Why bond investors should prepare for 'trouble ahead' due to climate risks

Failure to gradually reflect the effects of climate change in credit ratings will expose issuers to bigger, sudden losses, US-based non-profit IEEFA says

Large parts of North America, Europe, Asia and Africa have faced extreme weather including wildfires. EPA

Bond investors cannot rely on credit ratings to give them a fair assessment of the climate risk they are exposed to and they should brace for “trouble ahead”, the Institute for Energy Economics and Financial Analysis has said.

From within the big three credit ratings companies – Moody’s Investors Services, S&P Global Ratings and Fitch Ratings – warnings have already been issued, but these have gone largely unnoticed, the IEEFA, a US-based non-profit, said in a statement on Monday.

Inside the industry, “alarm bells have been sounding for months", said Hazel Ilango, an energy finance analyst focused on debt markets at the IEEFA.

The IEEFA notes that in June, S&P warned that climate change is becoming a “significant” driver affecting credit worthiness, but acknowledged that “very few climate-related rating actions” had taken place since early 2022.

Fitch has warned that about 20 per cent of companies face downgrades next decade due to climate change, while Moody’s has said credit risks linked to environmental, social and governance factors are rising.

But the warnings went largely unheeded, which is concerning, Ms Ilango said.

According to the IEEFA, a failure to gradually reflect the effects of climate change in credit ratings will expose issuers to bigger, sudden losses further down the road.

The warning comes as extreme weather dominates headlines, with large parts of North America, Europe, Asia and Africa hit by floods, drought and wildfires.

The gap between the reality of climate change and the risks currently reflected in credit ratings “could result in multi-notch downgrades and trigger sweeping bond sell-offs", Ms Ilango said.

In a recent analysis of an orderly energy transition by 2050, S&P Global Market Intelligence found that companies in five major carbon-intensive sectors – airlines, automotive, metals and mining, oil and gas, and power generation – faced a 31 per cent to 54 per cent downgrade risk.

A disorderly transition, meanwhile, would raise the credit downgrade risk by a further 2 per cent to 20 per cent, the analysis showed.

There is now an urgent need for regulators to step in and require ratings companies to update their approach, according to the IEEFA.

Without better rules, the industry is likely to remain “reactive, rather than proactive", Ms Ilango said.

The IEEFA says rating companies could adopt near-term and forward-looking alternatives, for example, by forecasting future earnings or impact on cash flows from a climate risk perspective.

Regulators should require credit rating committees to include non-voting independent climate specialists as members.

“Unfortunately, the wait-and-see approach to integrating climate risks has been the default mode,” Ms Ilango said.

"Credit assessments consider uncertain forward-looking climate risks only when these become visible and certain, by which time it could be too late. The need for a more sustainable, relevant and effective credit system is now.”