Default Risk and Transition Dynamics with Carbon Shocks Sujan Lamichhane WP/23/174 IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management. 2023 AUG © 2023 International Monetary Fund WP/23/174 IMF Working Paper Monetary and Capital Markets Department Default Risk and Transition Dynamics with Carbon Shocks Prepared by Sujan Lamichhane Authorized for distribution by Hiroko Oura August 2023 IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management. ABSTRACT: Climate mitigation policies are being introduced around the world to limit global warming, generating new risks to the economy. This paper develops a continuous time heterogeneous agents model to study the impact of carbon pricing policy shocks on corporate default risk and the consequent transition dynamics. We derive a closed-form solution to corporate default probability based on firms' intertemporal optimization decisions and explicitly characterize the transition speed. This allows for studying policy implications in an analytically tractable way. The model is calibrated to different US corporate sectors to quantify the heterogeneous effects of carbon price shocks. While carbon-intensive sectors face increased default risks, there are notable asymmetric effects within sectors. Higher carbon prices increase default risk but also induce faster transition towards the new post-shock steady state with a highly non-linear impact. Our results suggest that once a range of possible price shocks are accounted for, the increase in the cost of capital/risk premiums might be sharply different across sectors. RECOMMENDED CITATION: Lamichhane, S. 2023. “Default Risk and Transition Dynamics with Carbon Shocks.” IMF Working Paper 2023174, Monetary Fund, Washington, DC. JEL Classification Numbers: G32, G12, E44, Q58 Keywords: Default risk; climate risk; carbon price; transition dynamics; cost of capital; risk premium. Author’s Email Address: SLamichhane@imf.org WORKING PAPERS Default Risk and Transition Dynamics with Carbon Shocks Prepared by Sujan Lamichhane Default Risk and Transition Dynamics with Carbon Shocks∗ Sujan Lamichhane† This Version: June 2023 Abstract Climate mitigation policies are being introduced around the world to limit global warming, generating new risks to the economy. This paper develops a continuous time heterogeneous agents model to study the impact of carbon pricing policy shocks on corporate default risk and the consequent transition dynamics. We derive a closed-form solution to corporate default probability based on firms’ intertemporal optimization decisions and explicitly characterize the transition speed. This allows for studying policy implications in an analytically tractable way. The model is calibrated to different US corporate sectors to quantify the heterogeneous effects of carbon price shocks. While carbon-intensive sectors face increased default risks, there are notable asymmetric effects within sectors. Higher carbon prices increase default risk but also induce faster transition towards the new post-shock steady state with a highly non-linear impact. Our results suggest that once a range of possible price shocks are accounted for, the increase in the cost of capital/risk premiums might be sharply different across sectors. Keywords: Default risk, climate risk, carbon price, transition dynamics, cost of capital, risk premium. JEL Codes: G32, G12, E44, Q58 ∗ I would like to thank Robert Jarrow, Pierpaolo Grippa, Hiroko Oura, and seminar participants at IMF and JHU Carey for their helpful comments and discussions. † International Monetary Fund, email: slamichhane@imf.org. The views expressed in this paper are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management. 1 Introduction Climate-related policies are being considered around the world to limit the impact of climate change on human society. Nearly 200 countries signed the Paris Agreement in 2015, pledging to limit the global warming increase