An empirical analysis of climate and environmental policy risk, the cost of debt and financial institutions' risk preferences

Abstract

This study investigates how regulatory risk affects the cost of debt and risk preferences across energy sources. We use the OECD environmental policy stringency (EPS), loan spreads and investment decisions as measures of climate and environmental (CE) policy risk, cost of debt and risk preferences, respectively. To conduct our analysis, we analyse the loan spreads variance using a large sample of syndicated loan data across 40 countries from 2000-2019. We find that the stringency of CE policies risk is priced by financial institutions, which influences their investment choices among energy sources in the loan market. In the energy production sector, we observe that a higher level of CE policy stringency (such as carbon trading schemes) can lower the capital cost for loans issued to renewables, leading to an increase in renewable energy investments. We also find that the more stringent CE policies in a country, the lower likelihood of capital flow into oil & gas or coal. In the electricity sector, while no evidence supports that CE policies (solar & wind support policies) decrease the cost of debt for renewable electric utilities compared to fossil fuel and mixed electric utilities, they are still successful in attracting more capital to renewable firms.

Keywords: Climate and environmental policy risk, cost of debt, risk preferences, investment decisions