Climate Risk, Corporate Default Risk, and Sustainability Practices

Abstract

This study investigates how climate risk propagates into financial stability focusing on corporate default risk. It also explores the moderating effect of firms' sustainability practices, specifically green financing and environmental, social, and governance (ESG) activities. We uncover that climate risk, both physical and transition risk, increases corporate default risk, and this effect works through two key channels: the asset and financing channels. The materialisation of this effect is conditional to firms' sustainability practices, in particular, green financing and ESG activities help alleviate climate risk-induced default pressures. A notable exception is that transition risk-induced default pressure may increase when firms engage in green financing, which can be largely attributable to firms' greenwashing behaviors.

Keywords: Climate risk, Default risk, Sustainability practices, Green finance, Environmental, social and governance (ESG)