Climate Change Becomes an Issue for Ratings Agencies

The risk of a ratings downgrade can pressure cities and companies to take steps to mitigate climate risks, such as from sea level rise.

Aug 5, 2019
Tidal flooding in Alexandria, Virginia, in 2018. Credit: Matt McClain/The Washington Post via Getty Images

Moody's Corporation, which owns one of the largest U.S. ratings agencies, purchased a major stake in Four Twenty Seven, a company that analyzes climate risks to companies and governments, such as sea level rise, heat stress and storms. Credit: Matt McClain/The Washington Post via Getty Images

One of the main agencies that rates the creditworthiness of big borrowers, including cities and corporations, has brought on board a data firm specializing in climate risks. It's a signal that rating agencies are paying more attention to global warming and its impact in the financial markets. 

Credit ratings, much like individual credit scores, assess how likely it is that a borrower will repay debt. Those ratings can affect how much governments and companies are able to borrow and how much it will cost them. Just the threat of a lower credit rating can pressure cities and companies to be more proactive in taking steps to mitigate risks, and now those risks are starting to include climate change.

"More and more, issuers and investors want to know how they are exposed to climate events," said Michael Mulvagh, head of communications in the Americas, Europe, Africa and the Middle East for Moody's Corporation, which owns one of the largest U.S. ratings agencies

He said Moody's decision to purchase a major stake in Four Twenty Seven, a company that analyzes the risks to corporations and governments from climate extremes such as sea level rise, heat stress and storms, "will help us go deeper into and refine how we assess physical risks caused by environmental factors." 

For years, experts have warned about the increasing risks of climate disasters. Last year, the U.S. saw at least $91 billion in damage from the costliest storms, drought and wildfires, according to the National Oceanic and Atmospheric Administration. And some analysts have criticized the financial sector—particularly around bond ratings—for moving too slowly in incorporating climate risks into their credit assessments.

The move by Moody's signifies a notable step toward financial institutions committing to the idea that climate change should be a routine consideration when evaluating the financial strength of any government or company and their ability to pay their debts. 

"For [Moody's] to come and buy this company that's very focused and has some expertise in climate risks, it looks like they're making this a very big priority," said Kathy Hipple, a financial analyst with the Institute for Energy, Economics and Financial Analysis. "I think it's very positive and should be noted by the industry."

Which Places and Sectors Are Most at Risk?

In 2017, Moody's downgraded the city of Cape Town, South Africa, after a major drought there threatened the municipality's ability to provide water to the community. Earlier this year, it downgraded Trinity Public Utilities District in California due to the elevated risk from wildfires.

Climate change-related disasters are becoming more tangible and more frequent, said Carmen Nuzzo of the United Nations-supported Principles for Responsible Investment. "They can no longer be ignored."

Since about 2015, Nuzzo said, credit rating agencies, including Moody's, Standard & Poor's and Fitch Group, have been building their capacity to better analyze how climate change can factor into the financial stability of companies and governments around the world.

Both Moody's and S&P have released online tools—such as Moody's heat map or S&P's ESG Risk Atlas—to gauge which areas and what industries face the most "exposure" to the physical impacts of climate change, as well as which are risking transitional impacts as renewable energy demand rises.

According to Moody's heat map, the top industries with elevated environmental risks are unregulated utilities and power companies, the automobile industry, the oil and gas refining market and the transportation industry.

For several of those industries, "the risk is quite obvious," said Mike Ferguson, director of the Sustainable Finance Team for Standard & Poor's Global Ratings. "The economy is transitioning away from what they sell."

With cities and counties, ratings agencies pay attention to the local economy, including threats to the tax base, and to the government's management and financial planning, which can include whether risk-mitigation projects are being completed. Once a government is struggling with climate-related damages, such as from hurricanes or flooding, higher borrowing costs can become a vicious circle.

Slow Start, but 'Going in the Right Direction'

Hipple said credit rating agencies, especially around the bond market, have been slow to act on climate change, but they're "going in the right direction."

To some degree, credit rating agencies have always considered climate risks when assigning credit ratings, Nuzzo said, but only recently did agencies start routinely and explicitly incorporating climate risks into their assessment processes.

"Before, they were only looking at balance sheets," she said. "They still do, but they're also asking questions about how climate change can affect cash flow, costs, revenues, profits."

Ferguson said he has also seen an increase in credit ratings actions based on climate risks being a major factor. Between 2015 and 2017, he said, about 15 percent of corporate global ratings actions were based on climate risks as a main factor.

Still, Rachel Cleetus, the lead economist and climate policy manager at the Union of Concerned Scientists, thinks the financial sector could be doing more, especially when it comes to pressuring high-risk areas and industries to adapt more quickly to climate risks. 

"Everyone agrees that the science is real, the risk is real," she said, "but the market isn't accurately pricing it yet."

Published Aug. 5, 2019

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