Fifteen years ago, S&P, Moody’s Investors Service and Fitch Ratings famously misjudged the subprime mortgage market that triggered the 2008 financial crisis. Now, they’re under fire for potentially underestimating substantial climate losses in a rating system that may neglect to incorporate long-term climate change impacts into their methodology.
The current credit rating model is short-sighted and not intuitive enough to provide an early warning signal ahead of a climate-related crisis. An issuer facing heightened long-term ESG risks, particularly climate-related risks, may experience an abrupt rating downgrade sooner than expected. This severely impacts bondholders and triggers potentially significant bond sell-offs.
The credit ratings industry has so far struggled to figure out how best to incorporate climate risk in its models.
S&P, Moody’s and Fitch say they do account for climate risks, though it isn’t an easy calculation. Since the start of 2022, S&P has published five climate-related rating actions on non-financial companies and says it considers regulatory and policy risk to be most relevant for a company’s credit profile. However, it says climate regulations have yet to bite, and most companies’ net zero spending isn’t big enough to affect financials or ratings.
Oil and gas companies stand out as the most vulnerable issuers in an analysis by Fitch, which sought to gauge how businesses will cope with climate risks such as increasingly stringent emissions regulations.
Fitch’s models show that over the coming decade, more than a fifth of global corporates across regions and sectors face a material risk of a rating downgrade due to an “elevated” level of climate vulnerability. Half of those issuers are in the oil and gas industry, while coal and utilities also stand out as being particularly exposed to the risk of downgrades.
While adjusting methodologies is important to update the system, it is only one piece of the puzzle within the broader credit rating process. The credit rating committee, serving as the sole authority in assigning eventual ratings, plays a key role in ensuring that climate risks are adequately integrated into the assessment of creditworthiness. Also, it is imperative that they safeguard the independence and faithful representation of rating decisions to avoid the influence of business interests, political pressure and personal biases.
As such, it is critical that rating committees possess the right experience and ability to adapt to a changing financial environment where climate risk is a cause for concern for many issuers and investors. Although it is challenging to predict every eventuality, a holistic integration or, at the very least, a plausible estimation of this risk relies on robust discussions and decision-making processes within the rating committee.
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