1. INTRODUCTION

Climate change affects us all, and its potential impact is enormous. Predictions indicate severe consequences including clean water shortages, significant changes in food production conditions, and increased mortality rates due to floods, storms, droughts, and heat waves (IPCC, 2021). Almost all industries are threatened by the effects of climate change, either directly or indirectly. For instance, Martinich and Crimmins (2019) estimate that the U.S. could lose USD 520 billion across 22 sectors due to global temperature rise.

International agreements to lessen the negative effects of climate change have been developed in response to these concerning projections (UNFCCC, 2015). The 2015 Paris Agreement, commonly referred to as the Paris Accord, is a historic agreement that expands upon earlier agreements such as the UNFCCC and the Kyoto Protocol. By keeping the rise in global temperature far below 2°C over pre-industrial levels—and preferably below 1.5°C—it seeks to bolster the global reaction. Each Party is obliged to make significant efforts, referred to as Nationally Determined Contributions (NDCs), which change over time to account for equity and disparities in national capacities. Along with addressing loss and damage brought on by climatic impacts, the Agreement also focuses on strengthening adaptive ability and resilience, especially for poor nations that are most susceptible. In order to ensure successful implementation, it also recognizes the unique needs of developing countries with regard to funding and technology transfer.

Other notable accords are the Kyoto Protocol (2005), the first legally binding agreement to cut greenhouse gas emissions, and the Montreal Protocol (1987), which also contributes to mitigating climate change by phasing down strong greenhouse gas emissions through the Kigali Amendment (2016) (Maizland, 2023). Collectively, these international agreements provide a thorough framework for international collaboration in the fight against climate change, highlighting the importance of resilience, equity, and sustainable development.

Companies play a critical role in responding to climate change. They are not only one of the primary sources of greenhouse gas emissions but also pivotal in mitigating climate change impacts through innovation and policy implementation. Many companies are investing in renewable energy, implementing energy-saving measures, and engaging in carbon trading to reduce their carbon footprints.

Climate change-related risks can be classified into three types: physical, transitional, and liability risks (Zurich, 2021). Physical risks include immediate threats such as flooding, hurricanes, droughts, and wildfires that cause physical damage to people, property, and transport links. Transitional risks arise from the potential costs associated with implementing policies, laws, and regulations designed to address climate change. Liability risks involve failures to mitigate, adapt to, disclose, or comply with changing legal and regulatory expectations.

These risks create substantial financial hazards as they impact borrowers’ cash flows and capital, thereby affecting the financial health and solvency of companies. Physical risks are particularly menacing as some regions are more exposed to climate-induced extreme weather events, making them more vulnerable.

Research already in existence suggests a strong correlation between business credit risk and climate risk. According to studies (Li & Zhang, 2023; Song et al., 2024), companies that are more exposed to climate risk tend to use conservative financial methods, such lowering financial leverage, to deal with the uncertainty and probable financial instability that comes with it. Studies also show that news about climate change has an effect on the pricing of corporate bonds, with greater exposure resulting in lower returns down the road. This is because investors want bonds that can be used as a hedge against climate risk. Furthermore, eco-friendly companies may issue bonds that are more effective in mitigating climate risk (Huynh & Xia, 2020).

Natural disasters that inflict significant harm to property and interfere with business operations include floods, storms, droughts, and wildfires. Higher physical dangers result in stricter lending terms, like greater loan spreads and higher collateral requirements, because there is a greater perceived default risk, according to Huang et al. (2022). Nguyen et al. (2022) emphasize the difficulties in quantifying climate risk for ESG ratings and go on to explain how regulatory risk impacts firm-level default risk. Strong regulations help companies obtain better financing conditions, therefore effective climate risk management techniques can lessen these effects (Huang et al., 2022).

Despite these developments, there are still gaps in our knowledge of how various physical climate risk levels affect corporate default risk over the long run and how successful environmental regulations are in the long run. In addition to transition risks and the interaction between emissions data and default risk, this study closes these gaps by examining the temporal dynamics of physical climate risks and their effects on corporate default risk.
As mentioned, there is no previous research on the relationship of corporate physical risk and default risk. Therefore, our paper aims to study said relationship. Thus, the study should firstly delve deeper into the relationship between different levels of physical climate risk and corporate default risk over time. Investigating how varying degrees of physical risk influence default probabilities across multiple time horizons will provide a more nuanced understanding of the temporal dynamics involved. Secondly, while this study focuses predominantly on physical risks, future research could expand the scope to include transition risks. Exploring how economic and policy-driven shifts towards a low-carbon economy impact default risk can offer comprehensive insights into the multifaceted nature of climate risks. Thirdly, there should be an emphasis on the long-term effectiveness of environmental policies in mitigating climate risks. By further examining firms that have implemented robust environmental strategies, researchers can identify best practices and provide invaluable guidance for reducing climate-related financial risks. This will aid firms and policymakers in designing and implementing more effective sustainability measures. Lastly, investigating the interplay between emissions data and default risk can shed light on how firm-level environmental performance influences financial stability. Understanding this relationship can help determine the extent to which proactive environmental practices can serve as a buffer against the adverse effects of climate risks.

