Carbon default swap – disentangling the exposure to carbon risk through CDS

Using Credit Default Swap spreads, we construct and validate a forward-looking, market-implied carbon risk (CR) factor and show that the impact of carbon regulations on firms’ credit risk varies with the regulation’s scope and stringency, and with the speed of mandated carbon reduction. We find that explicit carbon pricing sharpens lenders’ evaluations, resulting in firms under such regimes incurring three times the additional credit protection costs. This impact escalates with the proportion of a firm’s direct emissions subject to regulation – the policy’s stringency – and varies by the sector in which the firm operates. With an increase in the CR factor, lenders foresee higher costs for short-term transitions.