Climate Change Considerations in the Syndicated Loan Market: An Investigation of Firm Environmental Performance and Loan Contract Strictness

Abstract

In this study, I investigate the relationship between contract strictness and the environmental profile of borrowers in the syndicated loan market. I examine this relationship in a three-pronged fashion to study the effect of (1) ex-ante environmental scores and carbon emissions on contract strictness; (2) bank commitments on contract tightening; and (3) the effect of stricter contracts on future environmental performance. To understand these effects, I utilize a novel measure of contract strictness that estimates the probability a borrower will default in the next quarter based on the construction of embedded loan covenants. This analysis covers a sample of 2,010 syndicated loans originated from 2008 - 2022. I find that banks do not write stricter contracts to firms just on the basis of carbon emissions. While firms with higher carbon emissions are not penalized with stricter contracts, firms with lower environmental scores do receive stricter contracts. I also find that contract strictness tightened in the period following the Paris Agreement of 2015 and staggered bank commitments to the Net-Zero Banking Alliance (NZBA). Lastly, my results suggest that stricter contracts do not have a significant impact on ex-post firm environmental performance. Taken together, my findings reveal that banks do not reflect the risk of lending to firms with higher carbon emission levels through stricter loan contracts.