Credit portfolio with carbon footprint overlay

Carbon Pricing & Credit Risk: How Climate Policy Impacts Your Investments

Nico Varela in Business & Economy December 2025 • 4 min read.

"A new study reveals the surprising ways carbon pricing affects credit portfolios, potentially reshaping investment strategies."

Climate change is no longer a distant threat; it's an economic reality. Governments worldwide are implementing carbon pricing—putting a cost on greenhouse gas (GHG) emissions—to encourage a transition to a low-carbon economy. But what are the hidden financial consequences of these policies? A groundbreaking study is shedding light on how carbon pricing propagates through credit portfolios, affecting everything from default probabilities to investment profitability.

The financial sector is facing increasing pressure to understand and manage climate-related risks. Transition risk, stemming from the shift to a low-carbon economy, poses significant challenges. Companies and industries unprepared for carbon pricing could see their profitability decline, impacting their ability to repay debts and ultimately affecting credit portfolios. This calls for innovative methods to assess and mitigate these risks.

Traditional economic models often fall short when it comes to capturing the complexities of climate transition. Integrated Assessment Models (IAMs), while useful for long-term trends, often lack the granularity and dynamism needed to understand short-term impacts. Moreover, many models fail to account for the interconnectedness of various economic sectors and the uncertainties surrounding future climate policies. This research seeks to bridge this gap by offering a more nuanced approach to evaluating climate transition risk in credit portfolios.

How Does Carbon Pricing Affect Credit Risk?

Credit portfolio with carbon footprint overlay

The study adapts a stochastic multi-sectoral model to examine how carbon pricing affects credit portfolios. This model incorporates GHG emission costs for both firms' production and consumers' consumption, using carbon prices derived from Network for Greening the Financial System (NGFS) transition scenarios. The model then assesses how sensitive firms' production and households' consumption are to carbon prices, while exploring inter-sector relationships.

Unlike traditional models, this approach analyzes short-term effects of carbon pricing and injects randomness to account for productivity and transition scenario uncertainties. By integrating Discounted Cash Flows (DCF) with a structural credit risk model, the study shows carbon prices distort firm value distributions and increase banking fees via provisions for expected losses.

Probability of Default: Carbon pricing increases the likelihood that companies will default on their loans.
Expected and Unexpected Losses: Banks face higher expected losses (which they can prepare for) and unexpected losses (which threaten their capital reserves).
Banking Fees: These costs are passed on to clients through higher fees, reflecting the increased risk.
Bank Profitability: Ultimately, carbon pricing can reduce banks' profitability by forcing them to hold more capital to cover potential losses.

The research further computes sensitivities of credit risk measures to carbon price changes, establishing more precise criteria for assessing climate transition risk in credit portfolios. This framework allows for a preliminary assessment of how credit risk measures evolve in a multi-sectoral credit portfolio under a given climate transition scenario.

Navigating the Carbon Pricing Landscape: Implications for Investors

This research provides a crucial first step toward understanding the intricate links between climate policy and financial risk. As carbon pricing becomes more widespread, investors and financial institutions need to incorporate these factors into their decision-making processes. By quantifying the impact of carbon prices on credit risk, this study offers a foundation for building more resilient and sustainable investment strategies in a rapidly changing world.

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This article is based on research published under:

DOI-LINK: https://doi.org/10.48550/arXiv.2307.12695,

Title: Propagation Of A Carbon Price In A Credit Portfolio Through Macroeconomic Factors

Subject: q-fin.rm econ.gn q-fin.ec q-fin.mf

Authors: Géraldine Bouveret, Jean-François Chassagneux, Smail Ibbou, Antoine Jacquier, Lionel Sopgoui

Published: 24-07-2023

Everything You Need To Know

What is carbon pricing and how does it relate to the financial sector?

Carbon pricing is a policy implemented by governments to put a cost on greenhouse gas (GHG) emissions, incentivizing a shift to a low-carbon economy. This policy directly impacts the financial sector by creating what is known as transition risk. Companies and industries that are not prepared for carbon pricing can experience a decline in profitability, impacting their ability to repay debts. This, in turn, affects credit portfolios and investment strategies, making it crucial for financial institutions and investors to understand and manage these climate-related risks effectively.

How does carbon pricing specifically impact credit portfolios, according to the study?

The study reveals several key impacts of carbon pricing on credit portfolios. It increases the Probability of Default for companies, meaning there's a higher chance they will be unable to repay their loans. Banks face higher Expected and Unexpected Losses, which can threaten their capital reserves. Furthermore, the costs associated with these risks are often passed on to clients through higher Banking Fees. Ultimately, Carbon Pricing can reduce Bank Profitability, as they must hold more capital to cover potential losses. The study uses a stochastic multi-sectoral model to analyze these effects.

What are the limitations of traditional economic models in assessing climate transition risk?

Traditional economic models often struggle to capture the complexities of climate transition. Integrated Assessment Models (IAMs), though useful for long-term trends, lack the necessary granularity and dynamism to understand short-term impacts. Moreover, these models often fail to account for the interconnectedness of various economic sectors and the uncertainties surrounding future climate policies. The study aims to bridge this gap by providing a more nuanced approach to evaluating climate transition risk in credit portfolios, using a more detailed and dynamic model.

How does the study model carbon pricing's effects on credit risk?

The study employs a stochastic multi-sectoral model that incorporates GHG emission costs for both firms' production and consumers' consumption. It uses carbon prices derived from Network for Greening the Financial System (NGFS) transition scenarios. The model assesses how sensitive firms' production and households' consumption are to these carbon prices, while exploring inter-sector relationships. Unlike traditional models, this approach analyzes short-term effects and injects randomness to account for productivity and transition scenario uncertainties. It integrates Discounted Cash Flows (DCF) with a structural credit risk model to show how carbon prices distort firm value distributions and increase banking fees.

What are the implications for investors and financial institutions in light of this research?

This research highlights the crucial link between climate policy and financial risk, emphasizing the need for investors and financial institutions to integrate carbon pricing considerations into their decision-making. By quantifying the impact of carbon prices on credit risk, the study offers a foundation for building more resilient and sustainable investment strategies. As carbon pricing becomes more widespread, understanding and managing the implications, such as increased Probability of Default, Expected and Unexpected Losses, Banking Fees and impacts on Bank Profitability, will be essential for navigating the evolving financial landscape and making informed investment choices.