The Relationship Between Climate Change and Credit Scoring

The skies above Auckland turned a vivid orange earlier this year as the impact of Australia’s raging bushfires became visible from the other side of The Tasman.

And while there is debate about the cause of the devastating fires, there is no doubt the disaster has focused global attention on the causes, extent and impact of climate change, and on Australia’s dependence on exports of coal, considered a major source of global warming.

A recent study published in Bioscience, backed by 11,000 scientists, called climate change a “clear and unequivocal” emergency.

There is no doubt that the impact of climate change is increasingly being factored into credit scoring and credit risk assessment.

Global ratings agency Moody’s Corporation signalled the growing importance of the issue last year when it acquired a controlling stake in Four Twenty Seven. The California-based company measures the physical risks of climate change and the New York Times reported, was the latest indication that global warming can threaten the creditworthiness of governments and companies around the world.

Moody’s Myriam Durand said the acquisition would allow its credit analysts to be more precise in their review of climate-related risks. “You can’t mitigate what you don’t understand” she told the NY Times.

For financial institutions, the climate change risk will mostly come from three major sources, according to Canada-based credit risk expert Naeem Siddiqi in a recent article. These are:

• Physical risk: from the increased frequency and severity of weather events such as hurricanes, floods, droughts, heat waves and a rise in sea levels.
• Transition Risk: From disruptions to the fossil fuel industry and supply chains, as markets, policies and consumer preferences shift to greener options.
• Reputational Risk: Firms that fund fossil fuel projects or do not take steps to reduce their own carbon footprints, will see an increase in negative sentiments to their reputation.

Siddiqi describes credit scoring as an emerging discipline. But he notes that regulators such as the European Banking Agency are already encouraging lenders to consider climate change factors in lending, and says a more pervasive global approach will probably happen in the mid to long term.

Maps showing the actual and potential impact of climate change, from the increased incidence of hurricanes, to potential rises in ocean heights, are now easily accessible. And these can be interpreted for potential negative impacts on assets.

Siddiqi says the mortgage market, in particular, is susceptible to this risk, and some banks and investors are already taking it into account. There are already lenders who will no longer finance coal projects, for example.

New Zealand, with a renewable energy supply of around 40 percent, the fourth-highest in the OECD according to the NZ Ministry Of Business, Innovation and Employment, is much better placed than many countries to address the challenges of climate change.

But many New Zealand homeowners have already been impacted with major changes to property values as a result of erosion maps that show increasing ocean encroachment on formerly coveted beachside locations. Climate change and how we deal with it will be a major issue for the mortgage industry.