Climate regulation and corporate bonds
There are three components of climate risk: physical, technological and regulatory. Recent research shows that regulatory risk is the one that investors and others in the finance community believe has the most immediate relevance. This suggests that regulation is a major channel through which climate and other types of environmental risks get embedded in security prices.
In this paper, Seltzer et al. analyze how climate and other environmental regulatory risks affect firms’ bond ratings and spreads. They consider a setting in which expectations regarding future climate regulations receive an exogenous shock, namely the December 2015 Paris Agreement, under which world governments agreed to take actions to limit global temperature increases. They then employ a difference-in-differences analysis of firms’ credit ratings and yield spreads in the months around the Agreement date to test whether the Paris Agreement had indeed greater effects on the corporate bonds more exposed to climate regulatory risks. Their data includes bonds issued by U.S. public non-financial companies over the 2009-2017 period, which are classified as corporate debentures and corporate medium term notes with maturities ranging from one month to 30 years. They find that:
- Controlling for time-invariant firm characteristics and macroeconomic trends, changes in climate regulatory risk affect bond credit ratings for firms with more problematic environmental performance, specifically including those with more significant carbon footprints.
- Yield spreads of treated bonds increase significantly after the Paris Agreement, suggesting that, besides credit rating analysts, bond investors also react to potential future regulatory changes. Seltzer et al. find that yield spreads for bonds issued by firms that belong to top carbon-emitting industries increased by about 38 bps.
Climate Regulatory Risks and Corporate Bonds
Authors: Lee Seltzer, Laura T. Starks, Qifei Zhu
From: Federal Reserve Bank of New York, University of Texas at Austin, Nanyang Technological University
