For a long time, the rating agencies were stiff and silent when it came to climate change and environmental, social and governance investing. Our job is to assess credit risk, they argued — why ask us about anything else?
That’s changing. The Paris COP 21 agreement has made the radical changes needed in the world economy, as climate change accelerates, glaringly clear. And bond investors are thirsty for guidance on how to think about these issues.
“There is a wide consensus that the transition to a greener economy is going to require a very significant level of investment,” says Michel Madelain, vice-chairman of Moody’s Investors Service. “The question is, how is this going to be funded? This is made more challenging by uncertainty about the trajectory of the transition — what will happen with technological development, the changes in policy? A number of variables are creating uncertainty — one has to think about how to mitigate it and how conventional financing can be deployed to support that transition.”
Until now, rating agencies have been on the sidelines of these developments, quite understandably. When environmental issues directly affected a company’s finances — as with BP’s oil spill in 2010 — they became credit issues, and were considered. There seemed little need to do more, or no obvious way to do it.
Red hotspots on the map
But in the past year, the agencies have got involved. Moody’s is grappling with how to think about risks that we can see coming, but whose timing and precise effects are hard to predict.
Last November, Moody’s published a framework for incorporating environmental risks into its ordinary credit ratings.
It came with a ‘heat map’, showing how 86 sectors are exposed to five kinds of risk: air pollution; soil and water pollution and curbs on land use; carbon regulation; water shortages; and natural and man-made disasters. For each of these, Moody’s has scored every sector’s exposure at four levels of risk.
First in the firing line, with ‘immediate, elevated risk’ are the coal industry and unregulated power companies. They have $500bn of debt — a lot, but only 0.7% of the $68tr total in the survey.
In the next band, with ‘emerging, elevated risk’, are 11 sectors with about $1.5tr of debt, including car makers, oil and gas independent explorers and producers, steel and building materials.
Investors could have worked this out for themselves. But Moody’s analysis will save them time — a trusted authority has examined the problem and applied consistent standards to it, right across the rated universe. Fund managers may disagree with the rating agency, but for many, its view could be a useful starting point for their own thoughts.
Moody’s has not stopped there. In June, it produced a new study, focussing on the 13 highest risk sectors. Again, it broke the problem of carbon transition risk down into parts — regulatory uncertainty, direct financial effects, changes in consumer demand and disruptive new technologies — and assessed how each one could affect each sector’s credit quality.
“What we are trying to do is have a more consistent, holistic and predictive approach to those risks,” says Madelain, “starting from sectors and moving towards individual companies.”
Be precise about base case
An important point Moody’s made in June was that when considering credit risk, you need a base case for how the carbon transition is going to play out.
For this, Moody’s has picked the scenario that countries implement their commitments under COP 21 — though as it points out, this may not happen.
How COP 21 is implemented will affect regulation in virtually every country, but also how bad climate change becomes. Even if the Paris agreement is honoured, CO2 emissions are set to keep rising, and global warming is likely to exceed the official target of 2C, reaching 2.5C, 4C or even more.
Asked whether Moody’s should be looking further ahead in its risk assessments, at the catastrophes climate change could bring, Madelain says: “Our role is to look at the impact on risk of default. Except for in certain very specific circumstances, the most impactful source of risk for investors tends to be either regulatory or displacement of demand. An issuer might have properties exposed to flooding — but these very long term trends tend to be outside the scope of what we do. Most of the securities have shorter risk horizons.”
Madelain is concerned about how the carbon shift will be financed, and sees a role for Moody’s in helping investors manage that. But he stops short of saying investors should push to speed up the transition — for example, by disinvesting from fossil fuels.
“There is nothing specific about financing the transition to a green economy,” he says, “except for some investors who have made an investment theme of it, and are maybe willing to make some trade-off. But this is not the mainstream. Mainstream investors are behaving in the same way and following the same type of criteria for financing this transition as for any other investment. They want visibility of risk and return and predictability of policy.”
In other words, the power to make the green transition happen lies not in investors’ hands, but in those of governments. If they set the right policies and incentives, investors will come.
Marking green bonds out of five
In the past few years, a small but noisy green bond market has grown up, matching issuers proud of their green credentials with investors that want to feel their money is helping tackle climate change.
Again, there seemed at first no role for the rating agencies — from a credit and legal point of view, green bonds are identical to ordinary bonds.
But in March, Moody’s launched a Green Bond Assessment product, grading green bonds from 1 to 5 according to how well they are set up and managed.
The move is an intriguing one, for several reasons. Moody’s appears to be setting its seal of approval on a financial product that has no defined meaning, legal existence or financial purpose.
“It’s not an endorsement, so much as a recognition that there is an increasing volume being issued, and there was a transparency and information gap that needed to be filled,” says Madelain.
While many in the green bond market are desperate for some authority to tell them what is green, Moody’s has stayed away from that.
Instead, it is offering a unified, consistent framework with which investors can compare green bonds from different issuers, according to their quality of management and reporting. “A green bond is a promise around an investment opportunity against a set of expectations the investor has,” says Madelain. “We think we can contribute to increasing the level of transparency and information made available to investors about this alignment, or misalignment. We are very focused on the promise being made and the likelihood of it being met.”
Green bonds can play a greater role in financing the green transition, Madelain argues, but will not be the sole source. Conventional financing will be essential — and that means investors thinking about environmental risks, right across their portfolios.