A new report published by the Centre for International Environmental Law (CIEL) claims that credit ratings agencies are not adequately accounting for climate change risks and may be repeating the mistakes of the credit crisis. If business as usual output continues, the global average temperature increase could be in the order of 4°C rather than the 2°C that was previously agreed in order to avert catastrophic climate change risk.
Credit ratings agencies appear to assume that global average warming will be 4°C or greater, which is artificially inflating credit ratings and financial values of companies that are contributing to global warming. According to the CIEL report, this could potentially expose those rating agencies to legal liability.
The report also states that financial risks from both a 2°C and 4°C or greater warming scenario are not adequately expressed in rating agency methodologies. One example from Australia-Moody’s generic project finance methodology-relies on a business as usual scenario without specifically addressing direct climate change impacts, carbon constrained negative demand shifts and potentially large shocks to carbon-based financial models and issuances.
In particular, the CIEL report highlighted how such a methodology did not take into account how a 2°C and 4°C or greater warming scenario increases competitive pressure from domestic supply in target markets and renewables, softens coal demand, may decrease the stability of projected net cash flows and increases the legal and regulatory risks, risks associated with force majeure events, and supply, market, infrastructure, environmental and reputational risks.
Incorporating both a 2°C and 4°C or greater warming scenario into credit rating agency methodologies will help facilitate a smoother transition to a lower carbon economy and avoid potentially huge down grades and the associated shocks to capital markets. Over investment in carbon intensive projects and industries is ultimately a driver of climate change, which threatens the lives, livelihoods and rights of people around the world who face the immediate and very stark realities of climate change according to the report.
There are a number of indicators that the trend away from a 4°C or greater warming scenario will continue to gain momentum including clean energy market opportunities, the decoupling of economic growth and carbon intensity and evolving social, consumer, legal and regulatory norms.
Evaluating risk based on a dynamic approach which incorporates both temperature ranges presents two major financial risk categories – climate impact risks and carbon constrained demand risks. Climate change risks, as the title suggests, comprises risks that are readily apparent from climate change such as physical risks which have a tangible impact on a debt issuer’s business and operations, such as changing weather patterns, rising sea levels, temperature extremes and changes in the availability of water and other natural resources.
Carbon constrained demand risks arise from constrained fossil fuel demand when the 4°C or greater warming scenario is changed to a 2°C scenario, in which fossil fuel investments risk being stranded as they are no longer supply constrained scarce commodities. Deutsche Bank explains this as “oil left in the ground means a big chunk of the industry’s current net asset value goes with it”.