Climate change driving credit risk
Climate change is an increasingly significant factor in our daily lives. The transition to a low carbon economy carries different risks for corporations and could unfold gradually over time or through sudden shocks. There are multiple risks in play to consider. This blog will look at how these various factors impact credit risk decision making and long-term outlooks. We have identified three key areas driving this risk…
Firstly, consider regulatory change. Currently there is a move towards nationalism and a decrease in global cooperation. The United States recently withdrew from the Paris Agreement and the Brexit crisis diminishes Europe’s ability to focus on driving global cooperation on climate change, at least in the short term. However, if we assume that over time there will be renewed support for global cooperation to tackle climate change this will most likely incite regulatory tariffs on companies to ensure they reduce their carbon output. Satellite data technology advances allow the monitoring of carbon output levels from power plants and factory chimneys. In short order, there could be a significant regulatory financial impact on companies that pollute, which inevitably leads to increased likelihood of a credit default over a given time horizon. When we determine our risk appetite for a particular counterparty we need to start considering their carbon output. Two similar companies, with very similar balance sheets, financial performance and identical public ratings might currently produce an identical internal rating and limit recommendation. However, if we consider that the first company is investing heavily in renewable energy sources and is reducing their carbon output and the second company is currently building new coal-fired power plants, our longer-term view of their financial viability could be very different. It is certainly the case that a significant increase in regulation to tackle carbon emissions will lead to bankruptcies of some companies and a significant opportunity and financial advantage for others. This should be considered in our credit risk scoring models.
Climate change impacts the environment in different ways depending on the location. Rising tides will impact coastal areas and low-lying areas are particularly vulnerable to flooding. At the same time, some regions are becoming ever more exposed to wildfires, as we are now seeing in California and some areas of South America. In other regions, water shortages and drought can have a major impact on the local population. If we consider this from a corporate credit risk viewpoint then these geographical factors become measurable and significant. Does my counterparty have significant assets in areas subject to flooding? Does my counterparty own an oil refinery in an area with increased risk of wildfires? If I am a fund manager, should I be re-considering my investment in a textile manufacturing company with labour-intensive production in locations with major exposure to drought and water shortage risks for the local workforce? These geographical exposures will become significantly more relevant as the climate crisis increases in the coming years. Our risk models need to consider these factors when setting credit limits and risk appetite and when modelling longer term potential credit events and default probabilities on the current portfolio.
A third factor that will drive the financial viability of our counterparties is public sentiment. Nationalist movements are reducing global government co-operation, but public opinion is shifting dramatically. With the continued stream of scientific data and daily news of floods and fires, the demand from the public for action has never been greater. As more and more data becomes available, companies that are polluting the planet will continue to be exposed. This negative sentiment will ultimately impact their financial performance. We have seen in the retail energy markets the rise and popularity of clean energy providers. Companies that promote their renewable credentials are gaining market share at the expense of the more established providers. Credit Risk Managers should therefore factor in corporate behaviour as a driver to determining the long-term credit worthiness of their counterparties. They need a measurable sentiment score, that, along with other more traditional factors, should be a driver to the overall credit risk analysis of their counterparties.
The world is changing fast. Carbon transition risks include government policy changes, reputational impacts, shifts in public opinion, market preferences, norms and technology. Transition opportunities include those driven by resource efficiency and the development of new technologies, products and services, which could capture new markets and sources of funding. These risks and opportunities vary across geographies, sectors, time horizons and in line with government and business commitments to limit global temperature rises. All these factors are increasingly significant, and the most proactive credit risk managers will be considering this in their credit analysis.