WRITE THE MAIN OBJECTIVE OF THE PAPER, AND A SUMMARY OF THE MAIN RESULTS (WHEN DONE) OF IT.

The paper is organized into several sections. First, a comprehensive literature review synthesizes existing research on climate risk exposure, credit risk, and default risk. This is followed by the development of hypotheses based on identified gaps in the literature. The methodology section then describes the data collection and analytical techniques employed in this study. Subsequently, the empirical results are presented and discussed. Finally, the paper concludes with the implications of this research and provides suggestions for future studies.

2. LITERATURE REVIEW

Climate change has emerged as a significant risk factor for businesses, with far-reaching implications for financial stability and operational efficiency. The physical manifestations of climate change, such as extreme weather events, and the transitional impacts associated with regulatory and market shifts towards a low-carbon economy, create complex challenges for firms (IPCC, 2021). These challenges not only affect companies’ physical assets and operations but also have profound implications for their financial risk profiles, especially in terms of default and credit risk.

Several studies have explored the relationship between climate risk and corporate credit risk. According to Li et al (2023) highlight that firms with higher exposure to climate risks tend to adopt more conservative financial strategies, such as reducing financial leverage, to mitigate potential impacts. In this study, default risk indicators and access to capital measurements including Altman Z-Score, credit ratings, and liquidity ratios are used to assess credit risk, while a textual analysis of financial reports is used to quantify climate risk exposure by counting the frequency of climate-related phrases. This conservative approach is primarily driven by the need to manage the increased uncertainty and potential financial instability caused by climate risks (Song et al., 2024).
Furthermore, research has examined the influence of climate change news on corporate bond pricing. It has been found that bonds with higher exposure to climate change news risk tend to exhibit lower future returns, reflecting the asset pricing implications of investor demand for bonds that can hedge against climate risk (Huynh & Xia, 2020). Furthermore, Huynh and Xia (2020) highlight the significance of environmental performance in bond pricing decisions, suggesting that investors may view bonds issued by environmentally conscious companies as superior risk hedges against climate risks. Consequently, these bonds may have lower yields due to their perceived lower credit risk. Climate risks are broadly categorized into physical and transition risks. Transition risks arise from the economic and policy shifts required to transition to a low-carbon economy.

These hazards are linked to elements in the market, politics, law, technology, and reputation. These expenses include the price of the asset modifications required to transition to a low-carbon economy, as well as the costs of any national laws that may have an impact on business investments or operations. These risks can lead to significant changes in market dynamics, regulatory landscapes, and technological advancements. Semieniuk et al. (2020) discussed the economic and financial impacts associated with the transition to a low-carbon economy, emphasizing the potential for destabilizing financial systems due to asset revaluations, debt defaults, and the emergence of bubbles in burgeoning industries.

On the other hand, physical hazards are associated with the harm brought about by unfavourable and intense natural events as a result of climate change. They fall into two categories: acute events (such as hurricanes, cyclones, tropical storms, and floods) and chronic events (like high temperatures, droughts, sea level rise, and desertification). These hazards cause significant harm to tangible assets and interfere with operations, raising expenses for businesses. Huang et al. (2022) explored how firms’ responses to physical climate risks affect their access to bank loan financing. Their study highlights that firms facing higher physical risks often encounter more stringent loan terms, such as larger loan spreads and higher collateral requirements, due to the perceived increase in default risk.

The relationship between climate risk and firm-level default risk has been gaining attention in recent studies. Nguyen et al. (2022) elaborate on the challenges in measuring climate risk within Environmental, Social, and Governance (ESG) ratings due to noise in data aggregation across different providers. Their study highlights that climate risk, particularly regulatory risk, significantly affects firm-level default risk. Firms that more frequently disclose transition risks in their annual filings tend to experience a shorter distance to default, indicating increased default risk. This underscores the importance of distinguishing between different types of climate risks and understanding their specific impacts on default risk. In addition, analysis by Huynh and Xia (2020) underscores the necessity of incorporating climate change risks into asset pricing models. It also finds that environmental performance plays a crucial role in bond pricing, particularly under heightened concerns about climate risk.

The moderating role of firms’ environmental policies in the transmission of climate risk to financial risk is a critical area of investigation. Effective climate risk management practices, such as adapting to physical risks and complying with regulatory requirements, can mitigate the adverse financial impacts of climate risk. Huang et al. (2022) illustrate that firms with robust climate risk management practices tend to secure more favorable corporate financing terms. By integrating climate change considerations into business strategies, board governance, and risk management systems, firms can enhance their resilience against climate risks.

