Climate Transition Risk Mitigation: Introducing the CLoCo Bond

Abstract

R ecent events regarding governmental climate transition policy (e.g., UK announcement on electric vehicle roll-out, statements on climate change by political parties in the United States) and uncertainties linked to the ability for industry sectors and consumers to manufacture and purchase low carbon technologies, respectively, have led to a wider need to embed a richer framework for uncertainty in climate transition outcomes. This uncertainty creates a number of financial risks for firms, their investors, the banking sector, potentially also including sovereign risks. With the current academic literature (for a review see Cormack & Shrimali) and documentation by professional bodies and institutions (e.g., ISDA, CFRF, NGFS, ECB, BoE) modelling has been focussed on building frameworks that can transmit climate change external risk factors from physical or transition pathways to financial impacts. Furthermore, there has been an increased interest in embedding the variability and uncertainty of climate change risks, leading to a need to develop a probabilistic framework (e.g., Rebonato & Kainth, and Kenyon, Macrina & Berrahoui). In this article, we build on these concepts and propose a probability space that supports climate transition risk. The main objective is to develop novel applications to develop financial instruments for firms to reduce the risk of climate transition policy changes and adverse economic environments. In particular, we propose greenhouse gas (GHG) emission trajectories on a probability space for firms within a specified industry sector for regions worldwide. The GHG emissions trajectories are specifically linked to defined emissions policies. Here, we endeavour to develop a tangible prob-abilistic approach with measurable quantities which are clearly linked to policy objectives. An associated goal is to build tools that can assist firms, their stakeholders, and governments in reducing risks exacerbated by climate change. As an example of a risk-sharing instrument, we propose a novel financial product, termed climatecontingent convertible (CLoCo) bond, whose financial structure permits firms to reduce the risk of default due to adverse climate transition policies over the product's lifetime. We utilise the transition probability space and detailed firm-level models to develop the pricing theory for such an instrument. The implications of the proposed financial instrument are such that it can lead to not only reduced risk of default for firms, thereby increasing the expected firm value, but it also reduces the dependency of firm failures on the banking sector and potential bail-out costs incurred by sovereign nations.

Keywords: Climate Risk, Climate Mitigation, Climate Finance, Climate Transition Risk, CLOCO, ESG, financial products

JEL Classification: Q54, Q59, Q55, Q58, G13, G11, G17, G21, G24, G33