A Structural Model of Climate Credit Risk

The finance literature on carbon risk focuses mostly on the extent to which this risk is currently priced in financial markets. This paper sheds light on a complementary question, i.e. what could be the level of potential carbon risk implied by different future climate policy scenarios. To this end, we develop a novel structural climate credit risk model that links the firm's default probability to the climate scenarios developed by financial authorities. Climate transition risk results from changes in market players’ expectations regarding the realization of the decarbonization scenarios. We derive closed-form expressions for the adjustments in firms' default probability, and value of issued bonds and equities, conditioned to any given climate scenario. We show that adjustments vary greatly with the severity of scenario and the energy technology mix of the firms