Estimating the effects of an increase in energy expenditure on corporate credit risk

On 22.09 Bank of Italy (“BoI”) published “Assessing credit risk sensitivity to climate and energy shock”', the new issue of the series “Markets, infrastructures, payment systems” (“Study”).

The Study is part of a broader effort within the BoI to define the impact of transition policies on corporate performance. The impact of climate policies on credit risk has some similarity with that of the energy market disruptions that firms and households have experienced since the second half of 2021.

Scope and purpose

Climate change poses a threat to economic activity via several channels, e.g. owing to reduced labour and energy productivity; some extreme weather events have also drove down short-term economic growth. The biggest threat is for the most climate-exposed sectors such as agriculture, forestry, fishery, energy, and tourism. Climate change has an impact on financial institutions as well. The risks for the stability of the financial system will also depend on the climate policies and on the exposure of the different sectors of the economy to such policies.

In particular, climate-change may have many effects for the financial sector. Natural disasters, in fact, by disrupting the activities of companies and households, raise their financial vulnerability and lower the value of the collateral pledged for loans. Repaying loans may become more complex due to the diversion of resources for restoring damaged property. Environmental shocks may increase the number of non-performing loans in the portfolio of those banks that are particularly exposed to households and businesses in the areas most at risk. This could induce banks to restrict the supply of credit, which would potentially affect the effectiveness of the credit channel of monetary policy. If these effects occurred on a large scale, they might threaten the stability of the financial system as a whole.

In the light of above, climate-related credit risk management will increasingly be a key element for successful banks, that will enable them to assess the impact of climate on the borrowers’ ability to repay their loans.

With reference to these risks:

1. the estimation is a challenging task because the impacts of future climate manifestations will be highly uncertain, non-linear and largely endogenous;
2. the evaluation at individual firm level is made even more challenging due to the lack of detailed and comparable data on the exact geographical location and on the carbon intensity of individual activities.

By virtue of above, public and private institutions, central banks and supervisors are promoting joint efforts to assess the possible implications of climate policies on the economy and the financial sector. Central banks are well positioned to assess the threat posed by climate change on the financial system.

The relationship between climate change and credit risk

The literature on the impact of climate change on credit risk obtains mixed results; some studies find that the distance-to-default is negatively associated with firm’s carbon emissions and carbon intensity, other studies use granular data at the counterparty level to estimate the impact of alternative carbon tax levels on energy demand and costs, thus identifying the most financially vulnerable sectors. These studies estimate the impact in terms of default rates at the sector level; they find that credit risk stemming from the introduction of a carbon tax raises the one-year probability of default (“PD”) of firms but it remains below the historical average.

Methodology

The Study:

1. extends the above analyses to firm-level PD information using the in-house credit assessment system of the BoI (“BI-ICAS”) and has two components: i) the statistical component, with an extremely wide coverage of Italian non-financial companies; ii) the expert component, which applies to a subsample of companies. The statistical component is a highly automated system which produces an estimate of the probability of default (Statistical PD) for Italian non-financial corporations on a monthly basis;
2. simulates the detailed energy expenditure of each firm and employ an estimate of the additional cost due to the effect of different levels of carbon tax on operating costs in the financial statement of each firm. These values are then used as an input for BI-ICAS to calculate the stressed 12-month PD;
3. has the flexibility to assess the channels and the exposure with greater detail compared to the existing studies;
4. has an approach not limited to climate policy shocks, but it can be used to assess how other types of climate and energy shocks might affect credit risk.
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Simulation

The Study, in order to assess the impact of a climate policy shock on firm PDs, used 2019 fiscal year financial statement data for approximately 200,000 Italian non-financial limited-liability companies.

In particular, the Study simulates the effects of three possible carbon taxes that are consistent with the trajectories of the following three Network for Greening the Financial System (“NGFS”) scenarios: Below 2°C (EUR 40 per tonne of CO2), Net Zero 2050 (EUR 90) and Delayed Transition (EUR 140).

A carbon tax is often used as a climate policy shocks: due to its effectiveness in adjusting the (mis)pricing of climate risks and in providing an incentive to move away from fossil-fuels; but its simplicity is counterbalanced by its low social acceptability. However, a change in the relative price among different energy fuels might arise from other drivers, such as a ban on a specific type of carbon-intensive technology (e.g. Internal combustion engine cars) or the support for low-carbon energy sources.

Results

The effect of a carbon tax on the credit-worthiness of Italian non-financial corporations would be contained and diversified across industrial sectors. When considering the total economy, the average PD in the e different scenarios (carbon tax of EUR 40, EUR 90 and EUR 140) would increase respectively by 0.6, 2.3 and 4.1 basis points. On the one hand, the higher the increase in energy costs the higher is the relative impact on companies’ operating margin and leverage and, consequently, the effect on PDs is increasing and non-linear. On the other hand, firms’ energy demand elasticity compensates this effect but not entirely. The average increase on the PDs is heterogeneous across different economic sectors, with Agriculture and Services being the most exposed considering both the energy consumption and the low reactivity to change in energy prices.

The Study shows that:

1. all sectors, excluding Construction, show a high dispersion of average PD increments;
2. the five most exposed industries are a) Water transport; b) Air transport; c) Petrochemical; d) Land transport and transport via pipelines; and e) Fishing and aquaculture. So, between the most exposed industries, we find sectors with a very high dependence on fossil fuels such as the Petrochemical sector and/or sectors with an inelastic energy demand (a proxy of their possibility to switch to a greener energy mix), such as Water transport and Air transport.