Ratings agencies and climate change: The next financial crisis?

Ratings agencies are contributing to inflated corporate valuations by not fully quantifying exposure to climate change risks

S&P Global Ratings (S&P) is one of three leading global credit rating agencies. It assesses the creditworthiness of debt issuers, which include companies and governments, through credit ratings. Its 1,400 credit analysts[1] assess factors and trends that affect creditworthiness, focusing on credit, legal and regulatory, operational and counterparty risk.

Climate change, and efforts to prevent it, have created additional risks that are not fully being reflected in S&P’s ratings at present. One risk is that more frequent natural disasters disrupt global supply chains, reducing corporate credit quality. Insurance companies are also likely to be exposed to a greater degree of catastrophe risk, increasing payouts and reducing profits over the medium to long term.

An additional risk specific to the energy sector results from climate change prevention policies. Limiting global average temperature increases to 2°C requires structural changes to reduce our economies’ reliance on fossil fuels and associated carbon emissions. Hence, vast quantities of recoverable fossil fuels will need to remain underground in order to stabilise the global climate[2], rendering them worthless. These assets are currently held on the balance sheets of oil and gas companies and the probability that they will need to be written off is not accounted for by S&P’s current approach.

S&P has led its market in publishing its analysis in reports and making statements regarding the effect of climate change on credit ratings[3]. Furthermore, S&P states that it qualitatively and quantitatively incorporates risks associated with environmental, social, and governance factors throughout its analytical ratings framework. Specifically, it says that, “since all rated entities operate in the natural and social worlds, we regard these risks as ubiquitous across the ratings spectrum”[4]. This vague language, combined with the challenges associated with quantification, implies that there is no specific focus on the broader risks of climate change and their implications for corporate issuers within the organisation. It is unlikely that they have, for example, created roles with accountabilities for monitoring the potential impact of climate change with this approach.

Furthermore, credit rating agencies tend to consider a shorter time frame in their analysis, such as five years, whilst the risks associated with climate change tend to be longer term, around ten years or more[5]. Hence even if the appropriate risks were considered, S&P may not be assessing these within an appropriate time horizon.

As a result, where firms are exposed to climate change risks, S&P is contributing to inflated corporate valuations by not reflecting these risks in their credit rating assessments. If the market is shocked in to realising this suddenly then the value of corporate bonds (particularly in the energy sector) could deteriorate dramatically, just as sub-prime assets became worthless during the credit crisis. This could trigger a financial crisis and economic downturn. The impact of resulting legal action – not to mention further reputational damage to S&P – has the potential to be severe.

S&P should take the following actions to ensure that it is accurately incorporating the risks associated with climate change into its credit ratings and avert potential disaster:

  • Assign accountability for incorporating climate risks into credit assessments to specific individuals
  • Develop a transparent risk assessment methodology to identify current and emerging climate change credit risks, using an appropriate medium to long term timeline (e.g. 10 years). Fully incorporate this assessment into credit models
  • Invest in forecasting capabilities (perhaps leveraging a broader range of data, new analysis technologies and collaborating with environmental research centres) to improve accuracy of assessments
  • Require firms to disclose more information on the impact of climate change for their businesses
  • Clearly communicate to market participants how considering these new factors influences rating decisions

Given that such changes require significant investments, S&P should prioritise assessment of industries that are likely to be most exposed to the impact of climate change, for example the energy sector.

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Sources

[1] Standard & Poor Global Ratings website. http://www.spratings.com/

[2] OECD, “Divestment and Stranded Assets in the Low-carbon Transition.” https://www.oecd.org/sd-roundtable/papersandpublications/Divestment%20and%20Stranded%20Assets%20in%20the%20Low-carbon%20Economy%2032nd%20OECD%20RTSD.pdf

[3] Standard & Poor, “Insights (Dec 2015).” https://www.spratings.com/documents/20184/984172/Insights+Magazine+-+December+2015/cff352af-4f50-4f15-a765-f56dcd4ee5c8

[4] Standard & Poor Global Ratings website. http://www.spratings.com/

[5] Center for International Environmental Law, “(Mis)calculated Risk and Climate Change.” http://www.ciel.org/wp-content/uploads/2015/06/CIEL_CRA_Brief_24Jun2015.pdf

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5 thoughts on “Ratings agencies and climate change: The next financial crisis?

