The Effects of Climate Change and Climate Policy on Credit Risk

This study examines how climate-related physical and transition risks affect credit risk. We develop a modular framework based on a threshold model for credit migrations, linking the latent credit cycle to key economic indicators to measure credit risk in corporate bond markets. Using historical rating migrations, we estimate the model parameters and apply the framework to U.S. data to assess the implications of alternative transition scenarios. These scenarios generate projected paths for credit cycles that differ markedly in direction, magnitude, and volatility. These differences translate into substantial variation in both expected losses and tail risks for diversified bond portfolios. Notably, high-quality bond cohorts are also sensitive to policy choices. Comparisons with a continuation of current policies show that orderly transitions, characterized by reduced physical damages and increased transition costs, entail higher initial expenses but deliver net savings from 2035 onward. In contrast, disorderly transitions result in steep cost increases after 2030 and overall higher costs by 2050.