How Climate Scenarios Help Identify Potential Credit Impacts

Authors
Marion Amiot | Head of Climate Economics, S&P Global Ratings
Alexandre Birry | Global Head of Credit Research and Insight, S&P Global Ratings
Terry Ellis | Global Climate Transition Risk Specialist, S&P Global Ratings
Paul Munday | Global Climate Adaptation and Resilience Specialist, S&P Global Ratings

Climate Change Has The Potential To Be Credit Material

S&P Global Ratings believes that 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 is a notable megatrend that can have material impacts on the creditworthiness of issuers and debt instruments (and is already identified as one of the key risks to credit conditions) as a result of transition and physical climate risks. Depending on their specialization and geographic location, economies and sectors can be relatively more affected by transition and physical climate risks in tandem or individually.

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 and to pursue efforts to limit the increase to 1.5 degrees C per the Paris Agreement on climate change. We believe that 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 will materialize — irrespective of today's policy choices. Increasingly frequent and severe physical climate hazards (including wildfires, storms and flooding), chronic events such as changing temperature and precipitation patterns, and rising sea levels will likely impact issuers’ losses and ability to operate, absent investments in adaptation and resilience. 

The timing and potential magnitude of harm associated with physical climate hazards can be difficult to estimate and may be intensified by uncertainties. For example, depending on how and when climate hazards occur, the possible impacts would be influenced by various factors, such as the role of insurance coverage and the effectiveness of adaptation and resilience measures. The precise transmission channels to creditworthiness from physical climate risks are therefore often unclear.

The Role Of Scenario Analysis In Identifying Credit Materiality

Clarity on how and when climate transition and physical climate risks are transmitted to creditworthiness is generally low, considering how the transmission channels tend to be indirect and vary across sectors. Scenario analysis is particularly useful when uncertainties are high — which is generally the case for climate risks — since this tool can provide insights on a range of possible outcomes and highlight potential vulnerabilities.

Outlining Plausible Climate Scenarios

To understand how different conditions could affect future climate transition risks, our latest white paper explores three plausible scenarios for climate transition risks and four for physical climate risks.

These leverage the S&P Global Commodity Insights Energy and Climate Scenarios and the Intergovernmental Panel on Climate Change's Shared Socioeconomic Pathways. We do not attribute probability to any scenario being realized. They provide a starting point when analysing climate-related credit transmission channels and are not the only scenarios we may consider.

Credit risk drivers evolve differently under all aforementioned scenarios, with varying potential rating impacts. These may originate from the climate transition as reducing carbon emissions implies shifts in policy, technology, consumer behavior or market pricing. They may also originate from physical climate risks, where disruption of economic activity is mainly through the supply side, while adaptation and resilience investments may reduce some of the impacts but lead to upfront costs.

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).

Over time, we would expect companies and countries to continue to adapt and respond to evolving climate-related risks.

Climate Transition Risks: Reducing Carbon Emissions Implies Policy, Technology And Demand Shifts

Decarbonization efforts require systemwide changes across technologies and practices that, directly and indirectly, affect all aspects of the economy. Where environmentally friendly technology is not competitive, decarbonization efforts are most likely to come from a shift in policy and demand. Yet this will differ according to countries' constraints and priorities.Overall, climate transition risks are driven by shifts in three key factors: policy, technology, and consumer behavior or market pricing.

While such trends are difficult to foresee, understanding how they may intersect or coalesce in any given scenario can help assess the potential impact on issuers' revenue, costs or other financial metrics. They may be more pronounced for heavy emitting sectors but with potentially broader indirect effects:

• Significant changes in regulation are normally announced with time for affected industries to respond but can be sensitive to changes in political regime and other macroeconomic factors. In some cases, companies might seek to move production to less regulated jurisdictions. Carbon taxes or carbon emissions trading schemes can have a direct impact on costs and profitability for certain industries or require additional clean investments, with indirect costs for customers. Greater coverage and cost of such regulations, such as in S&P Global Commodity Insights' Green Rules scenario, could be a significant credit transmission channel. This could change the shape of affected sectors and the competitive position of individual companies, potentially mitigating certain financial risks of newer technologies or requiring new investments or write-downs of older assets.

