year, showing that these firms did not stockpile sufficient quotas and are therefore more exposed to the implementation of the program. Indeed, the anecdotal evidence in Figure 3 suggests that many companies were proactive as net buyers of permits during the period just prior to EU ETS Phase III.
Figure 2 EUA price over the sampling period
figure 3 Number of quotas over the sampling period
Our analysis, placing financing costs at the heart of the effect of environmental policy, has real implications for polluting companies’ activities. By identifying the lower financing costs of polluting companies after the implementation of phase III of the EU ETS program, we essentially show that any increase in the costs of this program could have been offset by a decrease in financing costs for the treated companies. . We document a significant negative association between credit spreads and verified CO2 emissions of the companies processed, which together with our main findings suggests that the decline in CO2 emissions (e.g. Bayer and Aklin 2020) would in fact have been still lower if the financing costs had not decreased. . Our estimates show that there would have been a further 7.9% drop in CO2 emissions had it not been for the narrowing of credit spreads.
Our results reveal a strategic role for engagement, through the storage of permits or equivalent actions, so that future interest rates are distorted downward. Without undermining the claimed benefits of permit storage, such as cost smoothing over time, the strategic incentive presented here can be harmful in terms of pollution. Our results may also provide empirical corroboration for stability reserves in permit markets, such as the EU ETS market stability reserve introduced in 2019 (see ICAP 2020) where the regulator could withdraw permits in the event of an excessive surplus of quotas. Our reasoning is that when there is an excess of allowances, along with the reduction in the price of permits, this also reduces the credit spread which, in turn, leads to even higher emissions. The withdrawal of permits dissuades banks from easing interest rates. Therefore, the exact level of limits is critical to financing costs and the associated response of companies to emissions or their investments in general.
* About the authors:
- Fabio Antoniou, Assistant Professor, Department of Economics, Athens University of Economics and Business
- Manthos delis, professor of financial economics, Montpellier Business School
- Steven ongena, professor of banking, University of Zurich, Swiss Finance Institute and KU Leuven; Researcher, CEPR
- Christos Tsoumas, Assistant Professor in Financial Management, Hellenic Open University
Antoniou, F, MD Delis, S Ongena and C Tsoumas (2020), “Pollution permit and financing costs”, CEPR Discussion Document 15517.
Bayer, P and M Aklin (2020), “The European Union’s Emissions Trading System has reduced CO2 emissions despite low prices”, Proceedings of the National Academy of Sciences of the United States of America 117: 8804-8812.
European Commission (2015), ETS Handbook.
Financial Time (2020), “European banks accused of supporting coal polluters“, July 14th.
The Guardian (2019), “Banks warned against Saudi Aramco by environmental groups», October 17.
ICAP (2020), Global Emissions Trading: 2020 Status Report, Berlin: International Partnership for Carbon Action.