Environmental issues gaining traction

Investors and credit rating agencies (CRAs) agree that governance plays a crucial role when assessing creditworthiness. This is unsurprising, as weak governance increases the probability of distress more than, for instance, environmental accidents or others related to social factors (against which an issuer might be insured). Even when Honduras was hit by Hurricane Mitch, significantly impacting the country’s infrastructure and economy – as well as having devastating social consequences – there was no sovereign default.

Furthermore, governance is directly applicable to all issuers, whereas environmental and social risks (and hence the probability of their materialisation and their frequency) may vary depending on the issuer’s sector, its location and the diversification of its industry within the country. However, insurance is no excuse for complacency: as climate-related incidents increase for example, insurance premiums might become unaffordable, resulting in underinsurance, which could impact issuer credit ratings.

However, beyond governance, there has been an increase in focus on the impact of environmental risks over the last few years, perhaps because they are more quantifiable with greater public resonance – hence the proliferation of research in this field and of metrics to capture these risks. Attention also seems to stem from policy developments, the more tangible impact of climate change and the significant transformation that the market is undergoing to reduce greenhouse gas emissions.

Following the COP21 Paris Agreement – and the subsequent withdrawal from it by the US –  it remains challenging for CRAs to assess the impact on individual companies before policies are announced and for issuers to adjust their strategies in a changing landscape. Nevertheless, awareness that environmental risks can no longer be ignored is increasing.

The pace at which market dynamics are driving the transition towards low-carbon economies is accelerating, partly owing to economies of scale that have reduced the cost of renewable energy. However, in a scenario where this transition occurs late and abruptly, there could be a sudden re-pricing of carbon-intensive assets – assets that are largely financed by debt and could quickly become stranded (i.e. unusable). This could result in a spike in costs and impact an issuer’s creditworthiness (ESRB, 2016).

The ESG in Credit Ratings Initiative receives financial support from The Rockefeller Foundation