Change the credit rating agencies, change the world

Integrating climate risk in judgements of creditworthiness could transform debt markets

Credit rating agencies (CRAs) are the gatekeepers of the bond market. Few companies would be able to sell debt without their imprimatur, and an investor would be foolish in buying any without first consulting their judgements.

CRAs also shape the investment fund universe. In creating taxonomies of creditworthiness, they allow portfolio managers to stratify the bond market into well-defined risk groups and map their investments accordingly. Right now, the Federal Reserve itself is using the ratings produced by CRAs to define its corporate bond-buying program, one of the many extraordinary measures the central bank is taking to support the coronavirus-ravaged economy.

CRAs are therefore able to affect the flow of huge amounts of capital. But with great power comes great responsibility. Today, these financial oracles are passing up the chance to champion a “greening” of the bond markets by failing to factor in issuers’ susceptibility to climate risk in their ratings.

If they did, they could spark a wholesale revolution in credit markets: stimulating a wave of investment in “green” industries ripe to benefit from the transition to a net-zero carbon economy, and pulling billions from “brown” sectors — like fossil fuels — imperilled by this shift. What’s holding them back?

Eyes on the horizon

A CRA’s rating methodology is their secret sauce. But at its most basic, an issuer rating should revolve on its ability to meet its financial commitments. Any and all factors that affect this should count in a CRA’s decision.

Major CRAs say that environmental considerations are taken into account, but their own disclosures suggest this is only true to a point. For example, Moody’s reported that 33% of its 2019 private-sector ratings actions were linked to environmental, social and governance (ESG) factors. However, only around 400 of the 7,637 total were explicitly affected by environmental concerns — a piddling amount considering the value at risk as a result of climate change to global assets ranges from $4.2 to $43 trillion. To put that in context, the US corporate bond market as a whole is about $9.6 trillion in size.

Fitch, meanwhile, produces “relevance scores” to convey how material ESG considerations are to their ratings decisions. Again, however, few ratings decisions appear to have been impacted by these. Of 638 bank issuers, for instance, Fitch says ESG factors had no effect on 78% of entity ratings — and for barely any were environmental issues alone material.

This should ring false to climate risk watchers. Both the physical and transition risks of climate change should affect almost every sector and every borrower. Take transition risk. Policies to avert runaway global heating, mandated by the Paris Agreement, will alter the cashflows of all kinds of businesses and introduce new incentives that should fundamentally transform the allocation of capital. Why, then, does it appear to be so underestimated in CRA’s decision-making?

To put it bluntly, because these policies lack teeth. Fitch says that an emerging “climate policy gap” — the distance between government pledges to honour the Paris Agreement and concrete actions to reduce carbon emissions — poses a big risk to corporations as it implies a short, sharp shift in policy at some point in the future that will upend the global economy.

But right now, Fitch says existing policies lack “financial impact or immediacy”. Essentially, governmental efforts to curb carbon emissions are too paltry to affect company creditworthiness in the short-term.

This is a big problem, as CRAs generally only care about the short-term. The standard credit rating horizon is 3-5 years. Fitch’s rating criteria for US public power companies looks at their financial flexibility through a forward-looking five-year stress scenario.

Meanwhile, achieving the Paris Agreement goal of limiting the global average temperature increase to well below 2°C will require a net-zero carbon economy by 2050. Climate policies to hit this target therefore need to be made soon — very soon — but the wheels of legislation are turning too slowly right now for these to factor in CRA’s considerations.

Similarly, the physical risks of climate change, though already manifesting in extreme weather hotspots around the world, will only start to really hurt corporations later this century.

This horizon gap is a major impediment to the full and proper pricing of climate risk. Pierre Monnin of the Council on Economic Policies writes that an adequate assessment of climate risks requires a ratings horizon of 15 years.

Besides the length of the horizon, what also matters are the assumptions used to forecast creditworthiness over this period. The Center for International Environmental Law says CRAs should use a “dynamic climate change trajectory” to project an array of possible impacts to an entity’s creditworthiness reflecting different potential actions governments could take to curb global heating. Right now, they’re using a business-as-usual approach that does not account for a sudden collapse of the “climate policy gap”.

Put simply, CRAs don’t look far enough, or intelligently enough, to capture the threat of climate risk. A decade or two ago, with climate-related financial risk management in its infancy, they could be forgiven this oversight. But a recent fintech boom in climate risk makes their blindness hard to countenance today.

Evolve or die

Policymakers and financial watchdogs have to take their share of the blame too, though. In Europe, officials drawing up a framework for sustainable finance will oblige CRAs “to report in which cases ESG factors are key drivers behind the change to the credit rating or rating outlook” — something they are already doing. They will not, however, compel CRAs to explicitly factor in climate risk in every rating decision.

Under European Union rules, CRAs must account for all “material” factors that could affect an issuer’s probability of default. If “material” were clearly defined to include climate risks, and an explicit timeframe imposed on CRAs over which these had to be assessed, perhaps ratings would better reflect an issuer’s vulnerability to climate-related default risk.

Another regulatory failure concerns the classification of climate risks. Fitch says it is “very hard to track and incentivize change without a consistent, comparable and clear way of measuring it”. By not imposing uniform disclosure standards on corporates that could be used by CRAs to gauge non-financial risks, whether they be ESG or climate-related, lawmakers are hindering their ability to make appropriate judgements of creditworthiness.

The EU has made a step to remedy this in the finalisation of a taxonomy for sustainable activities. But it is just a first step. Until laws and regulations tied to this taxonomy are in place that alter investors’ financial incentives, it will be worth only so many reams of paper.

CRAs may not want to wait for policymakers to induce new behaviours, though. As it stands, they risk being left behind by the very actors that use their ratings the most — institutional investors.

BlackRock, the world’s largest asset manager, said its Risk and Quantitative Analysis Group will be evaluating ESG risks in monthly reviews with portfolio managers, meaning for the first time these will be considered by the firm “with the same rigor” that it assesses credit and liquidity risk. It will also publicly disclose data on sustainability characteristics for all its mutual funds.

This sounds like taking the job of assessing climate risks in house. BlackRock already has a proprietary Carbon Beta tool to gauge its investments’ resilience to transition risk, too. Perhaps with its latest initiatives BlackRock will be able to bypass CRAs altogether when it comes to climate risk.

Then there are the banks. French lender Natixis has rolled out a green weighting factor across most of its lending portfolio, meaning the risk-weights assigned to client obligations are tweaked using a bespoke climate risk rating system. “Green” assets judged resilient to climate risks attract a lower weighting than a straightforward credit assessment would imply, and “brown” assets a higher one.

Other banks are understood to factor some measure of climate risk, sometimes in the form of a carbon pricing impact, in the calculation of borrower probabilities of default, a key input to their internal ratings-based systems.

If they can do this for their own loan books, it’s not hard to imagine the same analysis migrating to their bond portfolios. CRA judgements may then find themselves increasingly de-emphasised by top banks that instead prioritise their own more detailed, more in-depth scrutiny of climate risks.

Perhaps the rating agencies do not need to change to satisfy regulators, then. They need to change to stay relevant in a financial world evolving faster than they can keep up with.


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