• Shifts in policies and investments to decarbonize could drive technological change, leading to changes in companies' costs, investments and market positioning. None of the three scenarios are predicated on a revolutionary breakthrough in technologies, but the extent of change could affect creditworthiness. Entities offering new, less emissions-intensive products could eventually disrupt markets. This could lead to dislocation of traditional market players if demand shifts to more environment friendly products.For other industries, this may lead to aggregate cost savings and increase consumers' purchasing power. However, under a slower transition, such as in the Discord scenario, incumbent technologies may face lower risks with less need to invest, at least in the short to medium term, possibly reducing potential impact.

• Investment sentiment, how markets operate, and what consumers value could look very different under the three scenarios. Shifting consumer preferences may result in higher demand for some technologies than for others, especially in transportation. For example, in all three scenarios, sales of electric vehicles increase to 35% of total light vehicle sales or higher by 2040. Such demand can shift entire markets, with potential winners and losers throughout the value chain and in different countries. Willingness to invest and availability of capital are closely linked to how investors view climate risks, which in turn reflects regulatory and technology developments that could differ across the three scenarios. In future scenarios, where there is more uncertainty on regulation, investment flows to more novel solutions may be limited, with the focus remaining on existing or legacy technologies. At the same time, investors and central banks looking at the long-term need for decarbonization may price environmentally friendly solutions more favorably.

Physical Climate Risks: Disruption Of Economic Activity Is Mainly Through The Supply Side

The way that physical climate risks may influence creditworthiness usually originates from damage to capital or productivity impairments. Capital is destroyed when acute risks materialize, such as storms and flooding. Productivity is impaired when chronic risk events occur, such as heat waves or droughts. The impacts may be direct or indirect and/or emerge over different timescales depending on the sector:

• Direct impacts include unexpected or increasing operating costs. Acute physical climate risks, such as flooding, can damage infrastructure and assets and/or cause operational disruption, resulting in higher-than-expected investments to rebuild and adapt buildings, roads and bridges, for example. Such climate events can also put pressure on health systems and reduce workforce productivity. Chronic climate-related changes, such as water or heat stress, may require development of alternative water supply resources to safeguard agricultural and energy production or investment in cooling technologies. They may also require modifications of construction materials to allow buildings to withstand higher external temperatures and longer periods of extreme heat conditions.

• Indirect impacts may materialize as even greater financial risks, including due to supply chain disruptions and resulting short-term inflationary pressures, reduced access to capital, higher cost of debt, increased insurance premiums, reduced insurance coverage, litigation, or unforeseen stakeholder reactions to the climate event (political, regulatory or legal, for instance). Furthermore, adaptation through geographic, economic and/or demographic changes could result from extreme heat conditions, leading to changes in property prices linked to area exposure and rebuilding costs in exposed areas. These factors could strain governments' financial resources, for example by eroding tax bases due to relocation of companies and people. 

These impacts can be difficult to foresee and may be intensified by uncertainties. For example, depending on how and when climate hazards occur, the possible impacts would be influenced by various factors, such as the role of insurance coverage and the effectiveness of adaptation and resilience measures. The impacts of rising global temperatures will not be evenly distributed. Lower-income and lower-middle-income countries are more at risk than wealthier economies and are less ready to cope.

With this in mind, we believe that climate-adaptation financing will become as important as climate transition financing in protecting wealth and lives over the next few decades. Slower decarbonization pathways may also make adapting to certain physical climate risks more difficult.

Looking ahead

Scenario analysis helps us understand the possible channels through which climate change may influence creditworthiness. While often looked at in isolation, climate transition and physical risks are intrinsically linked across different scenarios. More rapid decarbonization will lead to less physical risks globally in the medium to long term. By contrast, the potential impacts of physical climate risks are set to increase as long as emissions continue, even if decarbonization is underway.

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 issuers take to adapt and the idiosyncrasies of specific sectors, among other factors.

We do not 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 through our own research and data sources or through market engagement.