Carbon Default Swap

Researchers from the Grantham Research Institute and the Centre for Climate Change Economics and Policy present an innovative proxy that can be used to assess how perceived exposure to carbon risk influences firms’ creditworthiness on a granular level. The authors define carbon risk as “the carbon component of transition risk”.

The paper’s findings show that higher carbon risk is a determinant of higher credit risk, as lenders demand greater credit protection to offset firms’ exposure. The results have implications for central banks and regulators assessing the adequacy of collateral frameworks, prudential policy and existing emissions disclosure regimes.

Analysing the impact of perceived carbon exposure on firms’ credit default swap (CDS) spreads, the authors construct a forward-looking, market-implied and observable proxy that shows how transition risk transfers to credit risk. By examining the market prices of firms’ CDS contracts, their methodology isolates how, where and when carbon risk affects creditworthiness.

The authors define carbon risk as the “carbon component of transition risk”, and can be described as the expected impact of unexpected changes in the scope, timing and speed of emission mitigation policies.

The results show a positive relationship between lenders’ perceptions of carbon risk and firms’ cost of default protection. The marginal impact of carbon risk was particularly pronounced in Europe, in the tails of credit spread distribution and in high-emitting sectors such as energy, utilities and construction materials.

The transition is also likely to have an imminent impact on European business valuations, especially for firms that are unprepared. In Europe, carbon risk accounts for 6.9% of the standard deviation of CDS spread returns, making it the second most influential driver of credit spreads, and the effect on the CDS term structure is particularly salient for shorter time horizons.

The results of this paper have three major implications for regulators:

• as carbon risk is significantly amplified at the tails of the credit spread distribution, risk management practices and prudential standards must incorporate carbon risk;
• the results show that the market perceives carbon risk as serious and imminent in Europe, raising concerns regarding the sufficiency of collateral frameworks within existing monetary policy horizons;
• the findings imply a need for improvement in the quality and comparability of carbon emissions disclosures and emissions reduction strategies to properly assess credit risk.

The authors also found that lenders are more sensitive to carbon risk when market-wide concern about climate change risk is elevated in the news and media. When announcements of tightening regulations trigger a rise in carbon risk, lenders demand more or less protection according to their perception of a firm’s ability to absorb the associated costs.