A rich man holds the world

For decades, scientists across the globe have warned about the effects of climate change. Given that these changes—global warming, rising sea levels—happen over time and that their disastrous results may not be obvious for decades, studying the effects of climate change on financial markets has posed a problem.

Christoph Herfpfer
Christoph Herpfer, assistant professor of finance

According to Christoph Herpfer, assistant professor of finance, Goizueta Business School, most of the existing literature that deals with the effect of climate change on financial markets considers “indefinitely lived assets,” such as owning stock or owning a home—assets that “don’t have an expiration date,” explained Herpfer. To evaluate the effect of climate change in the long run on these assets then requires discount models—ways to value something today based on what it could be worth decades from now. 

Herpfer, a banking and corporate finance specialist, studies short-lived assets that, on average, expire after 4.5 years. Herpfer wondered if there could be “an alternative channel in which climate change already impacts companies today,” he explained. One that didn’t have to deal with all the “challenges associated with long run discount rates,” he added. 

In The rising tide lifts some interest rates: climate change, natural disasters, and loan pricing,” Herpfer and his colleagues—Ricardo Correa, deputy associate director, Board of Governors of the Federal Reserve System, Ai He, assistant professor of finance, University of South Carolina, and Ugur Lel, associate professor, Nalley Distinguished Chair in Finance, University of Georgia, Terry College of Business—consider this question by studying corporate borrowing costs. In 2020, the paper received the best paper award at the Boca Corporate Finance and Governance Conference.

The foursome had a novel idea: In recent years, there has been scientific consensus that climate change fuels natural disasters. So Herpfer and his fellow authors wondered if financial institutions took climate change-amplified natural disasters into account when pricing short-term loans. Their answer was, unequivocally, “yes.” 

When Climate-Change Related Natural Disasters Occur, Interest Rates Rise

To arrive at their conclusion, the authors needed to “disentangle” the effects of a direct hit from a natural disaster (business interruption, physical damage) from how lenders updated their overall expectations regarding the frequency and severity of future climate change-related natural disasters. To do so, the authors focused on firms that are at risk of such natural disasters but were not located in the area that suffered a direct hit. Herpfer and his colleagues dubbed these businesses, “indirectly affected borrowers.” 

In a simplified example, rather than study lending practices in southern Florida after a major hurricane hit Miami, the authors looked at borrowers located on the Gulf Coast in Texas. As Herpfer explained, this time the company in Texas got lucky, “but the bank realizes that as hurricanes become more frequent and stronger, they should be more careful and should increase the interest rate for the loan in Texas,” he added. Which is to say, the bank should institute a climate change risk premium for businesses most likely to be affected by climate change-related natural disasters.

To see if they were on the right path, Herpfer and his colleagues studied the effects of the natural disasters most strongly linked to climate change according to climate scientists: hurricanes, floods, and wildfires. Utilizing data from the Spatial Hazards Environmental Disasters for the United States and National Establishment Time Series data, they found that, following climate-related natural disasters, banks did indeed charge higher spreads on loans “to indirectly affected borrowers that have large exposure to disasters, while not being directly affected,” the paper states. The effect was 8.6 basis points for hurricanes, 9.7 basis points for wildfires, and 9.8 basis points for floods—just under a tenth of a percent for each natural disaster. 

“You can do a back of the envelope calculation,” explained Herpfer. “Since the volume of loans that are at risk of climate change-related disasters exceeds two hundred billion dollars, all of a sudden we’re talking about 200 million dollars per year in elevated interest rates. This is a lot of money that’s being spent because of climate change—not a hundred years from now, but today.”

The researchers also found that the more severe a disaster, the stronger the market reaction, and, additionally, that banks update their lending practices after “high profile public disclosure” of climate change reports. “These results imply that the majority of banks’ adjustment to climate change is concentrated in the time periods when public attention to the topic is highest,” the paper states.

While their research focused on the primary market for syndicated loans, the researchers also found climate risk priced into the secondary market as well. “This is important, as it suggests the decision to raise capital is not a driver of the observed increase in loan spreads,” they write. “Moreover, this result suggests that investors beyond banks also price the climate risk embedded in these types of loans.” 

To be sure this effect was climate change-related and not merely natural disaster-related, the authors tested their analysis against three non-climate change-related disasters: earthquakes, tornadoes, and winter weather. According to their research, borrowers with indirect exposure to these types of disasters saw “no changes in interest rates in either the primary or secondary loan markets,” they write. 

Herpfer wasn’t surprised that non-climate change-related disasters affected the markets differently than climate change-related disasters, but he was a bit in awe of just how well banks priced the effects of climate change-related natural disasters into their loans and how consistently they did so. “These are all very different disasters that receive different media attention, that hit different localities, that hit different firms and consistently, time after time, the market prices this right. This is fascinating,” he explained. “It’s very impressive how well the market catches it—and how this result is not there for snowfall and earthquakes.” 

Writing this paper also made Herpfer more curious about what this means long term for firms that operate in areas at risk for climate change-related disasters, such as hurricanes. “I would expect companies to shift their locations,” he said, adding that he’s not talking about retail stores like Starbucks which need to stay close to their customers, but about manufacturers with a few concentrated facilities in areas susceptible to climate change-related natural disasters. “The next paper we want to write is how the physical footprint of companies is changing and whether they are leaving at-risk areas and relocating to safer areas more inland,” Herpfer added. “That would be a huge deal.”

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