How credit default swap market measures carbon risk

Given the increasing concerns about the carbon risk’s influence on economy, this paper is aimed at exploring the impact of carbon emission on credit risk, measured by credit default swap. By using monthly updated data of 363 unique US companies among a period between 2007 and 2020, we uncover that firm’s direct carbon emission increases its CDS spreads, whereas indirect emission is not priced by credit market seriously. Considering dynamic effects of carbon risk, we find a positive correlation between carbon risk and the CDS term structure, which implies that carbon risk’s influence on long-term concern of credit risk can be more pronounced. Using exogenous shock: Paris Agreement, our finding remains robust. Finally, we also examine potential channels, including companies’ sustainability awareness, green transition willingness, and ability, through which carbon risk is priced among the credit market. This paper provides further evidence of carbon credit premium and contributes to the implications of carbon cutting activities.