Fitch is seeking market feedback after proposing to use its Climate.VS framework to assess the future vulnerability of sectors and companies that are highly exposed to climate risks, so that investors can be better informed of the scenarios behind rating downgrades.
- Fitch Ratings is proposing to add climate vulnerability scores (Climate.VS) to its credit ratings for non-financial companies in the most vulnerable sectors.
- Climate transition is an increasingly important long-term risk in assessing creditworthiness at the sector and entity level.
- The rating agency has published a position paper on its proposed methodology and is asking market participants for feedback.
Fitch Ratings first published its climate vulnerability scores for the utilities, oil and gas, and chemical sectors in 2021, extending them across all sectors in April 2022. The scores provide an understanding of the long-term risks associated with climate change and its impact on investments and lending portfolios.
They can help investors and financial institutions with security selection, portfolio management, risk management and ongoing monitoring and reporting. They also serve as a framework for market participants to assess global climate vulnerability risk at the portfolio and at the entity level, until 2050.
What is Fitch proposing in its position paper?
In order to provide transparency and be consistent in the way it assesses the impact of climate risk in its rating process, Fitch is proposing to use its Climate.VS framework as a tool to screen entities that are highly vulnerable to such risks.
The scores resulting from the screening will be disclosed in Fitch’s rating reports at the entity level, along with any additional analysis of the entity that may be required. Where climate risks are the main determinant of a credit rating, the scores will be provided with the rating action commentaries.
The Climate.VS framework and scores provide an entity- and sector-level snapshot view of the vulnerability of companies and industries to a low-carbon transition between 2025 and 2050 using scenario analysis. Fitch is looking to gauge the importance of providing the information conveyed by Climate.VS frameworks, and will initially trial an entity-level version.
Will the Climate.VS trial affect credit ratings?
The agency has specified that issuers’ ratings would not change as a result of its new approach to identifying climate risk, nor is it meant to indicate a change in methodology relative to the way it assesses corporate ratings.
The main idea, according to Fitch, is to accurately and consistently assess risks related to climate change, which it expects will become a major factor in its analysis in the future. The firm stressed that it is not looking to say that climate risk is more important than other risk factors that affect credit ratings.
The World Economic Forum, however, identified climate change, the physical impacts of climate disasters, and biodiversity loss as the most severe threats facing the world today. Extending the impacts of climate change to the social aspects of businesses could raise the severity of climate-related risks, and imply an even bigger financial impact on business operations.
What feedback is Fitch looking for and what is the timeline for the feedback?
Fitch is inviting comments from market participants on its position paper by 31 March 2023. While the position paper established the methodology it will use in applying the Climate.VS framework, it is not proposing a change to its criteria.
Specifically, Fitch is asking for feedback on whether climate-related risks are important enough to warrant further analysis, beyond their identification and scoring, at an entity and sector level. It has also chosen a cut-off level VS score of 45, and 2035 as a cut-off year as criteria to conduct a scenario analysis, which will help it decide whether it needs to conduct further in-depth analysis.
Fitch chose 2035 as it represents a time when the material impacts of climate change will be evident in many industries, especially those most vulnerable to climate risks. The cut-off VS score of 45 was picked because, since the scorings were published, this level of scoring has been linked with a credit rating action.
What this means is that if, for example, a company is likely to get a VS score of 70 in 2040 in the scenario analysis, unless that company planned to find ways to mitigate those risks, such as exiting certain businesses, or regions, or else it faces a high likelihood of a rating downgrade.
Using Climate.VS scores may be useful in forewarning companies, and even entire sectors, of the economic and financial impact of failing to act on climate risks. Whether this will actually affect behaviour remains to be seen.
For the time being, high-polluting industries such as oil and gas seem to be ignoring the most severe threats facing the world, while policymakers seem to be resorting to fear-mongering – in the case of energy security – or politicisation – such as the Republicans’ anti-ESG stance in the US – to justify their business-as-usual attitude.