Climate Default Swap – Disentangling the Exposure to Transition Risk Through CDS

Abstract

The substantial economic transformation required to mitigate and adapt to climate change will lower the value of certain businesses as well as some firms' assets in the not-too-distant future. Firms will need to transition to a less carbon-intensive business model, but may do so at different times and at different speeds, incurring different costs and risks in the process. We propose and implement a novel market-based measure of exposure to transition risk (transition risk factor) and examine how this risk affects firms' creditworthiness. We discipline the exercise by using Credit Default Swap (CDS) spreads to capture differential exposure to transition risk across economic sectors. We show that the transition risk factor is a relevant determinant of CDS spreads and provide evidence of the relationship between the differential exposure to transition risk and firms' cost of default protection. This effect is particularly pronounced during deteriorating credit market movements. However, effects vary substantially across industries, reflecting the fact that transition risk impacts firms' valuation differently depending on their sector. Our findings also suggest that investors seek greater protection against transition risks in the short– to medium-term, indicating an expectation of a swift transformation of the entire economic structure.