Taking the carbon out of credit insurance

Shaking up the credit default swap market could amp fossil fuel firms' borrowing costs, making it harder for them to leverage up

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Decarbonising the economy means decarbonising credit. After all, climate-harming companies won’t be pushed to change their behaviour if they are allowed to borrow cash with no green strings attached. 

But traditional loan origination is only part of the picture. A huge chunk of the financing big companies receive is through the sale of bonds and equity securities sold in capital markets. In the US, bonds alone accounted for 34% of all corporate debt financing in 2016.

Carbon-intensive firms are no strangers to this kind of funding. Take a look at Barclays’ latest climate-related financial disclosure. Loans and advances to oil and gas firms on the UK bank’s book amounted to $13.4 billion at end-2019. But it raised more — $20.1 billion — for the sector through the debt and equity markets that year.

Decarbonising credit therefore means decarbonising the capital markets, too. Financial institutions committed to the transition to a zero-carbon economy have made steps towards this goal, for example through the underwriting of green bonds: debt sold with the understanding that the proceeds will be used to fund climate-friendly activities, such as renewable energy projects.  

But while innovations like these are good for funding sustainable businesses, they do nothing to alter the behaviour of ‘carbon hogs’.

There is, though, one corner of the capital markets where a shake-up could have an outsized influence on their borrowing habits.

Take cover

This is the credit default swap (CDS) market. Simply put, a CDS is a contract that insures the buyer against the default of a corporate bond. If Company X welshes on its debt, the holder of a CDS contract on Company X will receive a payout that is the difference between the par value and market value of the defaulted-on bond obligation. In return for this coverage, a CDS seller charges the buyer regular premium payments.

Bondholders buy these derivatives to hedge their default risk. Speculators, on the other hand, sell the contracts to gain synthetic credit exposure.

CDS achieved notoriety as the “financial weapons of mass destruction” that sank US insurer AIG in 2009. At the market’s peak in 2007, there were $61 trillion of CDS notional outstanding. Following post-crisis regulations, it has shrunk dramatically. As of end-2019, CDS notional amounted to $7.6 trillion — 88% down from its zenith.

Of the current amount outstanding, around 54% are notionals tied to CDS indexes — contracts that provide protection on a series of bonds, instead of just one. These instruments are popular because they offer exposure to, or protection on, a broad swathe of corporate credit in one tidy package. Since the indexes are standardised, the contracts are traded over popular exchanges and cleared through central counterparties (unlike the bulk of single-name CDS), which makes them less risky and more convenient to investors.

The two leading indexes of US CDS are the CDX.NA.IG, which tracks investment-grade quality firms, and the CDX.NA.HY, which follows junk-rated corporates. The corresponding indexes for European CDS are the iTraxx Main and iTraxx Crossover. 

So, what does all this have to do with the borrowing habits of carbon hogs?

First of all, studies suggest that CDS lower the cost of issuing bonds for covered corporates. The fact an investor can protect themselves from default by purchasing a matching CDS makes it less risky for them to hold the underlying, putting downward pressure on the bond price. 

Second of all, CDS may give rise to the so-called “empty creditor problem”, which holds that for the very reason bondholders can purchase credit insurance, they become sloppy monitoring the companies they’re invested in — leading to higher defaults.

If we accept these two thesis, then investors in the CDS of fossil fuel-hungry firms are both directly subsidising their borrowing costs and facilitating moral hazard.

The same is true of those buying and selling CDS indexes. Take a look under the hood of the iTraxx Main. Of the 125 names referenced by the index, just 29 have an ‘A’ climate rating from the CDP (formerly the Carbon Disclosure Project), and 31 have grades of ‘C’ to ‘F’ — the worst possible scores. Only 55% of the constituents are signed-on supporters of the Task Force on Climate-related Financial Disclosures (TCFD).

