Episode 048: Olaf Weber
Climate change, carbon pricing, government regulations. These are words that strike fear into the hearts of the resource extraction companies that form such a huge part of the Canadian economy. Climate change has made the future risky for all of us. These risks have financial consequences. Climate risk becomes credit risk. Prof. Olaf Weber, the CIBC Chair in Sustainable Finance at the Schulich School of Business, has some new research to share on this topic.
Transcript
Cameron: Climate change, carbon pricing, government regulations. These are words that strike fear into the hearts of the resource extraction companies that form such a huge part of the Canadian economy. Climate change has made the future risky for all of us. This cannot be understated in the resource extraction industries, particularly oil and gas.
These risks have financial consequences. Who wants to lend money to a company that may be forced to go out of business if public opinion or government policy shifts away from fossil fuels? Climate risk becomes credit risk. Olaf Weber, the CIBC Chair in Sustainable Finance at the Schulich School of Business, has some new research to share on this topic.
My interview with Olaf is up next.
Welcome to Podcast or Perish, a podcast about academic research and why it matters. My name is Cameron Graham, Professor of Accounting at the Schulich School of Business at York University in Toronto.
Olaf, Welcome to the podcast.
Olaf: Hello. Thanks for having me.
Cameron: Could I get you to introduce yourself to our audience?
Olaf: Yes, sure. So my name is Olaf Weber. I am the CIBC Chair in Sustainable Finance at the Schulich School of Business. And just today, I got all the congratulations for my first year at Schulich, so it's, it's one year ago that I, uh, that I started. I am, in the sustainability area, and, uh, still a bit connected to Waterloo, where I came from, the University of Waterloo.
I have still some grad students there that I supervise. And, yeah, my area of specialization, as the title says, is sustainable finance. So I, um, address financial risks in the credit industries or credit risks that are caused by sustainability issues, for instance, by climate change.
But I started very early, you know, by contaminated sites and things like that. So the earlier environmental risks. And I'm doing that since some decades already, focusing on credit risk, but also investment risks and opportunities as well, the use of ESG, environmental, social, and governance indicators for investments and credit risk decisions and so on.
And so I'm generally interested, um, how can we make the financial industry more sustainable or address sustainable development, uh, in a, in a better way than do now? Not saying that they are not good in doing it so far, but, uh, there's always room for improvement.
Cameron: I'm going to ask you the question about which came first, the chicken or the egg. Did you get interested in sustainability first, or were you mainly interested in credit risk first?
Olaf: Very good question. So I kind of, I'm, I'm coming from a, from a risk management perspective in general. And so at the time when I started, I looked for cases in a way where I can apply my, my knowledge and the research as well. And there were two at that time. One was credit risk, the other one was environmental risk.
The nice thing is, in these two types of risks, you know what the positive and negative outcomes are. Oh, credit can be default or not, or you have an environmental risk like a contamination that has a negative impact or not. And so, to be honest, in the beginning, I thought it's quite independent from each other, but then especially, you know, it was kind of in the mid 1990s because of new environmental regulations, especially, both were connected. So, um, when, uh, we had no environmental regulations, contaminating a piece of land didn't have any consequences. After the introduction of certain regulations, it had consequences because you had to clean up the land. And then in case you are a lender and you have this land as collateral and you want to sell it, you got in trouble.
And so, yeah, it wasn't really planned to get into that. So, but, uh, it was a coincidence in a way, you know, that we, we had new regulations, new guidelines, addressing environmental issues that affected the financial industry as well.
Cameron: Now, you've got a paper that just came out in 2023, and you've got another paper that's under review that more or less go together. Can you describe what these studies are about?
Olaf: Yes, we want to figure out what is the effect of, uh, an emission price. So if you price greenhouse gas emissions, what we do in Canada, what we do in many other countries as well, what is the cost effect of that? And if there's a cost effect for companies, then, there's an effect on the credit risk of these companies as well.
