Title: The climate spread of corporate and sovereign bonds
Authors: Stefano Battiston - Ca\' Foscari University of Venice (Italy) [presenting]
Irene Monasterolo - Vienna University (Austria)
Abstract: Climate risk generates a new type of financial risk that standard approaches to risk management are not adequate to handle. Amidst the growing concern about climate change, central banks, financial regulators and policymakers are concerned with the risk of a disorderly low-carbon transition, i.e. a situation in which a sudden introduction of climate policy (e.g. a carbon tax) cannot be fully anticipated by investors and affects large portions of assets, causing asset price volatility (both positive and negative). We develop a model that allows computing the valuation adjustment of corporate and sovereign bonds conditioned to climate transition risk, based on available forward-looking knowledge on climate policy scenarios provided by climate economic models. Our model allows investigating the impact of the endogeneity and deep uncertainty of future scenarios on both the valuation of individual bonds and on standard risk metrics for leveraged investors, considering the role of fossil fuels and carbon-intensive activities in the economy of countries. Based on analytical results complemented by copula simulations, we show that the probability of default of investors is very sensitive to the characteristics of climate policy scenarios, including the default probability of the bonds in the portfolio and their correlation. Thus, Climate stress test exercises need to allow for wide enough sets of scenarios to avoid underestimation of losses.