Climate Risk and Credit Risk : Theory and Empirics

Given the potentially severe financial consequences due to climate change, understanding how climate risks contribute to firms’ credit risk is essential. Building on a Merton-type model, we propose a new model that introduces a random growth adjustment factor in the firm value dynamics to reflect the depreciation due to climate risks. We also review the current state of the literature on how structural models of credit risk are employed to model the impact of climate risk on financial markets. Motivated by the theoretical models, we utilize the information contained in the spreads of Credit Default Swap (CDS) contracts to construct a market-implied, forward-looking carbon risk (CR) factor. We examine empirically how the scope and speed of economic transformation vary across jurisdictions, sectors, and over time. Explicit carbon emission pricing enables lenders to sharpen their assessments. The breadth of the regulation intensifies financial repercussions from carbon risk. The impact differs significantly across industries, indicating that the market identifies which sectors are better poised for a transition to a low-carbon economy. Lenders expect that adjustments in carbon regulations in Europe will cause relatively higher policy-related costs in the near future.


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