Climate disclosure and risk premium in the European bond market

Abstract Stringent climate regulations are necessary to achieve robust mitigation targets, putting carbon-intensive activities under pressure and increasing the risk perceived in financial markets. This paper empirically investigates how transition risk is priced into European firms' risk and creditworthiness, using five-year credit default swap (CDS) spreads and Merton's Distance to Default (DtD). The sample comprises European listed companies covered by the EU Emissions Trading System (ETS). Evidence suggests that the ETS carbon price and verified emissions increase credit risk, whereas disclosing emissions reduces it. We find heterogeneous effects across the two indicators, which could indicate different ways in which transition risk is channelled to bond markets. Furthermore, the divergent effects between voluntary and compliance-based measurement of environmental performance could indicate underpricing of emissions relocated outside regulated jurisdictions.