Contagion and Climate Risk: Credit Ratings Agencies, Systemic Risks, and Default Probabilities

Climate change is reshaping financial markets, yet credit rating agencies (CRAs) continue to to be challened by how to include climate risk into default rates. This gap creates significant challenges for investors. By not fully including acute and chronic physical risks into default probabilities, CRAs cloud investors rationale make investments that address climate change risks and opportunities.

Why This Matters

• Banks and investors may fail to prepare financially for losses caused by climate-related events.

• Loans and bonds from areas heavily exposed to climate change may be priced incorrectly, making them riskier than they appear.

• Regulators are starting to demand that financial institutions include climate risks in their models, but many models are not yet designed for this. 

How Is Climate Change Transforming the Financial Landscape?

Climate change and escalating climate risks are transforming the financial landscape for businesses, communities, and investors in real time. The increasing frequency and intensity of extreme weather events, shifting regulations, and market pressures underscore a new reality where environmental issues directly affect asset values, operational stability, and long-term returns.

Yet, CRAs, which are long trusted by investors to evaluate risk when making investment decisions, consistently overlook climate risk in their fundamental methodologies.

What Risks Do Investors Face from Weak CRA Practices?

This poses a major problem for investors. If CRAs fail to evaluate climate preparedness, investors cannot differentiate which issuers are equipped to handle climate challenges and which are exposed. Several industry practices compound the issue—the issuer-pay model, where companies pay agencies for their own ratings; “ratings shopping,” which enables issuers to seek out agencies offering the most favorable scores; and limited regulation, including exemptions from expert liability and unresolved conflicts of interest. Together, these factors incentivize inflated ratings, reduce transparency, and ultimately foster systemic risk that leaves investors with a skewed picture of many financial products’ credibility.

Fundamentally, the methodologies used by CRAs ignore physical risk and climate exposures. Agencies rarely diverge from these published models, meaning critical climate risks, like wildfires and floods, are left out of baseline ratings. Issuers, consequently, have little incentive to invest in sustainability, since climate-related vulnerabilities won’t be considered in their ratings until after disaster strikes. As a result, climate risk is underestimated, compounding losses when negative climate events occur.

What Can Investors Do?

Climate risk is not a hypothetical threat—it impacts investments and valuations. The status quo, where credit rating change only once climate-related damage has already happened, can and must change. One powerful path forward is active investor engagement, such as submitting informed critiques and feedback during methodology updates.