Ratings agencies respond to climate risk, eye corporate adaptations

By Jeff Pines

Silver Spring, Md., March 3 – Politicians still argue whether climate change is manmade, natural, or even really happening, but some businesses already appear to be in the crosshairs of environmental changes.

In October, S&P Global Ratings notably downgraded Caribbean Utilities Co. Ltd. to BBB+, citing climate change as the major factor in the company’s downgrade, not the first time the agency downgraded a company on climate issues.

Moody’s Investors Service, the first of the three major ratings agencies to mandate change on this issue, began to reshape its policy regarding municipal entities and climate change as early as December 2017.

Last year, as an indication that the agencies continue to see climate change as an important variable to keep tabs on, Moody’s bought a majority stake in Four Twenty Seven, a firm that measures the physical risk of climate change.

Moody’s outlined in a 2018 report that the two sectors facing the most immediate risk are unregulated utilities and power companies, and coal mining and coal terminals, accounting for a collective $517 billion of rated debt.

In hindsight, the 2018 report was precisely predictive to credit quality as hotter temperatures had dried out vegetation, making it easier for fires to sweep across California in mid-2018 and again in 2019.

PG&E Corp. is on the hook for billions of dollars in claims as a result of the California wildfires its equipment sparked. The utility filed for bankruptcy in late January 2019.

Moody’s 2018 report also pointed to an additional nine sectors, including automotive manufacturers, oil and gas exploration, and production and commodity chemicals, that face the risk that their elevated environmental exposure could become material to credit quality within three to five years. These sectors account for rated debt of $1.7 trillion.

S&P evaluates environmental, social and governance factors and has studied different sectors, including corporates, sovereigns and project finance among others.

For the environment, S&P said it considers greenhouse gas emissions, water use, waste and pollution and land use and biodiversity to help it develop a profile for the company. S&P then adds company specific data into its analysis.

In addition, it looks at preparedness, or can the company forecast and adapt to disruptions? The agency says the part of the assessment that investigates preparedness is more based on interaction with management to help it develop an ESG evaluation.

It’s well known that investors are increasingly looking at ESG factors when they choose where to invest their money.

Managing risk

Mike Ferguson, a director of U.S. energy infrastructure and sustainable finance ratings at S&P, pointed to PG&E as a utility hurt by climate change. He also sees the Caribbean as being a major area of concern.

“Certainly, companies in the Caribbean would be more exposed to the physical impacts of climate change, based on increasing frequency of storms; this would seem to make them more exposed to negative ratings actions, but, of course, we can’t rule out that management can take measures to reduce impacts,” Ferguson told Prospect News.

A key question for some is, are events, such as the storm that should only hit once every 100 years and wreak havoc, arriving more often, creating chaos?

“I think where there’s been some issues over the last 10-15 years is that the typical linear relationship which people used for forecasting weather events has broken down, with events occurring much more frequently than previously anticipated,” said Andrew Steel, Fitch Ratings’ global head of sustainable finance.

“If a company had previously planned for a risk occurring in a one in 20-year timeframe and then it occurs twice in seven years, analysts would expect the management to adapt their approach to being prepared for that risk.”

Ferguson said he sees more frequent occurrences.

“Drought, flooding, and extreme temperatures are also going to be more common, and they bring with them attendant risks to companies. So really, much of the globe is impacted, though the precise impacts are different depending on where, and what type of business models are being used,” Ferguson said.

Steel doesn’t think credit agencies are downgrading companies because of climate change, at least not yet.

“Investors are asking us to separate out the risks so that they can understand the pure credit aspects,” he said. “Companies in the past would treat risks on a probability of occurrence basis, a little bit like insurance companies, and this is now becoming increasingly difficult. For instance, if a bank is exposed to certain climate risks then it might look to ensure it has a higher nonperforming loan buffer than a peer not exposed to those risks. But if the linearity of events breaks down, it becomes very hard for an entity to estimate what type of buffer it needs to absorb those events, and manage the risks effectively,” he said.

At the fringes, some people might disagree with how climate change might be accommodated, but Steel doesn’t think there will be a lot of companies saying, “Well, we’ve always treated the risks this way and so see no reason to change, particularly as most companies actively benchmark their activities.”

If top managers see a competitor experience a series of events, then it would be normal for them to look at whether they’re likely to face similar risks and consider how to react. Good managers should be act proactively in managing the risks, he said.

Managers are now being asked to plan for 2050 2-degree climate change scenarios, but this is difficult as the main physical effects start accelerating post 2050, Steel said.

Regulation impact

Last year, Fitch introduced a system to analyze environmental risks and determine if they affected corporate ratings.

The agency studied 10,100 entities and transactions and looked at 14 different environmental, social and governance factors. Fitch now monitors and maintains more than 140,000 pieces of data to determine if environmental, social or governance factors are affecting individual credit ratings.

Out of more than 1,500 entities in 50 non-financial corporate sectors, Fitch said only 2.7% of those rated had seen their rating clearly change because of a single E, S or G factor, while 22% had seen some effect on the rating from one or more ESG factors in conjunction with other factors.

“When you look at it from a credit perspective and break it down, it’s predominately governance and social factors that have the biggest impact, rather than environmental,” Steel said.

Social trends and preferences have the most pervasive effect for companies in sectors such as tobacco, health care and pharmaceuticals.

With utilities, credit profiles are affected by environmental aspects. Carbon dioxide reductions are costing them money, but for oil and gas entities it is much more about governance where operational failures cause accidents or spills and end up crystalizing additional costs.

Ratings agencies do not make a judgment about whether the environmental, social or governance issues are good or bad; rather, the agencies are evaluating the financial impact these conditions pose for companies’ credit profiles, he said.

Regulation plays a key role in the ultimate financial effect companies face from an environmental perspective, as it tends to drive cost into credit profiles. Some areas in Europe such as utilities have already been affected but generally are able to absorb and pass on the costs; other sectors such as agriculture and air travel, which are also big contributors to CO2, are likely to find it harder to absorb costs due to thin margins but as yet have not seen much impact from regulation.

With climate change and CO2 reduction targets that have been set, there’s probably a greater risk to companies’ credit profiles from sudden changes in regulation than from the actual climate events themselves.

In developed markets, such as North America, companies are more affected by governance than social issues or environmental ones, but interestingly in developed Europe social risk factors are slightly more prevalent than governance. Public awareness and populist government reaction to media may partly explain the European phenomena, he said.

© 2015 Prospect News.
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