In search of climate distress risk

Using the Merton distance to default model we investigate whether a firm's climate risk affects its default (distress) risk. S&P 500 non-financial firms during 2010–2019 are analysed and we employ both corporate carbon footprints and climate risk disclosures in annual filings to measure climate risk. Our results show that climate risk has a negative impact on firms' distance to default. This impact is limited to the disclosure of transition risk in annual filings. In contrast, disclosures of physical or non-specific risk do not affect firm-level default risk, while the impact of corporate carbon footprints is inconsistent but insignificant in most models. We also find that the negative effect of climate transition risk on firms' distance to default is stronger for firms headquartered in states with carbon pricing (California and states covered by the Regional Greenhouse Gas Initiative) and temporarily strengthens because of the Paris Agreement in 2015. However, this ‘Paris’ effect is short-lived and fades away in subsequent years. •We investigate whether a firm's climate risk affects its default (distress) risk.•Corporate carbon footprints and climate disclosures in filings are our risk measures.•Climate risk has a negative impact on firms' distance to default.•The impact is limited to the disclosure of transition risk in annual filings.•The effect is stronger for firms headquartered in states with carbon pricing.