The Rise of Climate Risks : Evidence on Firms' Expected Default Frequencies

This paper studies the relationship between climate risk and credit risk. We find a negative correlation between emission levels and default risk once firm's fixed characteristics are taken into account. By breaking down Moody's Expected Default Frequencies (EDFs) into its main components, we are able to uncover the drivers of this result. First, we show that carbon emissions are relevant for the probability of default, especially through the asset volatility channel. Second, we provide evidence that the 2015 Paris Agreement marked a policy turning point that reverberated on firms’ credit risk. After 2015, our results suggest that firms with high carbon footprints became riskier. We observe that this relation is driven by a decrease (increase) in asset volatility of small (large) emitters. With this analysis, we shed light on the channels through which climate risks affect credit risk, highlighting a number of aspects to consider when including climate risk in credit risk-related analyses