No. 59 - Modelling transition risk-adjusted probability of default

This paper introduces a novel methodology to estimate the effect of climate-related transition risk on the one-year probability of default of Italian non-financial firms. To this end, we derive a granular dataset integrating the EU Emissions Trading System (EU-ETS) with market and corporate financial data. Within the EU-ETS framework, firms with emissions above (below) their free allocated allowances generate additional costs (revenues), which can potentially affect their creditworthiness. We then run stochastic simulations on the price volatility of EU-ETS futures and an extreme event risk analysis on their distribution to generate price scenarios. We assess the extent to which the costs of (revenues from) excess (negative) emissions affect firms' financial statements under different price scenarios. Our findings suggest that this approach provides a more precise assessment of the impact of transition risk on firms' creditworthiness than the one based on the scenarios of the Network for Greening the Financial System; for a few firms, the rating is upgraded. Furthermore, our framework aligns the transition risk horizon with the standard twelve-month timeframe in credit risk assessment and allows for regular updates of credit ratings.