  1. This is a great post – I hadn’t previously thought about the scale of the impact of ratings agencies’ actions here. I’m curious, what do you think would motivate S&P to make these changes? I worry that the same conflict of interest that fueled the mortgage crisis – in which ratings agencies’ future profits depend on maintaining customer relationships and providing favorable ratings – would prevent S&P from incorporating climate risk before its competitors do. Given that lower ratings would lower valuations, is this a step S&P would be willing to take on its own? What do you think needs to happen to incentivize the agencies to accurately reflect climate risk in their ratings?

  2. I’m a big fan of this post as well. Thanks for starting the conversation.

    Considering how only a handful of companies (S&P, Moody’s, Fitch) are largely responsible for defining the way the world thinks about credit quality, perhaps this is an opportunity for the three competitors to embrace the fact that we collectively need to address how climate change impacts credit worthiness and risk. Said differently, I would advocate for the three companies to collaborate with one another and start a public dialogue on ways to properly account for relevant risks. It is not as if any of these three companies are quietly sitting on the answer right now. In reality, I think the markets have a lot of learning to do. I would hope these organizations can appreciate the need for transparency and thought leadership, especially following the recent financial market collapse, and lead the charge.

  3. This is so interesting. While I am familiar with S&P or other rating firms, I have never thought of the responsibilities of those firms on the climate change. However, if S&P, MDYS, FITCH and others start to take those problems into account while they decide a rating, it can be serious motivations for the companies who seek to get better ratings. While many companies boast their activities for the sustainability, there are no objective views to tell if those CSR activities are meaningful or not. If rating companies could play the role of evaluating those as a third-party, it may be one path to motivate companies to more care and get serious about environmental problems.

  4. Beth – Your post was very well written and informative. Incorporating a haircut to valuations for end-market and “business-model” deterioration due to climate change was something that I had never considered. I agree that agencies should be including this in their analyses. I say this because one of the aspects of the financial crisis that I find most interesting was how so many different parties, in so many different parts of the global economy, were reliant on the accuracy of Moody’s, S&P, and Fitch. Given this dependence, I feel that there should be an increased amount of scrutiny put on the methodologies and publications of these agencies, and your valuation point is a great reason why. The only argument that I disagree with is that a widespread fall in bond prices is enough to cause a crisis. The reason I disagree with this is because I believe it would take a more material event then the market being surprised in the damage that climate change could do over the long-term. This type of selloff of corporate bonds would not be related to the near-term (1-2yrs) financial health of the underlying issuers. A sudden drop in corporate bond prices, especially one large enough to cause a crisis, is usually seen as a catastrophic event because it implies that the companies that issued the bonds are no longer able to service their coupon payments and are likely to default. In the case of devaluation due to climate change, I don’t think the issuers would be in jeopardy of immediate insolvency, but would face long-term credit profile deterioration, which would have more of a “slow burn” impact on the global economy.

  5. Beth — This is a great post. I actually addressed the issue of assessing risk caused by climate change, but I used a different type of company. I looked at this risk from the perspective of property and casualty insurance companies who would insure against loss of property from storms and natural disasters. Similar to what I wrote about, it seems that S&P faces similar challenges assessing these risks. It is important for S&P to properly evaluate and attempt to quantify these risks. I agree that financial markets could be in trouble if storms become more frequent and more severe. I am glad to see that S&P is taking steps to better predict the probabilities of these events and incorporating these risk into their ratings.

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