Credit Rating Agencies and Climate Risk: Advice on Changing Ratings Methodologies

Credit rating agencies such as S&P, Moody’s, and Fitch monitor global finance, and their ratings are used by institutions and investors worldwide to assess in a standardized financial risks. Research from the European Central Bank reveals that financial and non-financial stakeholders still lack a fundamental understanding on to successfully engage with credit rating agencies on climate risk.

We all know the dangers of extreme weather accelerated by climate change and its impacts on the economy, yet credit rating agencies still do not systematically account for these risks. Let us explore why this is the case.

Why This Matters

• Rationale: If ratings do not account for physical climate risks such as hurricanes and floods, then financial institutions may hold mispriced sovereign debt issued by at risk corporations and supply chains, and vulnerable countries.  

• But: If regulators allow banks to assign a zero percent risk weight to sovereign debt with an artificially high rating, then those banks are holding dangerously insufficient capital against the systemic threat posed by extreme weather accelerated by climate change.

• Therefore: If a climate disaster triggers a sudden, widespread repricing of assets, then financial markets could face a bear market of mispriced corporate and sovereign bonds, threatening a global financial crisis.  

• Systemic Shock and Contagion: As countries globally increasingly face climate shock with mispriced debt, then their ability to repay their debt is further strained, trapping them in a cycle of higher borrowing costs and leading to global systemic shock as contagion spreads.

• Engage Effectively: Credit rating agencies are nationally regulated institutions who apply methodologies that are unique to each sector to assess risks, which have standardized to comment periods where stakeholders can suggest improvements to methodologies.

Can Credit Rating Agencies Change Their Methodologies?

Credit risk agencies methodologies are sector dependent and rely upon financial metrics. Often these methodologies do not include the non-linear nature of climate risk and resulting contagion risk. A hurricane once considered a “100-year event” may now occur every decade, and traditional models cannot predict this shift, creating a blind spot especially for countries exposed to climate shocks. Credit rating agencies methodologies also tend to focus on short-term risk assessments, typically a one-to-three-year horizon, which is not suitable for capturing the non-linear threats from climate change.

Climate Risk as Contagion Risk?

The Bank for International Settlements (BIS) forecasts that climate risk could trigger the next global financial crisis. Previously ignored climate threats that suddenly become real could lead to a sudden, widespread repricing of physical risks. This could trigger a “fire sale” of sovereign bonds as investors panic and sell off assets they now see as more vulnerable than their ratings suggest. This is a systemic vulnerability rather than a risk management problem.

Action Items

The price of inaction is higher than the cost of taking action. Evidence from central banks, regulators, and academic institutions makes it clear that this is not merely a theoretical concern.

• Financial institutions should invest in the capability to track, gather, and validate climate data, and use it to develop internal methodologies for their own risk models.

• Credit rating agencies must improve how they engage with stakeholders so that stakeholders can effectively comment on methodologies under review to empower incorporating climate metrics and giving them appropriate weight in their assessments.

• Regulators and central banks must accelerate the integration of climate risk into the regulation. The European Central Bank has already begun integrating climate into its monetary policy by "tilting" its corporate bond holdings to align with the Paris Agreement.

The time to build a resilient financial system, one capable of withstanding the inevitable shocks of climate change, is now.