The benefits of the positive externalities of an unpolluted environment and stable climate are enjoyed by all economic actors. Conversely, the costs of the negative externalities of the pollution and emissions that damage the environment and cause climate change have historically not affected individual firms. However, both positive and negative externalities can be internalized by a firm with the introduction of relevant policy- and market-based mechanisms.
For the first time for a Chinese financial institution, this paper discusses the impact of internalizing environmental costs onto a firm’s balance sheet and the consequent risks this creates for commercial banks. A relevant theoretical framework, transmission mechanisms and analytical methodologies are established to assess the impact of tightening environmental protection standards and climate change policies, joint and several liabilities that banks are exposed to via their customers’ activities and changes in the bank’s reputational standing in the eyes of its shareholders and depositors.
Two industries, namely thermal power and cement production, are selected for stress testing against a range of high, medium and low stress scenarios and the impact on their financial performance and credit ratings is assessed as a result. Actionable responses to this analysis are put forward. This bank-led approach to research in this focused field (i.e. assessing the impact of environmental factors on credit risk of commercial banks) is pioneering in China.
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