Bond investors can’t rely on credit ratings to give them a fair assessment of the climate risk they’re exposed to, and should brace for “trouble ahead,” according to the Institute for Energy Economics and Financial Analysis.
(Bloomberg) — Bond investors can’t rely on credit ratings to give them a fair assessment of the climate risk they’re exposed to, and should brace for “trouble ahead,” according to the Institute for Energy Economics and Financial Analysis.
From within the big three credit ratings companies — Moody’s Investors Services, S&P Global Ratings and Fitch Ratings — warnings have already been issued, but these have gone largely unnoticed, IEEFA, a US-based nonprofit, said in a statement on Monday.
Inside the industry, “alarm bells have been sounding for months,” said Hazel Ilango, an energy finance analyst focused on debt markets at IEEFA.
IEEFA notes that in June, S&P warned that climate change is becoming a “significant” driver affecting credit worthiness, but acknowledged that “very few climate-related rating actions” had taken place since early 2022; Fitch has warned that about 20% of corporates face downgrades next decade due to climate change, while Moody’s has said that credit risks linked to environmental, social and governance factors are rising.
But the warnings went largely unheeded, which “is concerning,” Ilango said.
According to IEEFA, failure to gradually reflect the impact of climate change in credit ratings will expose issuers to bigger, sudden losses further down the road. The warning comes as extreme weather dominates news headlines, with large swaths of North America, Europe, Asia and Africa afflicted by everything from floods, to drought to wildfires.
The gap between the reality of climate change and the risks currently reflected in credit ratings “could result in multi-notch downgrades and trigger sweeping bond selloffs,” Ilango said.
In a recent analysis of an orderly energy transition by 2050, S&P Global Market Intelligence found that companies in five major carbon-intensive sectors –- airlines, automotive, metals and mining, oil and gas, and power generation –- faced a 31-54% downgrade risk. A disorderly transition, meanwhile, would raise the credit downgrade risk by a further 2%-20%, the analysis indicated.
There’s now an urgent need for regulators to step in and require ratings companies to update their approach, according to IEEFA. Without better rules, the industry is likely to remain “reactive, rather than proactive,” she said.
IEEFA says rating companies could adopt near-term and forward-looking alternatives, for example, by forecasting future earnings or impact on cash flows from a climate risk perspective. And regulators should require credit rating committees to include non-voting independent climate specialists as members.
“Unfortunately, the wait-and-see approach to integrating climate risks has been the default mode,” Ilango said. “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.”
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(Updates eighth paragraph with analysis of transition risk and tenth paragraph with IEEFA recommendations.)
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