Credit ratings are underplaying climate-related risks, according to analysts at the Institute for Energy Economics & Financial Analysis (IEEFA), which is threatening market stability.
- While the financial universe is increasingly aware of the importance of factoring in climate risks, ratings are not accounting for them in a comprehensive manner.
- Despite this, globally respected firms including S&P and Fitch Ratings have recognised that such risks could lead to credit downgrades.
- To avoid volatility in the market, regulators should look at changing the status quo of credit ratings.
Analysts at the IEEFA warned that “a financial time bomb is ticking” if credit ratings maintain their status quo.
S&P Global Ratings does not take many rating actions on climate risks…
While the financial universe is increasingly aware of the importance of factoring in climate risks, there is not a consistent or comprehensive approach to how they are seen to affect credit ratings. S&P Global Ratings admitted that it has taken “very few rating actions”, mostly because “of the growing gap between policy pledges and the tangible effects of regulations, as well as companies’ so far limited spending on net zero investments”.
When the risk is that a supply chain will be interrupted, the risks accompanying that include risk of reduced sales, increased costs and even future lost revenues, loss of assets or even reputation. There are wider market implications too, including price inflation for scarce goods, all of which would have a direct impact on a company’s considered creditworthiness.
Yet the reality is that most credit assessments are reactive, rather than proactive, partly because regulation imposes a requirement that rating methodologies are based on historical data and statistical evidence. While that’s understandable, it is not an approach that lends itself to understanding or integrating forward risk.
Part of the challenge is that, as S&P noted, even though there is a sense of urgency in meeting the goals imposed by the Paris Agreement, the regulatory framework changes and actions taken so far have not been enough to disrupt most sectors. As such, their creditworthiness – the basis of a credit rating – is not being impacted, even though most (if not all) companies globally are facing some level of climate risk.
…but ratings agencies are aware of the dangers
Indeed, Fitch Ratings and S&P published their own research outlining how climate risks could lead to downgrades.
Fitch Ratings, for example, estimated that almost 20% of global corporates could face rating downgrades by 2035 due to climate vulnerabilities if such risks are not mitigated. One main driver of transition risks is the decline in oil use, whose timeline varies based on different regions.
In recognition of the importance of evaluating different scenarios, the agency proposed to add climate vulnerability scores to its credit ratings for non-financial companies in the most vulnerable sectors. Fitch 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.
Similarly, S&P Global Market Intelligence calculated that, in an orderly energy transition by 2050 scenario, companies in five carbon-intensive sectors – airlines, automotive, metals and mining, oil and gas, and power generation – faced a 31-54% downgrade risk. A disorderly transition, instead, would lead to a 2-20% downgrade risk.
The road to instability
According to the IEEFA, the fact that these risks are currently unaccounted for is a precursor to rating volatility and instability, which itself will bring challenges associated with uncertainty and therefore a higher risk premium, ranging from a higher cost of capital to the need to provide higher levels of collateral to access credit.
“Investors would need to transact the same securities with greater frequency, while regulated institutions would have to more closely manage their asset-liability risks and provide for significantly higher capital buffers so as not to be caught out by a sudden downgrade,” said analyst Hazel Ilango. “Issuers would face greater refinancing cost by raising more debt or pledging more collateral… this could result in multi-notch downgrades and trigger sweeping bond sell-offs. A financial time bomb is ticking.”
The IEEFA proposed that agencies adopt near-term and forward-looking alternatives by instituting a standalone climate risk assessment and a double rating analysis, such as forecasting future earnings or impact on cash flows from a climate risk perspective.
Analysts said this would also foster better alignment with the European Central Bank’s recommendations, as rating firms disclose the magnitude of adjustments to credit rating methodology as a result of material climate-related risk.
Ilango concluded: “Can a long-term investment-grade bond maintain its relatively robust status five years or more from today, if the rating system keeps the status quo? It seems unlikely particularly for hydrocarbon-dependent issuers, following the warning signs flagged by the rating agencies.”
“Unfortunately, the wait-and-see approach to integrating climate risks has been the default mode. Credit assessments consider uncertain forward-looking climate risks only when these become visible and certain, by which time it could be too late. The need for a more sustainable, relevant and effective credit system is now.”
SGV TAKE
The credit ratings issue highlights one key challenge that climate change is posing to the financial sector: it is difficult to estimate climate risk due to the lack of historical data and the unclear trajectory of developments such as the energy transition and extreme weather events.
As the IEEFA noted, regulators should consider changing the status quo of credit ratings to ensure that they provide a clearer picture of a company’s outlook.
