Default Risk and Transition Dynamics with Carbon Shocks

August 25, 2023

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Format: Chicago

Sujan Lamichhane. Default Risk and Transition Dynamics with Carbon Shocks, (USA: International Monetary Fund, 2023) accessed November 23, 2024

Disclaimer: IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.

Summary

Climate mitigation policies are being introduced around the world to limit global warming, generating new risks to the economy. This paper develops a continuous time heterogeneous agents model to study the impact of carbon pricing policy shocks on corporate default risk and the consequent transition dynamics. We derive a closed-form solution to corporate default probability based on firms' intertemporal optimization decisions and explicitly characterize the transition speed. This allows for studying policy implications in an analytically tractable way. The model is calibrated to different US corporate sectors to quantify the heterogeneous effects of carbon price shocks. While carbon-intensive sectors face increased default risks, there are notable asymmetric effects within sectors. Higher carbon prices increase default risk but also induce faster transition towards the new post-shock steady state with a highly non-linear impact. Our results suggest that once a range of possible price shocks are accounted for, the increase in the cost of capital/risk premiums might be sharply different across sectors.

Subject: Debt default, Economic sectors, Environment, External debt, Greenhouse gas emissions, Manufacturing

Keywords: Carbon price, Carbon price shock, Climate mitigation policy, Climate risk, Cost of capital, Debt default, Default rate, Default risk, Global, Greenhouse gas emissions, Manufacturing, Policy shock, Price shock, Risk premium., Transition dynamics

Publication Details

Pages:

51
Volume:

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DOI:

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Issue:

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Series:

Working Paper No. 2023/174
Stock No:

WPIEA2023174
ISBN:

9798400252440
ISSN:

1018-5941

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