On the Dependence of Investor’s Probability of Default on Climate Transition Scenarios

Abstract

Climate risk brings about a new type of financial risk that standard approaches to risk management are not adequate to handle. Amidst the growing concern about climate change, financial supervisors and risk managers are concerned with the risk of a disorderly low-carbon transition. We develop a model to compute i) the valuation adjustment of corporate bonds, depending both on climate transition risk scenarios and on companies’ shares of revenues across low/high-carbon activities, and ii) the corresponding adjustments of an investor’s Expected Shortfall and probability of default. Implications for central banks' climate financial risk management include that climate stress test exercises should allow for a wide enough set of scenarios in order to limit the underestimation of losses.

Keywords: Climate transition risk, climate policy scenarios, probability of default, corporate bonds, Expected Shortfall, climate financial risk assessment, risk management

JEL Classification: G10, G32, Q54