Climate Credit Risk and Corporate Valuation

We develop a micro-founded model of climate credit risk (CLIMACRED) for scenario-contingent valuation, linking adjustments of the firm's default probability and credit risk to the reference supervisory climate transition scenarios of the Network for Greening the Financial System (NGFS). We unveil a new economic mechanism of asset stranding, with transition risk emerging from the change in asset value triggered by a change in markets' expectations about the material impact of a climate policy scenario on the firm. We quantify the impact of changes in market's expectations about climate policy scenarios on the financial valuation adjustment of the firm's financial instruments (equity and bonds), applying CLIMACRED to a universe of utility companies. We find that the firm's valuation adjustment depends on the interplay of (i) the technology profile of the firm's assets and revenues, (ii) the timing and magnitude of the carbon tax (iii) the dynamic technology cost adjustment across scenarios. Firms with revenues from different energy technologies would face lower financial losses in disorderly transition scenarios,n comparison to firms relying solely on fossil fuels that would face up to 80% losses in valuation, implying larger credit and portfolio risk for the bonds' holders. The model was adopted by the NGFS for the development of its short-term climate scenarios to provide a comprehensive assessment of climate financial risk dynamics.