Carbon-intensive companies pay ever higher market interest rates

Pricing of transition risks is essential

At €1.600 billion, the European bond market is an important source of financing for many companies. Issuing bonds enables a company to borrow money from investors, who then receive periodic interest payments. The interest rate is partly determined by the risk underlying the bond and the company that issues it.

In two recent studies, DNB looked at the extent to which investors in corporate bonds take into account business risks related to the transition to a climate-neutral economy, in addition to financial risks. This is also known as transition risk.      

Transition risk includes factors affecting a business’s revenue model such as technological innovation, rising carbon taxes and climate-related regulation. These affect the profit margins and competitive position of carbon-intensive and other companies, and this is reflected in the interest rates investors require from them in exchange for financing.   

The fact that financial markets price in transition risks helps businesses achieve climate goals in an economically efficient way. It provides a financial incentive for companies to become more sustainable and to reduce their greenhouse gas emissions. Companies that do not take climate change into account, or take it too lightly, ultimately slow down the energy transition. 

Transition risk premium in bond prices on the rise

To estimate the extent to which investors price in transition risks, both studies use a company's carbon emissions as an indicator of these risks, in line with the ECB’s climate change-related indicators and DNB’s sustainability dashboard. They then look at the extent to which investors wish to be compensated for these risks. This surcharge, or the transition risk premium, is part of the bond yield spread defined as the difference between the risk-free interest rate and the interest rate companies actually pay on a bond. The studies also correct for financial and other factors affecting bond yield spreads.

Since 2020, a clear price difference has emerged between the costs of borrowing for companies with relatively high carbon emissions and those with lower (or no) carbon emissions. Figure 1 clearly illustrates this difference. The difference has since widened to over 40 basis points (0.4%). This is the case for bonds with both short-term and long-term maturities, and it implies that companies with lower emissions can finance their operations at lower costs.

The rising risk premium can possibly be explained by the implementation of stricter European climate policies. For instance, the European Commission introduced the European Green Deal in December 2019, followed by new climate legislation in 2020 and the Fit-for-55 package a year later. Higher European carbon prices have also been evident in the financial markets since 2020. At the same time, it cannot be ruled out that other macroeconomic developments or perhaps the COVID-19 pandemic also influenced the level of the transition risk premium.

Figure 1 – The transition risk premium on European bonds has been rising since early 2020
The dotted lines indicate the introduction of European climate policies.  Source:  DNB Working paper 798.

Lower transition risk premium for companies investing in sustainability

Additionally, carbon-intensive companies that invest more in sustainability pay a significantly lower premium on the bonds they issue. Figure 2 shows how the transition risk premium – estimated as the difference in the average bond yield spread between firms with a high and low carbon intensity – of European companies varies with the extent to which patents granted to a company can be labelled ‘green’. This difference in financing costs is about a quarter lower when carbon-intensive companies invest more in sustainable innovation than similar companies that do not make such green investments. Investors may be willing to settle for lower yields because they see investment in sustainable innovations as a signal that a carbon-intensive company is committed to going green over time, thus lowering its vulnerability to transition risks. 

Figure 2 – Lower risk premium for companies investing in sustainability
Average predicted bond yield spread depending on companies’ emission intensity (carbon emissions relative to revenue) and the degree of sustainable innovation by companies (2016-2022, global bond market). Source: DNB Working paper 797. 

Reliable information on climate transition risks essential for price estimation

Transition risks are already being increasingly factored into the price of a stock or bond. This helps make the energy transition more efficient and gradual. To properly assess risks, investors will need to take climate indicators into account. Many companies include these factors in their disclosures.

Greater availability of reliable information on climate risks is needed to avoid sudden shocks in risk premiums in financial markets and thus help to alleviate uncertainty. It is therefore more important than ever to continue improving the quality, quantity and comparability of available climate information at company level in combination with consistent and forward-looking climate policies.