Prudential Regulation and Transition Risk: Evidence from Bank Lending and Firm Emissions

Abstract:

We use Euro-area credit register data with firm-level carbon emissions to examine whether banks’ internal models price transition risk and the downstream impacts on capital requirements and loan pricing. We do not find evidence that banks’ internal models price transition risk, but rather the opposite. We find that firms with higher emissions are consistently assigned lower risk estimates than lower emissions ones, even within sectors. High emitting sectors such as agriculture, electricity and oil and gas are found to have lower estimates of risk compared to other sectors while low-carbon firms in the electricity sector have higher estimates of risk. This implies that low-carbon borrowers face higher funding costs and higher capital requirements which may not be representative of the underlying transition risk.