Banca d'Italia has published a study analyzing how transition climate risk can affect businesses' credit risk. Specifically, the analysis was conducted using companies' carbon emissions and the Expected Default Frequencies (EDFs) estimated by Moody's for 1308 companies, from 2008 to 2022.
What are Expected Default Frequencies?
Developed by Moody's Analytics, the Expected Default Frequency indicates the probability of default by a company and is based on three factors:
- the market value of assets (estimated by Moody's Analytics),
- the asset volatility,
- the default point, which is the level of the market value of a company's assets below which the company will be unable to make its scheduled debt payments.
Banca d'Italia uses this metric for the following aspects:
- Proprietary data and physical default probabilities: Moody's uses real default data to calculate physical probabilities, thereby removing the influence of risk aversion components that might complicate the interpretation of the data.
- Climate risk analysis: The EDF allows for studying the impact of climate risks on a company's default probabilities over 1, 5, or 10-year horizons, aiming to understand how transition risks can affect business performance over the long term.
- Component breakdown: Thanks to the ability to break down the EDF into its main components, it is possible to disaggregate the effect of carbon emissions on various credit risk drivers, thus providing a more precise and detailed analysis.
How Do Climate Risks Affect Credit Risk? Banca d'Italia's Evidence
The study conducted by Banca d'Italia revealed several significant results that could have a direct impact on corporate strategies, particularly concerning the management of climate risks and credit risk. The main findings from the study are:
- Direct emissions and default risk: Following the Paris Agreement, it was observed that companies with higher direct emissions have a higher probability of default, even within the same credit rating class. This highlights the importance of policies aimed at reducing carbon emissions, not only to reduce transition risk but also to improve business solvency. The Paris Agreement seems to be a key factor in the increased credit risk, amplifying the transition climate risk. Specifically, the analysis revealed that this influence mainly occurs through increased asset volatility, with a greater impact on high-emission companies.
- Relationship between carbon intensity and credit risk: The study confirmed a positive relationship between carbon intensity and credit risk, indicating that companies with a higher carbon footprint, within the same sector, incur higher default probabilities. This suggests that climate risk is becoming an increasingly relevant factor for investors, who may penalize companies with a greater environmental impact.
Conclusion
Banca d'Italia's study emphasizes how transition climate risk is becoming an increasingly determining factor in assessing companies' default risk, especially following the Paris Agreement. Specifically, absolute emissions (measured as total Scope 1 emissions) are significantly correlated with EDFs, primarily through increased asset volatility.
These results highlight the urgency for companies to adopt sustainable strategies that integrate not only climate aspects but also social and governance issues, in order to enhance their resilience and competitiveness in the current economic context. In a world where climate risks are becoming more relevant, companies investing in sustainability may benefit in terms of stability and access to capital.