Carbon default swap – disentangling the exposure to carbon risk through CDS

The decarbonisation prescribed by net-zero carbon emissions policies will require a massive economic transformation. These changes can generate sizeable costs with consequential impacts on business valuations, especially for firms that are unprepared for the transition. Understanding the impact of these transformational changes requires the measurement of carbon risk exposure in a way that also appropriately reflects firms’ future carbon profiles.

In this paper the authors use Credit Default Swap (CDS) spreads to construct a forward-looking, market-implied carbon risk factor and study how, where and when carbon risk affects firms’ creditworthiness by examining whether firms’ exposure to carbon risk is reflected in the market prices of their CDS contracts.

The authors show that even under ordinary conditions (i.e. for average relative changes in CDS spreads), carbon risk is a determinant of credit risk. They conduct further analyses to test for geographical and sectoral dependencies and show that the effect is larger for European than North American firms and varies substantially across industries, suggesting the market recognises where and which sectors are better positioned for a transition to a low-carbon economy. They also find that the effect of carbon risk on CDS contracts is even stronger during times of heightened public attention to climate change, suggesting that lenders appear to be more sensitive to carbon risk when market-wide concern about climate change risk is elevated.

Finally, the authors analyse the temporal dimension of this effect, extending the understanding of when carbon risk affects firms’ creditworthiness. They show that a shift in the expected temporal materialisation of carbon risk increases the carbon risk in the future. In Europe, the effect on the CDS term structure is particularly salient for shorter time horizons, suggesting that the market perceives carbon risk to be a short- to medium-term risk – i.e. over the next two years. This last result is of particular interest to central banks and speaks to the debate about the (horizon of the) carbon risk and the pertinence of monetary policy adjustments. Collateral in monetary policy operations is generally pledged for short periods only. If carbon risk is exclusively a long-horizon issue, central banks might be less concerned with carbon risk and associated consequences, such as stranded assets.

Key points for decision-makers

• A Credit Default Swap (CDS) is a type of derivative that transfers the credit exposure of fixed income products.
• Carbon risk can be described as the impact of unexpected changes in the scope, timing and speed of greenhouse gas emissions mitigation policies.
• The authors utilise the information contained in CDS spreads to construct the carbon risk, or CR, factor – a market-implied and forward-looking proxy for carbon risk exposure. They propose a method for constructing the CR factor and study how it affects firms’ creditworthiness.
• The carbon risk factor is constructed as the difference between the daily median CDS spreads of high-emission-intensity (polluting) firms and low-emission-intensity (clean) firms. This difference is used to identify how the lenders market perceives the differential exposure of polluting and clean firms to carbon risk. When policy events (e.g. announcement of tightening regulations) trigger a rise in carbon risk, lenders to more (less) exposed firms demand increased (decreased) protection, widening the CDS wedge, i.e. the distance between the price of default protection for polluting and clean companies. Conversely, if a loosening of regulation is expected, there is a narrowing of the wedge (or even a negative wedge). The carbon risk factor thereby represents changes in perceived exposure to carbon risk on a very granular level.
• By construction, the financial performance of this factor mimics the dynamics of a lending portfolio in which default protection is bought for a polluting firm and sold for a clean firm.
• The authors find a positive relationship between lenders’ perceived exposure to carbon risk and firms’ cost of default protection. This is significantly stronger in Europe – which is notably pro-carbon regulation – than in North America.
• Exposure to carbon risk also varies substantially across industries. There is a high sensitivity to carbon risk in the CDS spreads of the classic carbon-intensive sectors (e.g. energy, basic materials, utilities), while the market seems to regard other sectors (industrials, technology, healthcare) as capable of making the necessary adjustments to facilitate a low-carbon transformation. These sectors therefore benefit from a surge in carbon risk.
• The findings suggest that an improvement in the quality and comparability of current carbon emissions disclosures and emissions reduction strategies would facilitate better assessment of firm-level carbon and credit risk. The findings also highlight the relevance of a periodic and transparent disclosure practice in the market to better reflect firm-level carbon and transition risk.