Credit Risk Where It’s Due: Carbon Pricing and Firm Defaults

This study investigates carbon pricing-induced credit risk, the potential negative impact of carbon pricing on firms’ ability to meet their financial obligations. Applying a well-established credit assessment model to a novel data set combining financial statements and emissions data, we subject the over 2.5 million borrowers of the euro area’s largest banking groups to two carbon pricing stress scenarios. Our findings reveal a notable variation in impacts between and within sectors. However, even under the conservative scenario, many firms experience only a minimal increase in their probabilities of default. In the more realistic scenario, the aggregate impact on firms’ creditworthiness is not material. The analysis further suggests that the capitalization of euro area banks would not be significantly affected by the carbon pricing-induced increase in corporate credit risk. While this study does not consider the macroeconomic transmission channels, it indicates that higher carbon prices are not likely to trigger widespread firm defaults and jeopardize financial stability.