How Climate Change Could Impact Credit Risk
- As investors increasingly incorporate climate change into their risk management, estimating its impact on issuers' creditworthiness becomes an important ingredient.
- We investigated how different climate scenarios could impact the five-year default probability of a large sample of USD and EUR bond issuers.
- Our analysis showed that 16% of the investment-grade issuers in our sample could be downgraded to high yield in a "Net-Zero 2050" scenario.
A Stress Test of Transition and Physical Risks
Our previous blog post discusses the variety of scenarios available for investors to assess climate risks. In this post, we explore three such scenarios for transition risk based on three Network for Greening the Financial System (NGFS) scenarios: "Net Zero 2050," "Below 2⁰C" and "Nationally Determined Contributions."2 The transition risk can be broken down into "Policy Risk," resulting from more stringent regulation, and "Technology Opportunities," for companies that could stand to gain from the green transition. We combine the "Net Zero 2050" and "Below 2⁰C" scenarios, which are more ambitious in terms of greening the economy, with an "Average Extreme Weather" scenario, and the "Nationally Determined Contributions" scenario with an "Aggressive Extreme Weather" scenario.3
The interactive exhibit below illustrates how, for each of the scenarios, the median five-year implied probability of default (PD) changes and how each driver contributes to the change.4 For the sample of investment-grade (IG) and high-yield (HY) corporate-bond issuers we investigated, the changes in median PDs are relatively benign with increases of up to 0.03 percentage points for investment-grade issuers and 0.39 percentage points for high-yield issuers. Policy risk has the largest contribution for the "Net-Zero 2050 (Average Extreme Weather)" scenario, whereas extreme-weather risk is the main driver in the other two scenarios.
Contribution to Increase in Median Five-Year Default Probability
Loading chart...
Please wait.
The sample of USD investment-grade and high-yield issuers is determined by the issuers of bonds in the MSCI USD Investment Grade Corporate Bond Index and MSCI USD High Yield Corporate Bond Index, respectively. For EUR IG and HY issuers, the sample is determined by the MSCI EUR Investment Grade Corporate Bond Index and MSCI EUR High Yield Corporate Bond Index, respectively. Source: Moody's Analytics, MSCI
The impact on the median default probability hides significant dispersion within the universe of issuers. In the exhibit below, we show the impact of transition risk to the mean probability of default by sector.5 The increase in median five-year default probability could range up to 0.09 percentage points for USD utilities IG issuers and 0.45 percentage points for EUR energy IG issuers under the "Net-Zero 2050" scenario. We note increases up to 1.6 percentage points for USD high-yield energy issuers.
Transition-Risk Impact on Sectors' Five-Year Default Probabilities
Loading chart...
Please wait.
Source: Moody's Analytics, MSCI
In the next exhibit, we turn our attention to potential ratings migrations under the climate scenarios.6 Even though the impact to the median PDs was modest, issuers could experience credit-rating downgrades. Our analysis shows that under the "Net Zero 2050" scenario, around 16% of USD and EUR investment-grade issuers could experience a migration to high yield, while 26% and 28% of USD and EUR high-yield issuers, respectively, could be downgraded.
Rating Migrations Under Climate Scenarios
Loading chart...
Please wait.
The numbers in each cell indicate the percentage of total issuers falling in that cell. The color coding shows the probability of migrating from the base-implied rating (on the y-axis) to the scenario-implied rating (on the x-axis). Source: Moody's Analytics, MSCI
As investors increasingly incorporate climate change into their risk management, estimating its impact on credit portfolios becomes an important ingredient. Our analysis showed that default probabilities slightly increase on average; but more importantly, 16% of the investment-grade issuers could migrate to high yield, and an additional 27% of high-yield issuers could be downgraded, potentially putting downward pressure on portfolio returns.
The authors thank Andras Rokob for his contributions to his blog post.
Further Reading
1“Key elements of the 2021 Climate Biennial Exploratory Scenario and related documents.” Bank of England, June 8, 2021.2“NGFS Climate Scenarios for central banks and supervisors.” Network for Greening the Financial System, June 2021.3Using the past 40 years of observed weather patterns to set a historical baseline, MSCI ESG Research brings both acute and chronic climate developments into perspective through the end of the century. A probabilistic modeling framework is used to determine the probability distribution of the annual cost from weather extremes for company assets at any given location. This allows us to determine the average cost from climate change and explore the possibility of much more severe outcomes. The scenarios used are derived from the average and the 95th percentile of the cost distribution (“aggressive”), the latter exploring the severe downside risk within the distribution tail.4We use the MSCI Climate Value-at-Risk Model to determine the incremental costs and benefits a company incurs as a result of transition and physical risk compared to a climate-agnostic scenario. We then use a Merton model to estimate the impact of this instantaneous shock on the enterprise value to five-year issuer credit spreads on Sept. 17, 2021. The historical relationship between spreads and default probabilities is used to estimate the impact on real-world PDs based on Moody’s Analytics’ ratings and historical default rates. Note that, since we use a climate-agnostic base scenario for comparison, the shocks reflect a worst-case scenario, as they imply climate change is not priced in yet. The contribution is obtained by progressively switching on additional drivers of climate risk. Ratings source: Moody’s Analytics Inc., used with permission.5Sectors are omitted from the analysis where fewer than three issuers are in the final sample. Missing climate-impact data, lack of information on the capital structure of companies without public equity or any data errors could lead to the omission of an issuer.6The ratings-migration analysis is based on the implied rating category as a function of the credit spread under the base and stress scenario based on the long-term historical relationship between spreads and ratings using Moody’s rating and default-probability data. Note that the migration probabilities reflect ratings migration due to climate impact only and do not include migration in the business-as-usual scenario. Ratings source: Moody’s Analytics Inc., used with permission
The content of this page is for informational purposes only and is intended for institutional professionals with the analytical resources and tools necessary to interpret any performance information. Nothing herein is intended to recommend any product, tool or service. For all references to laws, rules or regulations, please note that the information is provided “as is” and does not constitute legal advice or any binding interpretation. Any approach to comply with regulatory or policy initiatives should be discussed with your own legal counsel and/or the relevant competent authority, as needed.