Credit rating agencies and climate change: The next headache for bond issuers in developing countries

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Benedict Libanda
 
A new report published by Moody’s on 1 December 2017 outlines how the credit rating agency will evaluate the impact of climate change in its ratings for bond issuers. Although the report focuses squarely on the United States of America, it is highly likely to be a yardstick for future global credit ratings.

Standard and Poor’s Global Ratings (S&P) confirms that climate change and efforts to prevent it have created additional risks that are presently not fully reflected in S&P’s ratings. Already in 2016, S&P warned that countries risk credit downgrades because of climate change with reference to the Caribbean and Southeast Asian countries.

 By definition, credit ratings are a reflection of the risk that a country or firms could default on loans or bonds. A lower rating indicates to lenders that there is a higher risk of default, so countries with unfavourable ratings often have to pay higher interest rates. What does this have to do with climate change, you may ask? Well, climate change has contributed to more frequent and severe natural disasters such as tropical storms, floods and droughts. These disasters disrupt global supply chains, reducing sovereign credit quality. Insurance companies for example are likely to be exposed to a greater degree of catastrophe risk, increasing payouts and reducing profits over the medium-to-long term. The frequency and intensity of extreme weather events – natural disasters, floods, heat waves and droughts – is likely to increase with the rise in global average temperature.

 Recognising the importance of mitigation (reducing greenhouse gases) and adaptation (building resilience) strategies to avoid the worst impacts of climate change, Moody’s has listed six indicators that the agency uses to “assess the exposure and overall susceptibility to the physical effects of climate change”. They include the share of economic activity that comes from coastal areas, hurricane and extreme weather damage as a share of the economy, and the share of homes in floodplain and drought-affected areas. The key rating metric is the probability of default, which is highly influenced by both fiscal (government financial) behaviour and growth. Climate change-related shocks can both cause governments’ to spend more than they ideally should (i.e. more or less as much money as they collect in tax over the long term) but can also reduce growth. This is a double-whammy effect on creditworthiness, as debt levels increase and with lower growth, the ability to service that debt decreases.
 The report explains how the credit agency factors these impacts into its analysis of an issuer’s economy, fiscal position and capital infrastructure, as well as management’s ability to marshal resources and implement strategies to drive recovery. For issuers, the availability of state resources is a key element that improves the response capabilities of governments and their ability to mitigate credit impacts. Moody’s analysis weighs the impact of climate risks on countries’ preparedness and planning for these changes while analysing credit ratings. Extreme weather events make significant impacts on an issuer’s infrastructure, agriculture, economy and revenue base, and environment.
 
One of the criticisms of the methodology is that 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, ten years or more. Hence, even if the appropriate risks were considered, rating agencies may not be assessing these within an appropriate time horizon. Although Moody makes a distinction between climate trends – long-term shifts in the climate over several decades – and climate shocks, defined as extreme weather events exacerbated by climate trends; there is still ambiguity combined with the challenges associated with quantification, implying that there is no specific focus on the broader risks of climate change and their implications for bond issuers. As a result, where countries are exposed to climate change risks, the credit agency will be contributing to inflated sovereign valuations. If the market is shocked into realising this suddenly then the value of sovereign bonds (particularly in the energy sector) could deteriorate dramatically, just as sub-prime assets became worthless during the credit crisis. To change any country’s credit rating based on its vulnerability to climate change, noting that the complexity of the phenomenon makes it difficult to assess the specific impact on any one nation.

 Developing countries will, therefore, be highly disadvantaged with the ratings, as they have limited means and capacities to avert the impacts of climate change while developed countries stand to receive high ratings on their bond simply because they are less vulnerable and have the technology, institutions and means to rapidly recover from natural disaster eventualities. It is not surprising that the most vulnerable countries are poor, agricultural-intensive nations located in regions of the world already prone to hurricanes, persistent drought and flooding. In the context of the agricultural sector in Southern African region including Namibia, four global models confirm that at a worst-case scenario, the region will lose between 27–32 percent for maize, sorghum, millet and groundnut for a warming of about 2°C above pre-industrial levels by mid-century. In light of credit rating agencies and absence of proofing measures, this scenario suggests additional risks on credit rating in the region because the developmental agenda is likely to be affected through the deviation of financial resources towards addressing humanitarian relief measures.     

 To mitigate the possibilities of being downgraded based on level of exposure to climate change risks, countries should seize the opportunity of capitalising on the workstreams and negotiation programmes under the United Nations Convention on Climate Change. The Loss and Damage workstream for instance considers approaches to address loss and damage associated with climate change impacts in developing countries that are particularly vulnerable to the adverse effects of climate change. Some of the Multilateral Climate Funds formed under the convention have the capacity to design hedging instruments for developing countries to mitigate climate risks on their bond issuance in that regards.

 At national level, it is highly important that responsive climate change policies are designed and appropriately implemented to demonstrate preparedness, pliability, and resilience. The National Adaptation Plans and Programmes of Action under the convention enable least developed country parties to formulate and implement interventions as a mean of identifying medium- and long-term adaptation needs and developing and implementation strategies and programmes to address those needs.

 Moreover, national institutions that trade in primary production economies should be adequately resourced to climate-proof tangible and intangible assets within those sectors. Countries should also have disaster risk management facilities or funds that are well capitalized and managed sustainably as they aid their efforts to enhance preparedness. Finally, mainstreaming and incorporating climate change risk into planning and budgeting process as well as national development programmes is key towards resilience and attaining a sound credit rating. This is in view that countries will be required to disclose such information and demonstrate preparedness in order to avoid credit downgrades.

 *Benedict Libanda is the Chief Executive Officer of the Environmental Investment Fund of Namibia. Published by the Finance Climate News, Mexico and New York.

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