The CDX.NA.IG is even less climate-friendly. Only 12 of the 125 have an ‘A’ climate rating from the CDP, and 13 have an ‘F’ grade. Eleven percent are TCFD supporters. 

Source: CDP

Green screen

One way to alter the borrowing habits of carbon-intensive corporates would be to ban CDS on their debt issuances. Doing so would elevate the credit risks for holders of their bonds, and investors would then demand higher coupons as compensation. Robbing ‘carbon hogs’ of credit insurance could also intensify scrutiny of their balance sheets, making it harder for them to leverage up in order to finance additional climate-harming activities. 

But pigs will fly before an outright ban on fossil fuel firms’ CDS gets approved. The household names among the carbon hogs — like BP, Shell and Caterpillar — have broad investor bases, and these bondholders demand access to credit insurance. It would take a radical, invasive expansion of regulatory power to bar the sale of such instruments.

However, it may be possible to use the market itself to steer demand away from these climate-intensive CDS. The key lies with the CDS indexes. Remember, these make up a little more than half of total notionals outstanding, and are popular with funds, asset managers and other institutions as a means to gain synthetic credit exposure and as broad-brush hedges.

What if new CDS indexes were created which had characteristics similar to the existing benchmarks, but which excluded the climate-harming names? The idea would be to displace the CDX and iTraxx stalwarts with these green variants, which would then become the go-to instruments for credit investors and hedgers.

It’s not an original idea. Students from Umeå University in Sweden wrote a thesis on how to minimise the greenhouse gas (GHG) exposure of the CDX.NA.IG and iTraxx Main, by creating replicating portfolios based on ECOBAR model scores — which are used to rank firms by their emissions.

They found that portfolios of just 10-30 CDS constituents could mimic the indexes with low tracking error and high correlation. Mass take-up of such GHG-lite contracts could lead to “increased corporate bond prices for the worst emitters” and therefore have “a real effect” on the financing of climate-harming businesses, the students concluded. In addition, the contracts could lower the CDS spreads of climate-friendly firms, making it cheaper for them to access funding.

Market participants have yet to take up the idea of a green CDS index, however — though they are not beyond tinkering with the flagship contracts. This year, IHS Markit — sponsors of the iTraxx indexes — launched an ESG variant of the iTraxx Main.

The iTraxx MSCI ESG Screened Europe Index excludes the single-name CDS of firms that make their money from “vice” activities — such as alcohol, tobacco and thermal coal — and those that fall short of international norms on issues such as climate change, biodiversity and land use. Data vendor and index provider MSCI polices the screening process.

This is no green index, though. Environmental considerations make up only part of MSCI’s exclusion criteria, and the names kept in aren’t necessarily those with top climate credentials. Of the 81 names included in the index, just over half are TCFD supporters, and 22 have CDP climate grades of B- or worse.

So, how come an ESG-based CDS product got off the starting line before a climate-friendly one? Markit gives away the game somewhat in the launch statement:

“2019 … saw record inflows into ETFs [exchange-traded funds] and index funds with ESG mandates with AUM exceeding $220 billion as of March 2020. Even in the face of the current pandemic, sustainable funds saw inflows of $14.8 billion in the first quarter of 2020.

Following these developments in the ESG space, there has been significant interest from market participants for a CDS index which would allow investors to gain exposure to (or hedge) ESG screened European corporate credit risk.”

In short, the mania for ESG investments is what’s behind this innovation. It’s likely the new index will win fans among structured product shops, which could use derivatives linked to the index to underpin ESG-friendly credit-linked notes, to be sold to institutions and high-net-worth individuals.

Now Markit has opened the door to CDS index variants, it can’t be too long before a green iteration makes an appearance.

Building the products is not enough on its own, of course. Sponsors will need to nurture an investor base and convince institutions that a green variant offers a decent substitute to traditional indexes.

Still, if they took off, such products could help make business that little bit harder for unrepentant fossil fuel firms, and a tad easier for their climate-friendly competitors.

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