A Signal to the World

With sustainability becoming a mainstream concern for many investors, TMI talks to Alex Griffiths, Head of Corporate Ratings, EMEA, Fitch Ratings, about climate-related assessments and ratings, and the delivery of a more appropriate model.

The role of financial products in building a sustainable future is clear, yet the means of assessing and rating products to help investors understand what they’re putting their money into is still shrouded in mystery and uncertainty.

The current lack of clarity is perhaps tolerable, given that the whole concept of the industrial-scale support of green financial services is still in its infancy. But as sustainable-focused investors become more sophisticated in their expectations of outcome – especially the real-world impact of their decisions – so the supporting players, notably the rating agencies, need to provide better information to help investors make the most appropriate decisions.

Ratings and analysis from the main agencies are, for serious investors such as corporate treasuries, a vital source of information. Indeed, the professional judgments of agencies such as Fitch are being used to help them correctly implement strategy and policy, and of course to manage risk.

But if the application of ratings across the world of climate-related investing is yet to catch up with its ‘normal’ counterpart, what value do these green ratings really have? Indeed, are current models of assessment of sectors and rated issuers even giving investors an accurate picture of climate impact?

First, it’s important to a step back and take a look at the aims of the investor, urges Griffiths. “Many are now trying to understand what is referred to as ‘impact’,” he notes. “This describes the external effect a company’s activities is having on the environment, and is distinct from what we call financial materiality, which in our world is a broad view of the credit impact of some of these risks.”

One way in which these investors are trying to assess impact is through carbon emissions data. The data, Griffiths explains, is not yet fully reliable but is improving in quality. Today, many large public companies operating in developed markets are investing considerable time and effort into making sure their data is not only available but that it is also subject to appropriate independent standards.

Progress in these markets with data quality, and applicable standards, is giving investors more confidence. As such, an increasing percentage of portfolios is today being allocated to climate-related targets. But that confidence level diminishes when target investments are from the emerging markets, or relate to private debt issues, simply because disclosures here are often far weaker.

While investors looking for impact are trying, and to a degree now succeeding, in acquiring a full carbon emissions dataset, Griffiths believes emissions data do not necessarily explain the risk to the company of its activities. Investors, he notes were “increasingly feeling the need for a different kind of climate change radar”.

As an example of investor plight, he offers the cement manufacturing industry, which produces around 8% of the world’s carbon emissions. It clearly has a huge negative environmental impact from emissions data alone, and as such would be a considerable investment risk. But the requirements to build for the needs of an expanding global population, and to build infrastructure to enable the climate transition, over the next couple of decades is also huge. This will require vast amounts of cement because currently there is no suitable alternative on the scale needed.

In economic terms this implies a very low elasticity of demand. So while cement plant owners will almost certainly need to transition by investing in schemes such as carbon capture and storage to offset their environmental impact, chances are good that this cost will be passed onto, and be absorbed by, others in the supply chain, placing the industry back on a relatively average risk footing.

The gap between the actual environmental impact of an industry, and its relative transition risk may be conveyed for the information of investors through Fitch’s Climate Vulnerability Signals (Climate.VS). This new tool, says Griffiths, is a concept that has been three years in the making and live since early 2023.

New view

Climate.VS seeks to superimpose Fitch’s analytical and market knowledge over a broader dataset to express economic impacts rather than carbon impacts. It achieves this by presenting a scenario, the UN Principles for Responsible Investment Inevitable Policy Response Forecast Policy Scenario [IPR], to Fitch’s analysts and asking them to develop a view on the impact on sectors and companies if this came to pass. The IPR forecasts a global average temperature increase of around 1.8C above pre-industrial levels.

These opinions enable investors to consider a business with, say, a 25-year forward view, and see how its potential credit exposure, in terms of ratings, will be shaped in that period.

The need for enhanced climate-related analysis now is very much dictated by the way in which climate change has taken on a new urgency, comments Griffiths. It is clear that the existing practice, known as relevance scoring – which expresses how much a range of ESG factors have influenced ratings – places environmental impact far down the list, with just 6% of ratings subject to its influence. Indeed, he says, given the predicted impact of climate change, “that figure feels very low”.