It's pretty straightforward. If you have higher costs, then, uh, you have less money to, to pay back your loan. And so you have a higher risk. And so this was the kind of starting point to see, okay, can we figure out what these costs might be? And so we started from the, you know, with the Canadian sample at TSX, uh, 260, and used the carbon pricing scenarios that we have in Canada, you know, that should go up until 2030 to 180 Canadian dollars per ton. So we are much lower now, but that's the plan. And that's, you know, that's not long. It's not a, not a long timeframe. And so we wanted to figure out, okay, given different, costs per tons of emissions, what is the impact on the costs? And so we used a standard credit model, Altman Z Score, that's a pretty easy model that's applied a lot. And we factored in the carbon costs as costs in the different indicators in this model. So, um, the EBITDA has a cost factor, for instance.
And so then we calculated, what is the impact on the Z score, that is the total credit risk. And so that was the approach. And, um so we did that for Canada first, and then now we are currently doing that for emerging countries as well, because, it's an important question there as well. Uh, what is a bit different in the international study is that we use scenarios of climate pricing, because we know that not all countries have the same climate price.
So we have to figure out what's the plan there. And so we try to model that as well and try to model the costs for the companies as well, depending on the emissions.
Cameron: Does your study take into account shifts in capital flowing from one country to another depending on the differences in carbon pricing?
Olaf: Not yet. So we use, to be honest, a relatively simple model, you know, so really focusing on per company, what would be the costs. And as I said, it's, it's very simple. You could also argue the question is, Are these really costs or would the companies be able to let the clients pay for the emissions, for instance?
You know, and so these are things that we might address in the future to get a better model, uh, on that. But we focused on the kind of domestic risks.
Cameron: If I understand it, and please correct me if I'm oversimplifying here, you're looking at a driver, which is the level of carbon pricing that is imposed by government policy, and its effect on the credit risk of these companies, and then what? If the credit risk changes, what's supposed to happen next?
Olaf: Yeah. So, you know, the thing then is, for the lender, what do we do now? And so there might be a change, you know, if you are in the middle of the pack, you might have slightly higher risks because of the cost, but this might not be really a threat for your lender or it doesn't change a lot or a bit, but you are good as well.
So if you're a company in good standing in a way, you can afford to emit more if you can afford the cost. The interesting case is that high emitting industries often have pretty high credit risk already. And so that's, for me, kind of the most, let's say, scary result of that, you know.
So, we see, especially the oil and gas, fossil fuel industry is very capital intensive. They have a lot of debt. And there's the risk, you know, and, and if then you have higher costs because the emissions and they have high emissions usually, then you have a kind of interaction between an already relatively high credit risk plus additional costs. And this is something regulators or the financial industry should keep in mind and consider.
You know, that high emitting industries are often industries that have relatively high credit risks already. So, it's not that they, you know, make a lot of money and they can take it easy, but it's the question, you know, how can I address that and do I run into a systemic issue then? If you have a look at Canada with a pretty strong fossil fuel industry, this might really have a big effect, but let's see, you know, in our international study, we have countries like Nigeria and others that have even a higher dependency on the industry.
And so there might also be issues then internationally that certain countries really get in trouble if they improve a carbon price, what many see as the solution to the problem.
Cameron: Just to clarify, when you're talking about, uh, lenders evaluating the credit risk of these companies, are you talking about, uh, regulated banks? Are you talking about the bond markets or what?
Olaf: It's both, you know. The model we use is typically a model that is used by, by banks, commercial lending. And so that's what we, we do there, but it's similar. There are other studies that used other credit risk models that are in a way similar. So you can use that for bonds as well, you know, the bond market. You can use that for commercial lending, uh, and other types of, of lending, project finance probably as well, you know, but, um, the costs are usually in, in these models and you can consider the costs and the models and then see what the final risk, um, the risk outcome is.
Cameron: Right. Now in the 2023 paper, you've got a graph in figure one that caught my eye because it shows the greenhouse gas emissions in Canada over the years. And it starts in, way back in 2010, it goes through to 2020, and I noticed that in 2020, the greenhouse gas emissions in Canada dropped below 700 megatons of carbon dioxide equivalent for the first time in years and years and years. Is that evidence that government policies are working, or is that just random?
Olaf: Um, 2020 is COVID.
Cameron: Okay that's what it is.
Olaf: So we know that, that went down, you know, in Canada and everywhere, you know.
Generally, environmental pollution, of course, you know, I think there was the first time where you could swim in the Ganges again. So that was a reason. It's going... I think the newest data said that it's going down in Canada as well.
