A Reduced Form Approach for Modeling Credit Risk Sensitivity to Excessive CO2 Emissions

Abstract

This paper presents a simulation study of a generalized Cox approach for modeling credit risk in the context of a firm exposed to extrem CO2 emissions. The study uses a Poisson process to model the random events associated with such excessive CO2 emissions, and a shot noise process to capture the impact of these emissions exceedances exceedances on the firm’s hazard process. The simulations show the effectiveness of the generalized Cox approach in capturing the impact of extrem CO2 emissions exceedances on credit risk, and the sensitivity of the results to changes in the model parameters.

Keywords: credit risk, Emissions Trading System, GHGs, default probability