Assessment of the Sensitivity of Transition Matrices to Carbon Price With Value Chain Effect

In the context of the transition to a low-carbon economy, the creditworthiness of banks' corporate debtors may deteriorate due to a dual effect. First, the macro-financial environment may change due to coercive regulations and the resulting unavoidable higher investment costs, which indirectly affects the creditworthiness of companies. Second, costs paid directly by economic actors (e.g., the price of carbon) may reduce their short-term income and thus their ability to repay their debts. Both of these effects change the structure of credit conditions, defined in particular in the rating transition matrices, and subsequently affect the capital requirements of banks as defined in the Basel Accord. While banks already manage forward-looking macro-financial risks to meet regulatory stress testing exercises and are therefore already prepared to incorporate the indirect effect into their forward-looking credit risk management, the direct effect of sector-dependent climate transition costs requires new methodologies. In this paper, we propose a method to assess the effect of climate transition cost trajectories on transition matrices, taking into account the diffusion of risk across the geo-sectoral value chain defined with a Leontief input-output model. As an illustration, we apply our method to US transition matrices