As evidenced by natural catastrophes such as earthquakes, storms and floods, environmental and climate risk is non-diversifiable and systemic. As such, the integration of E&C concerns into corporate credit ratings is of rising importance to investors, lenders and insurers. Comparable and consistent climate-related information helps these market participants to make informed decisions. Financial regulators are interested in understanding the possible E&C risks that may be brewing within the sector.
At present, risks and opportunities related to E&C factors are incorporated into credit ratings when they represent a material impact to the creditworthiness of an issuer. In order for these factors to be seamlessly integrated, comprehensive and reliable disclosure is essential.
A global framework
Moreover, better climate-related disclosure could further improve the effectiveness of peer analysis within the credit ratings methodology. Guidelines at the policy and government levels can help. For example, France has become the first nation in the world to mandate environmental, social and governance (ESG) disclosure. Its central “comply or explain basis” disclosure framework, Article 173, which came into force in 2016. However, different countries adopt different approaches and cross-jurisdiction inconsistencies have therefore continued.
In lieu of a mandatory global framework for disclosure, the Task-force for Climate-Related Financial Disclosures (TCFD) offered up their voluntary recommendations earlier this year. The TCFD’s recommendations aim to provide clarity around E&C risks and their impact in the financial markets by presenting a voluntary disclosure framework that aims to ease both the production and use of climate-related financial disclosures.
Relevant to most companies, the recommendations focus on four areas: governance, strategy (the actual and potential impacts on the organisation’s businesses and financial planning), risk management, and metrics and targets.
Despite their adoption being voluntary, the uptake of TCFD recommendations – and their market reception, more generally – has been positive. As well as featuring in the Hamburg Action Plan (which lays out the G20’s strategy for achieving “strong, sustainable, balanced, and inclusive growth”), the TCFD recommendations have garnered support from over 100 CEOs – representing companies with a combined market value in excess of $3trn.
Strong, continued uptake might encourage more companies to disclose the environmental impacts of their operations. In turn, investors might have access to valuable information that might help them to better hedge their exposure to climate-related risk as the market continues to adjust to the ongoing and inevitable effects of climate change.
Climate in credit
There is evidence that E&C risk – and disclosure of it – is increasingly significant in terms of impact on credit ratings. Our two-year report from mid-2015 to mid-2017, which covers nearly 9,000 research updates, notes that E&C risk was featured in credit analyses a total of 717 times. Of the 717, 106 listed an E&C risk or opportunity as one of the key reasons for a rating action – i.e. when a rating is either raised or lowered, an outlook is revised, or when a rating is placed on CreditWatch.
Not only is this a marked increase from the previous two-year review (from mid-2013 to mid-2015), in which 299 updates referenced an E&C factor, but there were also proportionally more positive ratings actions in the most recent report. In the 2013-2015 two-year review, 21% of rating actions were in the positive direction; this time, 44% were positive. So, while the majority of ratings actions that resulted from E&C rationales remain negative, positive ratings actions are becoming increasingly likely. Although it’s difficult to draw concrete conclusions at this stage, this trend could indicate that corporates are beginning to manage some forms of E&C risk – and may be benefitting from energy transition opportunities.
Ultimately, for investors, issuers and lenders to fully understand the impact of the climate on the financial market consistent climate-related financial disclosure is key. And, for this, the TCFD’s recommendations provide a comprehensive framework for disclosure on a global scale.
Michael Wilkins is managing director, Environmental and Climate Risk Research, S&P Global Ratings