Extending Risk Horizons: Impact of Carbon Emissions on Firm Default Risk Based on Global Panel Data

ABSTRACT This study assesses the impact of carbon emissions on firms' default risk in 44 major countries for overcoming the “tragedy of the horizon.” Carbon emissions affect firms' risk profiles at risk horizons through physical and transitional climate risks. A critical management issue is the likelihood and magnitude of climate change's impacts affecting firms' credit risk. We propose a random‐effects logistic generalized least squares regression model for panel data to examine the impacts and the firm heterogeneity by country and sector. The global and country‐wise panel data analyses show that carbon emissions increase firms' PDs in the global and four‐country markets for all risk horizons, whereas the sector‐wise analyses show that high carbon emissions reduce firms' PDs only in the industrials sector out of four sectors. In addition, for three countries (the United States, the United Kingdom, and Japan) and four sectors, the longer the risk horizon, the more the heterogeneity represented by the between‐firm residual variance decreases, whereas for China, the heterogeneity with Scope 3 fluctuates. Overall, this study provides an effective credit risk analysis methodology that considers carbon emissions for related entities, such as firms, lenders, investors, regulators, and policymakers.