Internalization of Emission Credits, Social and Environmental Risks of Lending Activities: An Extension of Dealership Model

Environmental legislation and regulation on corporate social responsibility has been increasingly restrictive across nations. Firms often bear costs of investing in environmentally and socially conscious technology or costs of cleaning up social and environmental damage. Financiers, banks in particular should take into account such costs in pricing and supplying loans. In Europe, the USA, and Pacific region, many banks have been voluntarily assessed the environmental and social impact but failed to transmitted the impact into prices. Thus, since 2005, banking regulation in Indonesia prescribes guidelines to assess and price environmental and social risk of lending activities. However, the regulation does not govern lending to project abating greenhouse gases (GHG) emission . Consequently, only a few banks in Indonesia factor the impact of emission credits into loan prices and supply . Lending to projects generating emission credits exposes Indonesian banks to uncertainty about price of emission credits while generating additional revenue from selling emission credits. This study investigates internalization of emission credits, environmental risk, and social risk into risk management of 51 Indonesian banks. Specifically, it examines the interplay between prices of bank’s product such as loans and 1) risk-return on loans generating emission credits, 2) portfolio effect of non-maturity deposits, 3) environmental and social performance of borrowing firms. The research problem is as follows: How are prices of bank’s products associated with risk-return on CER generating loans, environmental risk, and social impact of lending activities? The emission credit considered in this study is Certified Emission Reduction (CER), which is the only type of emission credits issued to developing countries such as Indonesia. Risk-return on CER generating loans is investigated in the context of CER prices. This study borrows from previous work in price dynamics of future price of European Union Allowance (EUA), emission credits issued to EU member states. However, bidirectional causality presumably exists between business cycle and prices of emission credits and energy. Thus, dynamics of CER is studied under VARMAX framework. The spot prices of CER are used instead of future prices to tackle debate about convenience yield in future prices of emission credits. The results show that positive shocks on the economy of the EU-27, technology switching cost, and EUA prices increase demand on CER. Extreme hot and cold weather also increases demand on CER. The results are robust to measures of technological switching costs and business cycle. The association between emission credits, environmental risk, and social impact of lending activities is examined by introducing Dionne and Spaeter’s (2003) idea about environmental liability into Ho-Saunder’s (1981) dealership model. Dionne and Spaeter demonstrated that when cost to clean up environmental damage influences debt service, banks essentially bear part of borrower’s environmental liability. The dealership model is selected as theoretical construct since it could capture the association between loan supply and prices, and deposit supply and cost. The dealership model is modified to demonstrate portfolio effect of deposit and the environmental and social impact of lending activities. The model is tested on unbalanced quarterly panel data of 51 banks from March 2005 to December 2010. The results confirm the modified dealership model. Supply of non-maturity deposit (i.e. savings and demand deposits) increases with spread between prices of maturity deposit (i.e. term deposit) and return on invested maturity deposits in money market. On the other hand, supply of maturity deposits decreases with spread between prices of maturity deposit and return on invested maturity deposits in money market. Spread between loan and deposit prices, known as intermediation margin, increases with market and credit riskiness of bank’s products, environmental and social performance of borrowing firms, degree of risk aversion, expected profit, price volatility of emission credits, transaction size, and market power. The price spread decreases with operating cost, opportunity cost of cash reserve, liquidity reserve requirement, and upper bound of deposit prices under mandatory deposit insurance scheme. It is important to note that price volatility of emission credits is not statistically significant in explaining variation in loan prices due to small number of banks factor emission credits in loan prices. The results are robust to the inclusion of time variables, clustering, and heteroskedasticity in residuals.