CORPORATE DEBT VALUE UNDER TRANSITION SCENARIO UNCERTAINTY

Since the landmark “Tragedy of the horizons” speech by Mark Carney (2015), the understanding that climate change creates both threats and opportunities for the financial sector became common knowledge. Among the climate-related risks, transition risks are likely to be the most material in the short-term. These risks are not directly related to climate events but rather to asset stranding, policy changes and shifts in consumer and investment sentiment related to climate change adaptation and mitigation (Bank of England, 2017; TCFD, 2017).

The Basel committee in its recent publications (Basel Committee on Banking Supervision, 2021, 2022) emphasizes that banks should identify, monitor and manage all material climate-related financial risks and in particular understand the impact of climate-related risk drivers on their credit risk profiles. This paper, published on July 2, 2022, therefore focuses on the impact of transition risk and transition scenario uncertainty on the credit risk of corporate bonds.

The authors, Theo Le Guenedal and Peter Tankov, develop a structural model for pricing a defaultable bond issued by a company subject to climate transition risk. They assume that the magnitude of the transition risk impacts depends on a transition scenario, which is initially unknown but is progressively revealed through the observation of the carbon price trajectory. The bond price, credit spread and optimal default/restructuring thresholds are then expressed as function of the firm’s revenue level and the carbon price. Numerical implementation of the resulting formulas is discussed and illustrated using real data. Their results show that under transition scenario uncertainty, carbon price adjustments are more likely to trigger a default than when the true scenario is known because after each adjustment the more environmentally stringent scenario becomes more likely. Another finding of the paper is that faster discovery of scenario information leads to higher credit spreads since better information allows the shareholders to optimize the timing of default, increasing the value of default option and decreasing the bond price.

This research was supported by ADEME (Agency for Ecological Transition) in the context of SECRAET project, and by the FIME (Finance for Energy Markets) research initiative of the Institut Europlace de Finance.