The rise of climate risks: Evidence from firms’ expected default frequencies

We investigate the relationship between climate transition risk and credit risk by analyzing firms’ carbon emissions and Moody’s Expected Default Frequencies (EDFs). We document a structural shift following the Paris Agreement, after which absolute emissions became significantly associated with higher EDFs. By decomposing EDFs into their core components, we find that increased asset volatility is the main channel through which transition risk affects credit risk for high-emission firms. Our analysis provides evidence on the mechanisms linking climate transition risk to financial risk, showing that the rise in asset volatility is primarily driven by firms operating in sectors with greater consumer sensitivity and in regions characterized by more stringent climate policy environments. The results are robust to various model specifications and control variables, suggesting that climate-related financial risks are becoming increasingly relevant for credit markets.