How Do Banks Price Climate Risk? Evidence from Firm-Level Lending in China

Commercial banks manage climate risk by pricing firm climate risk exposure into loan spreads. Using annual report disclosures, we measure this exposure and estimate its impact on loan pricing. A one-standard-deviation increase in climate risk exposure raises loan spreads by 40 basis points on average. Banks respond to firm transition risks but not to physical risks. This effect stems from transition risks that reduce firm profitability and increase default probabilities. In contrast, banks do not adjust loan spreads for physical risks which primarily cause losses in tangible assets. The pricing of climate risk intensifies for high leverage and risk firm, as these firms are more susceptible to climate-related shocks. External factors also matter: during periods of heightened public climate awareness and for banks with strong environmental commitments, the climate risk premium in loan spreads grows larger.