Rating Agencies

Rating agencies’ impacts on risk perception is critical

Department/ policymaker

 

101 ideas for a sustainable finance policy package

 

Provide clarity on green 

Tilt investment to green opportunities

Build green investment pipelines

private finance

public finance

blended finance

Rating agencies

 

58. Increase transparency on rating methodologies 

59. Lengthen risk horizons 

 

 

Credit ratings are a critical element in capital allocation. Ratings include climate risk exposure in several elements of their methodologies. For example, Moody’s ratings integrate environmental factors in growth dynamics, debt burden, political risk and external vulnerability risk assessments.[i]

CBs use credit rating agency (CRA) assessments in application of monetary policy and credit ratings are an important consideration for investment decisions. Robust integration of climate risk into credit ratings will therefore ensure capital flows take climate risk into account and will help shift capital to green. While climate risks are considered in ratings, the extent of this is unclear.[ii]

CBs supplement credit ratings with their own climate-related risk assessments. In order to ensure robust assessment of risks, they need to understand how much climate risk is considered by the CRAs. CRAs can increase transparency on how climate risk is assessed in methodologies. Regulators could consider requiring more granular disclosure from CRAs on their climate risk incorporation.[iii]However, such changes can also be driven by the CRAs themselves, in order to ensure robustness and relevance of their ratings to clients’ needs. For example, the proposed update to Moody’s sovereign rating methodology adds a description of the interrelationships among ESG considerations and the scorecard factors.[iv]

Credit ratings can be based on short time horizons. However, climate risks and transition plans are material over longer time horizons, meaning risks such as asset stranding may not be reflected in credit rating. In addition, in a short-term financial rating, transition investment may also be viewed merely as an increase in borrowing and a source of credit risk, which could dissuade entities from investing in transition for fear of downgrade and increased cost of borrowing. Increasing the time horizons of credit risk assessmentcould ensure all risks are appropriately assessed.[v]

Alongside transparency on risk assessments, this greater depth of information would also enable investors to better discriminate pricing and evaluate the entity’s impact on climate rather than individual project impact.  

Just as greater transparency is required in credit ratings, it is also needed in ESG ratings. Policymakers and regulators can encourage transparency of ESG rating methodologies and purpose. Rating providers can also be encouraged and enabled to use high-quality, forward-looking climate metrics. This would ensure market participants are better-informed in how to use ESG ratings for asset allocation and portfolio assessment. This can also enable comparability of ratings.[vi]

More granular disclosure, differentiating between physical and transition risks, will enable the credit rating to provide stronger information on risk exposure, as entities’ capacity to mitigate exposure to each risk will vary. Particularly for sovereign ratings, there is high uncertainty over government action and therefore transition risk exposure, far more than physical climate change impacts. Granularity over climate risks can therefore also enable greater understanding of certainty levels and provide guidance on how an entity might act to reduce its risk exposure. 

 

[ii] NGFS, 2022. Credit Ratings and Climate Change – Challenges for Central Bank Operationshttps://www.ngfs.net/sites/default/files/medias/documents/credit_ratings_and_climate_change_-_challenges_for_central_bank_operations.pdf

[iii] Breitenstein, M. et al., 2022. Disclosure of climate change risk in credit ratings, ECB Occasional Paper Serieshttps://www.ecb.europa.eu/pub/pdf/scpops/ecb.op303~eaa6fe6583.en.pdf?26d23c18fd6af8516a0d3b1c86384422

[v] NGFS, 2022. Credit Ratings and Climate Change – Challenges for Central Bank Operations, https://www.ngfs.net/sites/default/files/medias/documents/credit_ratings_and_climate_change_-_challenges_for_central_bank_operations.pdf

[vi] OECD, 2022. Policy guidance on market practices to strengthen ESG investing and finance a climate transitionhttps://doi.org/10.1787/2c5b535c-en