How do scenarios show the potential for climate change to affect creditworthiness?

The impact of a megatrend like climate change could be material to the creditworthiness of issuers and debt instruments. Scenario analysis can be particularly useful when we have limited visibility of how risks may develop—and can provide transparency on how transition and physical climate risks across different sectors or regions may evolve? and affect ratings.

What we’re watching:

S&P Global Ratings believes global megatrends can become material to its credit ratings if they affect factors that contribute to its assessment of creditworthiness. Some megatrends have already led to credit rating changes and, depending on how they evolve, may do so in the future. Climate change, in particular, is a megatrend that can have material impacts on the creditworthiness of issuers and debt instruments (and is already one of the key risks to credit conditions that we currently identify)—with outcomes that may manifest through both climate transition risks and physical climate risks.

Rising global temperatures will result in increasingly frequent and severe physical climate hazards (including wildfires, storms, and flooding), chronic events (like changing temperature and precipitation patterns), and rising sea levels, according to the Intergovernmental Panel on Climate Change. Most countries have made commitments to maintain global warming well below 2 degrees Celsius by the end of this century compared with pre-industrial levels, as well as pursue efforts to limit the increase to 1.5 C per the Paris Agreement. We believe these commitments—if they result in measures leading toward significant emissions reductions—would likely transform many issuers' operating models, especially as economies lessen their reliance on fossil fuels.

The scale and pace of decarbonization is likely to be uneven across countries and sectors. At the same time, we believe that physical climate risks, whether chronic or acute, will materialize—irrespective of today's policy choices. Economies and sectors can be relatively more affected by one of the two risks, or by both transition and physical climate risks in tandem, depending on their specialization and geographic location.

The timing and potential magnitude of harm associated with physical climate hazards can be difficult to estimate. And the unrealized implications of other factors, including whether investments in adaptation and resilience will be effective, increases the uncertainty around how such events may influence creditworthiness—if, when, and how they may occur.

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What we think and why:

Clarity on how and when climate transition and physical climate risks are transmitted to creditworthiness is generally low, since the transmission channels tend to be indirect and vary across sectors.

For credit materiality to be high and subsequently lead to a potential change in a rating or outlook, both the magnitude and clarity of credit transmission need to be sufficiently high. A combination of high magnitude events and low clarity of possible credit transmission channels underpins the need to understand the potential impacts of megatrends on creditworthiness.

Scenario analysis is particularly useful when uncertainties are high (which is generally the case for climate risks), since it can provide insight on a range of possible outcomes and highlight potential vulnerabilities. In our latest white paper , we explore for analytical purposes three plausible scenarios for climate transition risks, and four for physical climate risks. These scenarios provide a starting point when analyzing climate-related credit transmission channels and are not the only scenarios we may consider.

Credit risk drivers evolve differently under all of the scenarios, with varying potential rating impacts. They may originate from the climate transition (as reducing carbon emissions implies shifts in policy, technology, consumer behavior, or market pricing) and physical climate risks (where disruption of economic activity is mainly through the supply side, decarbonization benefits materializing only over a longer time frame, and adaptation and resilience investments reducing some of the impacts).

What could change:

Some of the main credit transmission channels for climate transition and physical climate risks include business disruption and depreciation of capital (from chronic climate change and acute climate hazards), competitive pressures (public policies and technology), investment needs (due to transition and adaptation), and cost of capital (market pricing). These channels exist in a world where companies and countries can adapt and respond to evolving climate-related risks.

Yet all entities also face other pressures, ranging from managing supply chains amid geopolitical risks, to adjusting to higher interest rates and the need to invest in digitalization and artificial intelligence.

Where climate transition risks are visible, we may take a rating action. For example, in January 2021, we revised our assessment of industry risk for oil and gas companies to moderately high from intermediate, which led to negative rating actions. The revision reflected our view of increased risk for the industry linked to the trajectory of oil and gas supply and demand, as well as the impacts of the increasing adoption of and transition to renewable energy alternatives to address climate change.

The nature of the scenarios we may use, our approach to assessing their possible impacts, and the sectors we apply them to, will evolve over time. That process will be informed by increased visibility over policy choices, technological developments, and changes in customer preferences, as well as by actions taken by issuers to adapt and the idiosyncrasies of specific sectors, among other factors.

We don't view these scenarios as exhaustive. Instead, they serve to provide common ground for future scenario analyses we may carry out. This allows us to revisit these initial considerations after gaining further insights and knowledge in the future, through our own research and data sources or through market engagement.

CreditWeek, Edition 39

Contributors: Alexandre Birry, Terry Ellis, Paul Munday, and Marion Amiot

Written by: Molly Mintz