Framework for Estimating Stressed Sovereign PD Due to Transition Risk
Ashwani Roy, Dr Rui Qin · 2025-02-07
Climate transition risk reaches a bank through its borrowers, and for banks holding sovereign exposure it reaches them through the state as well. In a hydrocarbon-dependent economy a rising carbon price compresses the share of GDP that comes from hydrocarbons, which moves the debt-to-GDP ratio, the credit rating and in turn the probability of default. This paper sets out a framework linking carbon price paths to stressed sovereign PD, with worked results for three GCC economies.
Main contributions
- GDP contraction modelled from the carbon price path, scaling the share of GDP derived from hydrocarbons by an elasticity calibrated on NGFS carbon emission and price data for the Middle East across 2016 to 2023.
- Debt-to-GDP recalculated on the contracted GDP base, since sovereign ratings depend materially on that ratio.
- Rating transition linked to the change in debt-to-GDP, with historical transition matrices used to map a downgrade through to a new probability of default.
- Stressed PD estimated through an empirical sensitivity factor relating the scale of GDP contraction to default probability.
- Results produced for the UAE, Bahrain and Saudi Arabia under Net Zero 2050 and Delayed Transition, projected in five-year steps to 2050, with the delayed pathway producing materially higher sovereign stress from the mid-2030s onward.
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