Pricing climate-related risks in the bond market

•A new model for climate-related risks and corporate bond pricing is derived.•Climate transition risk is modeled through a doubly-stochastic jump process.•The benefits of green investment on the firm creditworthiness are analyzed.•A bond classification in terms of relative ‘greenness’ is proposed. We develop a model for defaultable bonds incorporating both uncertainty about corporate earnings and uncertainty due to climate-related risks, which determine downward jumps in the firm value. In particular, we study how bond pricing is affected by transition risks, such as those coming from an abrupt change of climate policies. We show how the issuer’s credit quality changes as a result of its engagement in projects funded by green bonds and study the impact of green bonds on investors’ portfolio allocation. The way ‘green’ bonds may contribute to financial stability is also discussed.