The impact of CO2 emission costs in the EU ETS market on corporate lending

Climate change is of paramount importance to all of us, as it poses a threat to our planet. Due to its adverse impact on corporate asset values, climate change risk also represents a growing source of systemic risk that could destabilize the smooth functioning of markets and the financial sector. In particular, if new strategies to mitigate global warming are not implemented in a timely and effective manner, two scenarios could materialize. On the one hand, banks' exposure to industries and assets vulnerable to increasingly extreme weather events due to rising temperatures (floods, droughts, wildfires, and hurricanes, as well as steadily rising sea levels) could result in significant losses for the financial sector (physical risk). On the other hand, the potential introduction of delayed and abrupt regulatory measures aimed at achieving the Paris targets could negatively impact high-carbon industries and asset prices, with negative consequences for the financial system and the real economy (transition risk). Regulatory risk stemming from the need to rapidly reduce greenhouse gas emissions can be particularly costly for companies subject to carbon taxes or participating in the emissions trading system. More ambitious emission reduction targets, rising greenhouse gas emission allowance prices, and increased energy prices can directly impact the operating costs of these companies. Furthermore, high-carbon companies will be required to make costly investments in green technologies, which could lead to higher debt levels and increase their financing costs. As a consequence of the transition to a low-carbon economy, companies with reduced profitability and increased leverage may pose increased credit risk to banks, which are the main capital providers for these companies.

Although the literature on sustainable finance has rapidly developed in recent years, little attention has been paid to how greenhouse gas pricing mechanisms may impact bank stability through their exposure to carbon-sensitive companies. At this critical juncture, when global climate policies are being implemented at various international levels, it is crucial that policymakers and supervisors are aware of and can prepare for the transition risks facing the financial sector, which is also expected to play a crucial role in financing the transition to a climate-neutral economy. By filling existing gaps in the literature, this study will provide unique insights into the channels through which climate risk is transmitted to the banking sector.

In addition to contributing significant scientific value to the literature, the aim of this project is to foster collaboration between scientists, regulators, and experts involved in implementing climate change mitigation or adaptation strategies. The results of our research could be of significant importance to policymakers, as effective policies to counter the effects of climate change depend primarily on identifying the sources and channels through which this risk is transmitted to the financial sector. A better understanding of this phenomenon will fill gaps in the existing literature and provide unique insights necessary for appropriate macroprudential and monetary policy.