However, it's not going down in the Canadian fossil fuel industry. That's the bad news. The good news is that we still managed to decrease it. So that's the first time I think this year that it's going down without having such an external impact, you know, like, like COVID.
Cameron: So what did you learn from this study that would apply to the banking industry, and what did you learn that might apply to policymakers?
Olaf: Yeah. So for the banking industry, definitely consider these types of risks. And also consider the interaction with the credit risk that is already there, you know, and so, um, that's important. And also I would say it's not only the cost for, for carbon emissions. If you look at Canada, that might be also cost for carbon capture and storage, if a company follow that route, you know, but it won't be free. You know, I think we can say, okay, if you want to reduce emissions, it's never free. And so, you need to figure out how you can do that. So, I think that's from a banking perspective to address these risks. I think that most of them already do that.
The question is how long term do they do that? You know, especially in the lending industry, there's always this argument. A typical loan is five years, you know, so what? We can go out after five years, but that's not, you know, that's not real. If you look at the industry in Canada, for instance, you know, the banks have longer business connections to their clients than just five years.
And if these connections would break, you know, then they would get in trouble. So that's from the banks, you know, do a thorough risk assessment.
From a policy perspective as well, you know, to see what are the consequences, the economic consequences of different models.
We have to have a huge discussion. What is the effect of the climate pricing on the consumers now? Well, that's the current political topic, but you know, we should also think about what are the consequences for the industry and how can we transition industries without creating economic turbulences, you know, and I think this is something where we try to develop policies currently to address these things.
And nobody wants to have a whole sector in, in turbulence and then kind of affects the financial industry as well. And so we have to think about how can we, create these types of regulations and maybe also support using subsidies or something, to support transition process without creating big economic turmoil.
Cameron: I'm going to ask an impudent question if you don't mind. One possible outcome of this study would be that the banks would look at it and say, well, we really need to put pressure on the oil companies to reduce their carbon footprint. Isn't it possible that they turn around and put pressure on government not to raise carbon prices?
Olaf: Yeah, of course, I would prefer the first, but the second still has costs anyway in the future, because then we have the negative effects of climate change. And usually studies show that this is much higher than the investments we can take now.
So if we say, okay, we introduce a climate price and if it's really successful and brings down the emissions, then it's cheaper than dealing with the issues later. The second question is whether the industry is really only influenced domestically. You know, let's see, you know, most of the exports go to the U. S. And if, let's say, the U. S. starts to address emissions and says, you know, you have to pay a border tax on emissions or something like that, what is possible, the European Union thinks about that, then the industry will be affected anyway.
And then, if you have too high emissions in your product, you can't export it anymore. And this has a negative effect on the lender as well.
So I would not, recommend to put pressure on relaxing the policies, but rather to say, okay, what are ways that we can guarantee a long term transition that, uh, doesn't put too high risks on us.
Cameron: So we have this nexus of environmental issues, finance issues, and the time horizon, which you know, varies depending on what kind of decision people are making. Can you tell me a little bit more about this notion of time? You discussed it briefly when you said that banks have hypothetically a five year time horizon, but tell me more about this.
Olaf: Right, so that is an argument that is often used. You know, we have usually the contract of a loan is five years and climate change is a longer term. And if we realize that there's something happening, we can still, you know, finish the contract, but overall, that means, of course, that in five years, if that, if it's really higher risk, you can't do any new business anymore with them or kind of, you know, extend the contract because the risk is so high.
So you don't want to have that. So it's not really an argument. And, and what you see, that's the interesting thing on the long run, you know, if you look at pension funds, for instance, or other institutional investors, they look at that in the long run and they see it as well. And so they are afraid that if, especially if they have direct investments, it might be in the industry or even in other investments like, um, agriculture, forestry.
If you don't know what's going on in 20 years with the timber, with the forest that I have invested in, then you really get in trouble. So, and I think these is, is important. You know, you have these kind of direct risks that depend on the duration and all these things that make sense, of course, if you assess these risks.
But overall, you know, from a systemic point of view, it probably makes more sense to have a more long term view on these things. You know, you can bank on it saying, you know, okay, now the next five years I go full speed, you know, and there was some criticism about that the bank did it, you know, but it's, uh, uh, probably, you know, from a long term perspective and if we want to keep the stability of the financial industry, what is a kind of strength of the Canadian economy, then we should definitely address the problem.