Similarly, Huynh and Xia (2020) suggest that strategic financial decisions, such as adjusting debt concentration levels, are influenced by the necessity to manage climate risks effectively. Firms facing greater climate risks may consolidate their debt sources to enhance coordination among creditors, thereby improving their chances of successful debt renegotiation.

Thus, the reviewed literature indicates a significant relationship between climate risk and corporate default risk. Physical and transition climate risks both have substantial impacts on financial stability, influencing firms’ operational performance, cost of financing, and overall credit risk profiles.

2.1. HYPOTHESIS DEVELOPMENT
Based on the comprehensive literature review, the following hypotheses are developed to investigate the relationship between climate risk and corporate default risk and to understand the moderating role of environmental policies.

Physical climate risks, including extreme weather events such as floods, hurricanes, droughts, and wildfires, can cause direct damage to a firm’s physical assets and infrastructure, leading to significant operational disruptions. These disruptions can increase a firm’s financial vulnerabilities by causing revenue losses, increasing repair and maintenance costs, and potentially leading to operational shutdowns. According to Huang et al. (2022), firms facing higher physical climate risks often encounter more stringent loan terms due to the perceived increase in default risk. Furthermore, it has been demonstrated that large carbon emissions and poor management of greenhouse gas emissions have a detrimental effect on business value and are associated with financial distress (Beatty & Shimshack, 2010; Matsumura, Prakash, & Vera-Munoz, 2014). Therefore, this hypothesis posits that higher exposure to physical climate risks will significantly impact firms’ default risk by increasing the likelihood of financial distress and default.

Hypothesis 1: Firms’ default risk is significantly impacted by physical climate risk.

Secondly, we can expect that firms with robust environmental policies are better equipped to manage the risks associated with climate change. These policies may include reducing carbon emissions, improving energy efficiency, and adhering to environmental regulations. Effective environmental policies can mitigate the financial impacts of climate risk by reducing a firm’s environmental footprint, thereby minimizing exposure to regulatory fines and penalties. Additionally, firms with strong environmental policies may be more resilient to operational disruptions caused by physical climate risks. Huynh & Xia (2020), for example, highlighted how environmental performance can enhance a company’s financial health by drawing in environmentally sensitive investors and fostering better stakeholder interactions. Similar findings were made by Khan, Serafeim, and Yoon (2016), who discovered that companies with robust ESG policies are better equipped to handle risks—including those associated with climate change. As such, our second hypothesis suggests that firms with effective environmental policies will exhibit lower default risk due to their enhanced ability to manage and mitigate climate-related financial impacts.

Hypothesis 2: The effect of physical climate risk on firms’ default risk is mitigated for firms that implement effective environmental policies.
The compounding nature of physical climate risks means that firms exposed to higher levels of such risks will likely face increasing challenges over time. As climate change progresses, the frequency and severity of extreme weather events are expected to rise, exacerbating the financial strain on companies. This hypothesis posits that firms classified under higher levels of physical climate risk will show increased default risks in future years. Studies such as those by Semieniuk et al. (2020) highlight the potential for destabilizing financial systems due to asset revaluations and debt defaults driven by escalating physical risks. By investigating this hypothesis, the study seeks to establish a clear link between varying levels of physical risk exposure and the projected increase in default risk over specified future periods. This way, our third hyposthesis is the following:

Hypothesis 3: The effect of physical climate risk on firms’ default risk is higher for firms with high levels of physical climate risk exposure.

Finally, environmental performance reflects a firm’s commitment to sustainable practices and its capability to manage environmental risks proactively. Firms with high environmental performance are likely to have implemented comprehensive risk management frameworks that address both physical and transition risks associated with climate change. These firms may benefit from better access to capital, as investors increasingly prioritize sustainability in their investment decisions. Additionally, high environmental performance can enhance a firm’s reputation, reduce compliance costs, and improve operational resilience. Therefore, this hypothesis posits that the adverse impact of climate risk on default risk will be mitigated for firms with high environmental performance. As suggested by Nguyen et al. (2022), distinguishing between different types of climate risks and understanding their specific impacts on default risk is crucial. This hypothesis aims to demonstrate that environmental performance can effectively moderate the detrimental effects of climate risk on firms’ default risk. So, our final hypothesis is:

Hypothesis 4: Firms’ environmental performance moderates the impact of climate risk on default risk. (write in the future

By testing these hypotheses, this research aims to provide a comprehensive understanding of how climate risk affects corporate default risk and credit risk, and explore the moderating role of environmental policies in this transmission.
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