N°26-19: Climate Policy, Credit Risk, and Monetary Transmission

We study how monetary policy affects the choice between green and brown technologies when firms finance investment with bank loans. Climate policy affects brown firms through lower cash flows, shorter asset lives, and lower values of stranded assets. When default is costless, climate policy makes brown investment less sensitive to interest rates. When default is costly, climate policy also makes brown borrowers riskier, so higher interest rates raise their loan rates by more. In our benchmark, in which climate policy raises brown spreads by 30 basis points, the upper end of estimates, the higher loan rates offset about two-fifths of the reduction in brown investment’s rate sensitivity, and about three-quarters in a severe transition. At equal climate-policy stringency, default costs roughly quadruple the climate-induced rise in pass-through of tightening to brown loan rates. The offset is larger for carbon pricing and falling values of stranded assets than for phase out mandates.