{"id":10731,"date":"2016-11-04T01:24:46","date_gmt":"2016-11-04T05:24:46","guid":{"rendered":"https:\/\/digital.hbs.edu\/platform-rctom\/submission\/ratings-agencies-climate-change-the-next-financial-crisis\/"},"modified":"2016-11-04T01:24:46","modified_gmt":"2016-11-04T05:24:46","slug":"ratings-agencies-and-climate-change-the-next-financial-crisis","status":"publish","type":"hck-submission","link":"https:\/\/d3.harvard.edu\/platform-rctom\/submission\/ratings-agencies-and-climate-change-the-next-financial-crisis\/","title":{"rendered":"Ratings agencies and climate change: The next financial crisis?"},"content":{"rendered":"

S&P Global Ratings (S&P) is one of three leading global credit rating agencies. It assesses the creditworthiness of debt issuers, which include companies and governments, through credit ratings. Its 1,400 credit analysts[1] assess factors and trends that affect creditworthiness, focusing on credit, legal and regulatory, operational and counterparty risk.<\/p>\n

Climate change, and efforts to prevent it, have created additional risks that are not fully being reflected in S&P\u2019s ratings at present. One risk is that more frequent natural disasters disrupt global supply chains, reducing corporate credit quality. Insurance companies are also likely to be exposed to a greater degree of catastrophe risk, increasing payouts and reducing profits over the medium to long term.<\/p>\n

An additional risk specific to the energy sector results from climate change prevention policies. Limiting global average temperature increases to 2\u00b0C requires structural changes to reduce our economies\u2019 reliance on fossil fuels and associated carbon emissions. Hence, vast quantities of recoverable fossil fuels will need to remain underground in order to stabilise the global climate[2], rendering them worthless. These assets are currently held on the balance sheets of oil and gas companies and the probability that they will need to be written off is not accounted for by S&P\u2019s current approach.<\/p>\n

S&P has led its market in publishing its analysis in reports and making statements regarding the effect of climate change on credit ratings[3]. Furthermore, S&P states that it qualitatively and quantitatively incorporates risks associated with environmental, social, and governance factors throughout its analytical ratings framework. Specifically, it says that, \u201csince all rated entities operate in the natural and social worlds, we regard these risks as ubiquitous across the ratings spectrum\u201d<\/em>[4]. This vague language, combined with the challenges associated with quantification, implies that there is no specific focus on the broader risks of climate change and their implications for corporate issuers within the organisation. It is unlikely that they have, for example, created roles with accountabilities for monitoring the potential impact of climate change with this approach.<\/p>\n

Furthermore, credit rating agencies tend to consider a shorter time frame in their analysis, such as five years, whilst the risks associated with climate change tend to be longer term, around ten years or more[5]. Hence even if the appropriate risks were considered, S&P may not be assessing these within an appropriate time horizon.<\/p>\n

As a result, where firms are exposed to climate change risks, S&P is contributing to inflated corporate valuations by not reflecting these risks in their credit rating assessments. If the market is shocked in to realising this suddenly then the value of corporate bonds (particularly in the energy sector) could deteriorate dramatically, just as sub-prime assets became worthless during the credit crisis. This could trigger a financial crisis and economic downturn. The impact of resulting legal action \u2013 not to mention further reputational damage to S&P \u2013 has the potential to be severe.<\/p>\n

S&P should take the following actions to ensure that it is accurately incorporating the risks associated with climate change into its credit ratings and avert potential disaster:<\/p>\n