Credit Substitution in Sustainable Finance: An Achilles Heel?

The Paris Agreement’s commitment to align finance flows with net-zero transition pathways has catalysed an unprecedented shift in financial markets. Sustainable finance has evolved from niche to mainstream, with financial institutions increasingly incorporating environmental considerations into their decisions. Yet beneath this transformation lies a critical vulnerability: credit substitution.

My recent article examines credit substitution as an overlooked problem in sustainable finance. While governments and stakeholders rely on financial channels to influence firms’ environmental impact, firms’ ability to replace exiting creditors presents a fundamental challenge. This substitution weakens the effect of exit and results in risk migration rather than mitigation. Current regulatory frameworks—characterized by substantial cross-jurisdictional and cross-sectoral differences—create conditions highly conducive to credit substitution, undermining policy effectiveness.

Theoretical Foundations, Mechanisms and Evidence

Credit substitution rests on established corporate finance principles. The Modigliani-Miller theorem demonstrates that in perfect markets, firms remain indifferent among financing sources as capital structure does not affect firm value. While market frictions introduce preferences between different forms and providers of capital, the fundamental principle persists: firms optimize their financing mix based on relative costs and availability. This becomes particularly relevant when sustainable finance policies attempt to constrain capital access for environmental objectives.

Credit substitution operates through three mechanisms. First, heterogeneity across financial institutions creates substitution opportunities. Institutions diverge in their evaluation of climate risks, susceptibility to stakeholder pressures, preferences, and transition beliefs, generating variation in credit pricing and availability and enabling firms to substitute between sources.

Second, cross-jurisdictional regulatory differences create arbitrage opportunities. The EU has developed comprehensive frameworks integrating climate considerations into financial regulation. The UK maintains ambitious objectives but slower implementation. The US explicitly rejects climate-specific financial regulation. Asian centers present mixed approaches—Japan implements some measures while remaining a major fossil fuel financier, and China combines green directives with continued coal support.

These disparities create powerful incentives for international credit substitution. When institutions subject to stringent regulation restrict carbon-intensive lending, borrowers access capital from permissive environments. Evidence confirms this: as European banks retreat from fossil fuel financing, institutions from other regions expand. North American and Japanese banks have assumed leadership in sectors abandoned by European lenders, while US regional banks dramatically increase their participation. Australia’s coal sector exemplifies this too: following domestic banks’ financing cessation, companies secured funding from Japanese and Chinese lenders.

Third, cross-sectoral regulatory asymmetries enable substitution between financial intermediaries. This is evident in the EU’s divergent treatment of bank versus market-based finance that can facilitate credit substitution. Banks face comprehensive prudential regulation regarding climate risk and Paris-aligned lending while non-bank entities operate under lighter regimes.

A significant divergence concerns transition plans. The EU’s banking package mandates banks develop prudential transition plans detailing climate alignment strategies. These undergo rigorous scrutiny with enforcement powers including penalties and capital requirements. Market-based actors face no equivalent obligations. While disclosure regulations require transparency regarding sustainability risks, they neither mandate transition plans nor empower supervisory intervention. The Corporate Sustainability Due Diligence Directive’s relatively weak transition plan requirements for asset managers seem poised to be removed too. Banks under pressure might find clients turning to bond markets or private credit providers without comparable scrutiny or banks could transfer their non-compliant exposures to non-banks.

Empirical evidence demonstrates credit substitution across multiple channels. Banks employ mechanisms to transfer fossil fuel exposures including loan sales, securitization, and synthetic risk transfers. Private credit funds actively pursue opportunities banks abandon, explicitly targeting sectors facing restricted access. Research also documents substitution between bank lending and bond markets, and instances of inter-bank substitution driven by differential sustainability pressures.

Credit substitution avoids traditional adverse selection constraints. Banks exit entire sectors rather than selecting individual borrowers, removing adverse selection signals. Fossil fuel companies typically constitute large borrowers with transparent assets and proven reserves as collateral. Syndicated lending dominance further reduces information asymmetries, as remaining syndicate members can vouch for borrower quality.

While some research finds creditor exits constrain financing, these constitute a minority. Variation stems from context-specific factors. Coal financing illustrates this—studies may find limited substitution where economic unviability affects all lenders equally. However, exits in markets where demand remains robust likely result in successful substitution.

Implications for Financial Stability

Credit substitution affects financial stability beyond environmental policy. When banks exit climate-risky exposures, risks migrate to shadow banks, private credit funds, and less regulated institutions operating with reduced transparency and oversight. This parallels pre-2008 dynamics when securitization moved risks into shadow banking, ultimately amplifying systemic vulnerabilities.

Policy Implications and Regulatory Responses

Regulators must establish comparable requirements across credit channels. Current approaches stringently regulating banks while leaving others unconstrained create arbitrage opportunities undermining both stability and environmental objectives. Policymakers should evaluate second-order effects—tracking whether aggregate credit to carbon-intensive sectors declines or migrates.

Several proposals appear problematic. Green supporting or brown penalizing capital requirements would accelerate substitution, as banks forced to exit would transfer assets to unconstrained investors. Reviving securitization markets risks facilitating offloading carbon-intensive exposures to less supervised entities.

Given credit’s international mobility, effective policy requires coordinated action. The Basel Committee represents the natural forum for harmonizing standards, yet progress remains stalled by disagreements, particularly US opposition. Without coordination, unilateral efforts will redistribute rather than reduce harmful financing.

Conclusion

Credit substitution reveals a fundamental tension: in integrated markets, targeted interventions may redistribute rather than reduce environmentally harmful financing. This demands sophisticated policy design anticipating substitution dynamics. Only comprehensive approaches addressing the full financial ecosystem—across sectors, jurisdictions, and institutional types—can ensure sustainable finance achieves its objectives rather than simply reshuffling financial manifestations.

The author’s article can be accessed in the Journal of Financial Regulation.

Alperen A. Gözlügöl is an Assistant Professor of Law at the London School of Economics.