By: Pierre Georges, Global Head of ESG in Credit at S&P Global Ratings

Despite the numerous pledges by states to take actions to limit climate change, the severity of recent climate events and their implications for corporates, relatively few businesses have seen their credit ratings lowered. Pierre Georges, Global Head of ESG in Credit at S&P Global Ratings, explores

Global warming is inevitable. As time goes on, it will result in more frequent and increasingly severe climate-related risks, and preparing for such events could eventually weigh on credit quality. Yet while climate transition and physical risks are important considerations in credit analysis, S&P Global Ratings has taken very few climate-related rating actions since early 2022.

This is largely due to the growing gap between policy pledges and the tangible effects of regulations, as well as companies’ so far limited spending on investments to align with a net-zero world.

How are climate risks considered?

S&P considers factors that it believes can materially influence the creditworthiness of a rated entity or issue. For rated entities in certain industries, these factors may include climate-related transition risks. Should these risks impact the capacity and willingness of an entity to meet its financial commitments as they come due, its credit rating could be impacted.

For instance, we lowered the ratings for Dutch airport Royal Schiphol Group N.V. to ‘A-/A-2’ from ‘A/A-1’ following the Dutch government’s announced intention to reduce annual aircraft movements by 60,000. Within this, we see a heightened risk of environmental policy objectives potentially hampering Schiphol’s operations in the longer term. In addition, we revised the outlook of China-based automotive supplier Geely Automobile Holdingsfrom stable to negative due to the company’s push forhigher electric vehicle production weighing heaving on its profitability and leverage, as its accelerated electrification processes to mitigate transition risk have led to higher capital spending.

That said, climate risks are changing very few corporate ratings, a reflection of several important considerations we build into our credit analysis – including regulation, mitigation practices, and the availability of technology alternatives.

Transaction risk largely under control, so far

So far, rated entities are managing the main climate transition drivers. Climate transition risks can be classified around four pillars: regulation, technology, litigation, and consumer behaviour. At this stage we view regulatory and policy risk as the most relevant to a company’s credit standing because we believe the effects of technology and consumer behaviour may take longer to happen at scale and disrupt a whole sector, whereas regulation can change the landscape much faster.

There are currently relatively few carbon-pricing regulations in place, covering less than one quarter of global greenhouse has (GHG) emissions. And apart from Europe, where the price of GHG emissions under the EU Emissions Trading Scheme (EU ETS) has risen significantly in recent years, costs have generally remained insignificant. Furthermore, polluting sectors continue to benefit financially from significant free allowances awarded under the EU ETS. The EU aims to phase out these allowances with the introduction of its cross-border adjustment mechanism (CBAM), but the main cost impact will be toward the end of the decade to give in-scope sectors time to adapt.

We believe that, in some cases, higher carbon costs could partly be passed through to end-customers, with limited effects on margins. Furthermore, many EU-based issuers have an international footprint, so only part of their business is affected by such regulations. These issuers could mitigate risk by growing their presence in jurisdictions that do not impose similar GHG emissions costs.

The Inflation Reduction Act (IRA) in the U.S. is another recent significant policy development. It aims to support investments in decarbonisation solutions over the coming years and may help grow new technologies. The IRA could prove consequential as it will support renewables development and general decarbonisation efforts. We also believe certain segments in the power, autos, midstream utilities, agribusiness, and health care sectors could see marginal positive credit impacts from improved cash flows, as well as reduced development and technology costs for renewables and carbon capture.

Physical risk greater in certain geographies

Physical climate risks could have significant financial implications for some assets in certain jurisdictions, if and when such risks materialise. But where and when physical risks might cause economic loss is inherently unpredictable, as are the frequency of such risks, which may constrain our ability to factor in potential effects in advance.

That said, certain geographic areas face greater physical risk exposure than others. An entity’s degree of exposure to physical risks through extreme weather events depends on – among other factors – geographic location, levels of economic development and vulnerability, and the choices, implementation, and success of climate adaptation options. 

Similarly, entities that rely heavily on nature, such as those operating in the agricultural sectors, are generally more exposed. An entity that would find it harder to move assets due to its inherently local footprint, such as a regulated utility or airport, could also be more exposed to physical climate risks.

Despite the low number of climate-related rating actions historically, we believe climate transition risk and physical risk could become highly significant credit drivers that affect the creditworthiness of rated entities. This is because of policymakers’ efforts to reduce emissions or ensure GHG emissions reflect their full social costs, and the potentially increased impacts from more frequent and extreme weather events. Furthermore, significant incentives worldwide to develop new environmentally friendly technologies and production processes could result in greater rating differentiation over time.

The post Guest Post: Why Climate Risks Are Changing So Few Corporate Ratings first appeared on ESG Today.

The post Guest Post: Why Climate Risks Are Changing So Few Corporate Ratings appeared first on ESG Today.