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Climate Change Could Make Borrowing More Expensive

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Hurricane Maria was devastating for the residents of Puerto Rico. It hurt debt investors, too. Some of the island’s bonds plunged more than 40 percent after the storm flooded the island, knocked out its electric power, and clobbered its economy.

Now bond rating agencies such as Moody’s Investors Service and S&P Global Ratings are looking at whether they should be including more disaster forecasting in calculating the grades they give to government debt and to companies in industries ranging from insurance to construction. The agencies have looked at these risks for years and issued reports on them, but in recent months they’ve been working to integrate this research more into individual ratings. In November, Moody’s warned coastal cities and states to address their climate risks or face possible downgrades. A month later, it issued a report highlighting 18 small islands, from Fiji to the Bahamas, that were “particularly susceptible to climate change.” S&P analysts are working with its insurance practice on climate models and scenario research.

In the U.S., costly natural disasters are becoming more common. The National Oceanic and Atmospheric Administration tallied 16 major, billion-dollar-plus storms, fires, and floods in 2017, including Maria and Hurricane Harvey, which devastated Houston. That compares with an average of about six a year since 1980. The weather and climate events wreaked a record $306.2 billion of damages, NOAA said. Companies and governments are feeling the brunt. A Moody’s study in 2015 found roughly $9 trillion in rated debt exposed to environmental issues such as pollution, carbon regulation, water shortages, and natural disasters. In a recent review of its research, S&P found 717 cases from mid-2015 to mid-2017 in which environmental and climate concerns were factors in corporate credit ratings, equal to about 10 percent of its research updates, says Michael Wilkins, who heads sustainable finance at S&P. That’s more than twice as many cases as in the previous two-year period.

Lower ratings can translate into higher borrowing costs for companies, but environmental changes can also help some businesses. S&P found that when it took a rating action based on a climate issue, 44 percent of the time it was upgrading the bond or issuer. That might happen if, for example, it expected higher revenue for a lithium producer because electric car battery demand is rising.

Investors are pushing ratings firms to give them more of a warning about the risks. “The pressure is really mounting,” says Carmen Nuzzo, a former senior economist at Morgan Stanley in London. Nuzzo is now leading a ratings project for Principles for Responsible Investment, a United Nations-backed organization that brings investors and other market participants together to talk about systematically incorporating environmental, social, and corporate governance factors into the investment process. More than 130 institutional investors—overseeing a combined $23 trillion—and 14 bond grading companies globally are participating.

Debt investors are still not completely clear as to how thoroughly ratings firms have considered these risks, says Jonathan Bailey, head of environmental, social, and governance investing at asset manager Neuberger Berman Group LLC. “We don’t know if they’re looking at every power plant and their relationship to rising sea levels, and we don’t know if they’re looking at rising temperatures and their impact on productivity,” Bailey says. “We want it to be clear how it’s being done.” Ratings firms often have better access to information than fund managers, which puts them in a stronger position to weigh in on these risks or compel the issuer to disclose more, Bailey says.

But ratings firms have previously been slow to cotton on to risks. Enron Corp. was one of the largest corporate frauds in U.S. history, but bond raters were far behind equity short sellers in recognizing the company’s problems: Moody’s, S&P, and Fitch Ratings Ltd. rated Enron investment-grade until four days before it filed for bankruptcy. A few years after that, bond graders gave top scores to complicated securities backed by subprime mortgages, which helped inflate the mortgage bubble. 

In the case of natural disasters, figuring out the potential damage for individual companies and governments isn’t easy. Weather and climate are known to mathematicians as chaotic systems, which means small differences in assumptions can have huge impacts on predicted outcomes. It’s often hard to know the cost of a climate shock—and who will bear it—in part because government-backed and private insurance can mitigate losses. A Fitch review concluded in November that it is “rare” for environmental, social, and governance aspects to be the main driver of credit risk; the company says it focuses on such risks when it affects an issuer’s cash flow.

It’s clear that risks are rising, and borrowers should pay attention to them, says Rahul Ghosh, who heads environmental, social, and governance research at Moody’s in London. Disasters themselves can wound borrowers, but government policies concerning carbon emissions, for example, can have a big impact on them, too. “These trends will have pretty disruptive credit impacts,” Ghosh says.

    BOTTOM LINE – Last year, climate and weather events did more than $300 billion of damage in the U.S. Often that risk isn’t reflected in debt ratings.

    Read more: http://www.bloomberg.com/

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