Cameron: Yeah, well, I mean, the banking industry in Canada is very heavily regulated compared to some other countries.
Olaf: Yeah.
Cameron: Um, and our oil industry is, uh, somewhat regulated as well. I don't know whether it's as heavily regulated, but when you're talking about the regulations in the banking sector in particular, do the banks tend to have a longer time horizon or a shorter time horizon than the bond markets?
You mentioned these institutional investors who I presume are picking up a lot of the bonds. Is there a difference there?
Olaf: You know, in the bond market, it's probably a bit more long term than in just commercial credit. But, you know, banks are involved in the bond market as well. They are involved in project finance and other global equity investments, as well. And this is a more long term view. Our example is from, commercial lending, but I think, you know, at the end you can do very similar studies on other types of financing.
And, uh, probably find similar results as well. So you have the cost factor anyway, and, um, you know, the alternative is, is maybe then you just really go per year and see what is the carbon price this year, next year, this year. How long can I afford to do that? Of course, that's from a pure risk perspective, that's something.
But what you do generally, if you want to, you know, if you address the financial stability of a bank or of the industry, you, you check their whole portfolio and you want to see, okay, how much are they exposed to these types of risks? And then you have different types of products and services. Some are more long term, some are more short term.
So, so, but there are differences.
Cameron: Now, I don't think your paper looked at this specifically, but I'll ask you this question based on your own experience. We're living in a time where we've seen interest rates go up and they're starting to come back down a little bit. Do changes in interest rate affect the credit risk? Do higher interest rates amplify what you're seeing?
Olaf: Yeah, of course, you know, that was an interaction as well. If you have a very low interest rate, then overall you have less costs as a borrower and then you are better off, you know. And then again, you know, if you have an interaction here, if you have increasing interest rates plus Increasing costs for carbon emissions, then it increases the risk as well, you know. And then think about maybe you have less sales as well. And so things can amplify quite quickly then.
Cameron: So does this mean that higher interest rates are climate positive?
Olaf: That's the argument of the divestment movement, for instance. You know, they say, okay, we divest. We sell. That means that the value of the shares, of the equity, decreases and this will increase the interest rate because the risk of the company increases and that's what they bank on.
And they said, okay, if we have higher interest rates, then the fossil fuel industry cannot invest as much anymore into new sources, for instance. But that's the same, you know, if the interest rate is high, then the industry has less capital to explore new sources, for instance.
And so, yeah, that has definitely an effect and higher interest rate will probably lead to lower fossil fuel outputs.
Cameron: Do you get a chance to build your current research into some of the courses that you teach?
Olaf: Yeah, I do. I, you know, we discuss in the sustainability and business course, you know, what is the cost factor of sustainability? You know, if you have a better performance, does that increase the cost? Does it decrease the cost? What does it say about the company's risk?
So that's a part of that. I discuss generally sustainable finance, in a way, with the students. I'm also developing a new course on addressing sustainability in the financial industries, and so this will be definitely a topic there, the question, you know, how do they address these, these issues, how do they address climate change, but, um, I think the interesting thing here is, especially for students that do not have the sustainability perspective, that they see that sustainability is pretty material. It's nothing like a nice to have, you know, kind of tree hugging thing. You know, if you don't care and let's say if you don't check your emissions, if you don't decrease your emissions, you get in financial trouble. That's something that is good for business students to know.
Cameron: Hmm. Thank you, Olaf, for taking the time to explain this research. It's interesting to see you tackling a topic that is based on such huge portions of the Canadian economy. The resource sector and the finance sector are big pillars of the Canadian economy. And to see you tease out the interactions between them is quite fascinating.
Olaf: Thank you. It was great to talk to you.
Photo: Patrick Hendry, Unsplash
Links
Olaf Weber’s faculty profile page
LinkedIn: Olaf Weber
Articles by Olaf Weber
Fossil fuel divestment strategies
Carbon Costs and Credit Risk in a Resource-Based Economy
Credits
Host and producer: Cameron Graham
Co-producer: Andrew Micak
Photos: York University
Music: Musicbed
Tools: Descript, Squadcast
Recorded: September 24, 2024
Location: Toronto
