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 risk.
Several studies have explored the relationship between climate risk and corporate default risk. According to Li et al. (2023), firms with higher exposure to climate risks specially both physical risks and transition risks aim to adopt more conservative financial strategies, such as reducing financial leverage, to mitigate potential impacts from climate-related acts. In order to assess credit risk and provide a comprehensive view about firm’s default risk, there are different indicators employed. The Altman Z-Score, used to predict the bankruptcy risk and credit ratings, used to evaluate the creditworthiness, and liquidity ratios are used to evaluate firm’s ability to meet the short-term obligations. A textual analysis of financial reports is employed to quantify climate risk exposure by counting the frequency of climate-related phrases, which help firms to aware and response to both physical and transition climate risk. This conservative approach is 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). Huynh and Xia (2020) also 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. Physical risks involve the direct impact of the climate change events such as extreme weather condition and the natural disasters which can disrupt firm’s operations and influence its financial stability. While transition risks arise from the economic and policy shifts required to transition to a low-carbon economy such as new regulations and market adjustment. 
It is vital for the investors to understand the difference between actual and transition risk and their respective impacts on credit risk. As it can help them the potential returns of corporate bonds in the context of climate change.
Regards to physical hazards, they are associated with the harm brought about by unfavorable 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 study emphasizes the importance of understanding the relationship between physical climate risks and credit risk, as it highlights how these risks affect the financial stability and borrowing conditions of firms.
The relationship between climate risk and firm-level default risk has been gaining attention in recent studies. Huynh and Xia (2020) examine the broader impacts of climate change risk, incorporating physical such as direct impact of climate events and regulatory transition risks into asset pricing models. Their analysis highlights the need to incorporate climate risk into these models, highlighting that environmental performance is significant to bond pricing decisions. This study uses bond yields, credit ratings, and distance to default as measures of credit risk, reflecting how market participants perceive the creditworthiness of firms based on their environmental performance and climate risk. Conversely, 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 emphasizes specially on regulatory risk, a type of transition risk that 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. The credit risk measure used in their study is the default distance derived from the Merton model, which assesses the based on the value of a firm's assets relative to its liabilities. This underscores the importance of distinguishing between different types of climate risks and understanding their specific impacts on default 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 need 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 suggests 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. 
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