There is an ongoing debate among regulators and investors on the risks posed by climate change to the financial services industry and potential adverse effects on systemic stability. One source of risk is the impact of carbon pricing on the balance sheets of greenhouse gas (GHG) emitting firms and their creditors. The implications of such transition risks—financial risks which could result from the process of adjustment towards a lower-carbon economy—are currently unknown because most jurisdictions have not implemented climate change policies on a large scale. If financial institutions have large exposure to GHG emitting firms and limited flexibility to adjust their exposure in a timely manner, climate change policy may adversely impact financial stability. If, instead, financial institutions manage their exposure to transition risks appropriately, such risks should not be seen as a negative externality that prevents swift regulatory action on curbing GHG emissions.

In a recent study, we examine periods of high transition risks when major climate change policies move through the legislative process and identify their effect on corporate lending by exploiting quasi-exogenous variation in regulatory requirements. We focus on the two main cap-and-trade bills that have passed or came close to passage in the United States: the California and Waxman-Markey cap-and-trade bills. Both aimed at introducing a legally binding transition to a low-carbon economy and thus posed transition risks for covered firms. The bills constitute two independent natural experiments occurring at different points in time, with firms assigned to treatment and control groups along different dimensions. To assess their effects, we combine facility-level GHG emissions data from the Environmental Protection Agency (EPA) with comprehensive supervisory loan-level data on bank lending to private and public firms.

We find that lenders negotiated loan contracts following the passage of the California bill to mitigate their exposure to climate transition risks. Covered firms experience a reduction in loan maturities, increased reliance on credit line financing at the expense of term loan financing, and higher interest rates, while the total committed credit to these firms does not change significantly. Importantly, in our analysis of the effects of the Waxman-Markey bill—a distinct second natural experiment—we find lenders reacted in qualitatively similar ways.

These debt structure changes allow lenders to quickly reduce exposure should firms face future difficulties in operating under the cap-and-trade program. Short maturities allow lenders to frequently reevaluate credit relationships. Unlike term loans, the availability of credit lines is conditional on firms maintaining high cash flow, and banks can use discretion in preventing firms from drawing on their credit lines in times of economic and financial stress. Further, higher interest rates are consistent with banks requiring direct compensation for bearing transition risks.

In addition to the changes in the debt structure that are equilibrium outcomes in negotiations between banks and borrowers, in the Waxman-Markey analysis, we document that banks take unilateral measures to reduce transition risk exposure. First, banks participate less in the loan syndicates of covered firms, with shadow banks such as CLOs, hedge funds, and mutual funds taking a significantly larger loan share. Second, lenders with large ex ante exposure to high-emission firms reduce their syndicated loan holdings of covered firms to a greater extent. Finally, covered firms are more likely to have cash flow covenants in their contracts and be actively monitored by their lead lenders.

Virtually all the documented effects are concentrated within private firms. The differential effect of cap-and-trade policies on private firms is consistent with private firms facing higher operating costs as a result of cap-and-trade policies. Smaller, privately-held companies tend to have greater financial constraints than their public counterparts. The risks introduced by a cap-and-trade program could amplify such differences, thereby further reducing the ability of private firms to access external finance. Additionally, there could be economies of scale when complying with the new regulation that puts smaller private firms at a disadvantage. Finally, both anecdotal evidence and our data suggest that private firms have lower emissions efficiency than their public counterparts.

Overall, we find that banks pay attention to transition risks. The fluid nature of commercial lending relationships allows banks to react quickly to mitigate exposure to transition risks, retaining greater flexibility to cut loan exposures in the future. For regulators concerned with stability of the banking sector, this result is reassuring. However, the results also show that financing conditions for private firms exposed to cap-and-trade programs tighten at the same time these firms face potential increases in operating costs from the introduction of carbon pricing. Understanding such heterogeneity in the effect of cap-and-trade programs on emitting firms is important when designing cap-and-trade programs.

This post is adapted from the authors' working paper, “Banking on Carbon: Corporate Lending and Cap-and-Trade Policy,” available on SSRN. The views stated herein are those of the authors and are not necessarily the views of the Federal Reserve Board or the Federal Reserve System.

Ivan Ivanov is a Principal Economist in the Research and Statistics Division, Federal Reserve Board.

Mathias Kruttli is a Senior Economist in the Research and Statistics Division, Federal Reserve Board.

Sumudu Watugala is an Assistant Professor of Finance at the S. C. Johnson College of Business, Cornell University.

This post is part of the series ‘Business Law and the Transition to a Net Zero Carbon Economy’. This series consists mainly of posts summarizing papers presented and presentations made at the 5th Annual Oxford Business Law Blog conference on ‘Business Law and the Transition to a Net Zero Carbon Economy’ which took place online on 25 to 27 May 2021. The recordings are available here.


With the support of