Transitioning to a low-GHG economy : ESG differentiated pricing as a dynamic transition tool and its calibration

Abstract

This paper provides an in-depth discussion on the challenging task of transition that financial institutions (FIs) face in the context of key regulatory, market and competitive dynamics. In response to the necessary transition to a low-greenhouse gas (GHG) economy, FIs will need to adjust their business model and strategy to ensure future viability. Consequently, they need to change their asset mix from brown industries to green industries and direct their financing towards green activities and companies with favourable environmental, social and governance (ESG scores). They will need to do this in an orderly fashion, striking the right balance between future readiness and remaining sufficiently competitive and profitable along the way. To do that they need transition tools that allow them to steer their portfolio mix and activities towards the future low carbon economy, enable them to get paid for the ESG risks they take and ensure that they remain in control so that they can adjust and correct their lending mix as needed. In this paper, a transition tool that incorporates ESG risk into pricing is discussed. The proposed three-layer framework incorporates industry and loan purpose effects, as well as borrowers’ ESG scores as an idiosyncratic element. The calibration of the tool is explained using numerical examples.