A climate credit risk model: a structural approach

We introduce a structural model to assess the climate transition risk associated to portfolios of corporate bonds and equity shares, conditioned to climate scenarios, such as those developed by the Network for Greening the Financial System (NGFS).We translate forward-looking economic trajectories developed by process-based Integrated Assessment Models into adjustments in the valuation of financial securities issued by counterparties in economic sectors that are relevant for transition risk. Importantly, we consider the composition of firm’s revenues from high and low-carbon activities and how they will be affected would specific orderly or disorderly transition scenarios materialize. The adjustment in equity share value, default probabilities, loss-given-default and expected value of the bond depends thus on the interplay between the scenario and the technological profile of the issuer. We illustrate the outcome of the methodology on a sample portfolio of securities. Our approach is science-based, transparent and replicable. It contributes to fill an existing gap in the financial literature, thus contributing to strengthen climate credit risk modelling. This, in turn, is crucial for central banks and financial supervisors, being credit ratings a relevant part of the information set for both monetary policy implementation and reserve management purposes.

‍

‍

Selected by Virginie GASTINE MENOU