That percentage, he continues, has largely been influenced by what’s known as the ‘rating horizon’, which while not finite in scope, is definitely front-loaded. “Our forecasts typically go out three to five years. We try to incorporate both what the market and the company will do in that period, to address those environmental trends, and over this period we have reasonable visibility. When we shift the focus out to 15 or 20 years, that visibility declines dramatically.”

The level of uncertainty meant that ratings weren’t capturing some of the climate and related policy impact, and says, Griffiths, Fitch wanted to signal to investors what the realistic longer-term climate-related risks of a specific company might be.

The timing of Fitch’s response is important. The ratings that have been subject to the influence of environmental impact mostly affects two industries: automotive, which is subject to huge change around power train delivery; and utilities, which has been forced to reinvent itself away from its carbon-hungry past (with the transition in Europe fairly well advanced). The pressure on these and other markets is about to increase.

“What we’re going to see over the next five years is what’s known as the Paris ratchet,” notes Griffiths. “The Paris Agreement requires countries to review progress against their stated policies in 2023-2024 and in 2025, take a decision on whether they are meeting those objectives or if they need to ratchet up their effort.” He believes the preliminary conclusion is that they probably will have to ratchet. “This is driving the expectation that more policy will emerge. It will have an impact on companies, and potentially ratings.”

Climate.VS was thus introduced as a screening tool. To date, it has not forced any ratings changes. Instead, it is enabling Fitch, and by extension the users of its ratings, to take a future-proofed view of what climate-related outcomes it believes are coming.

Focused effort

The starting point for Climate.VS is a view on what would happen on a sector basis. Fitch analysts are asked to consider the impact of climate on a typical or ‘average’ company in a specific industry. The view can be nuanced  because the UN’s IPR forecast is based on the policies most likely to emerge in different countries. “It’s a tangible input for an analyst,” says Griffiths, noting that “it’s far easier to draw a conclusion from this than from carbon pricing data used by many models”.

Armed with an industry view based on an average participant company, Fitch is able to construct an individual list of longer-term climate-specific challenges for each company, based on what they do. Fitch uses these issuer level Climate.VS for internal consumption, but investors are able to access these signals in order to get a feel for any investment product involving a target company.

As an example, a bond issued to finance a coal-fired power station in India – with India still investing in this form of energy – may  experience only modest risks from the climate transition in the short term, says Griffiths. But in the longer term, as many emerging markets draw level with the more advanced economies’ policy approach to climate change, the view of that bond may be quite different. “Our signal can be used as an input for an investor’s thinking about what is investible in that industry, and how their portfolio should be tilted to accommodate that view.”

Climate.VS has a role in improving investor understanding of sector impact. But it also delivers, when it makes sense, a geographic or jurisdictional take on likely policy response to climate change, and thus the risk of exposure by different companies to those localised changes. For instance, whereas utilities’ regulation tends to be at a jurisdictional level, oil and gas regulation, as one vast market, is global; the sectors considered reflect these varying inputs.

With 420 or so industry-focused in-house corporate credit analysts on tap, Fitch uses its own research capabilities to construct Climate.VS views. Each leverages a close understanding of events – including policy shifts – across their own sector, overlaying the views on IPR’s own policy pronouncements, to determine a tailored VS rating.

Climate.VS purposely focuses on transition risks rather than physical climate risks, simply because the former is more imminent, says Griffiths. There is increasing evidence of physical climate risk reflected in the current 6% of ratings subject to environmental impact – wildfire or hurricane risks can move ratings – but for now the modelling tends to reveal that the risks build over a longer period.

And with most companies that are rated today tending towards the larger end of the business spectrum – with many covering multiple geographies – the physical climate risks to which they are exposed are less concentrated. As Griffiths says: “We’re not ignoring the physical risk but it’s less likely to change a rating anytime soon, whereas the risk of transition is more immediately impactful, and is already changing credit profiles.”

Response required

Even with uncertainty as to how climate transition will unfold, investor response to Fitch Climate.VS should be much the same as with standard ratings; it’s a guide to risk. Some of the risks Fitch considers are climate related, some relate to governance, and some are social, but, as Griffiths notes, “it’s the same broad framework we’re using every time”.

With Climate.VS aiming to provide a view across the next couple of decades, investors can make their own minds up as to whether they want to incorporate that ‘signal’ into their portfolio approach or not. And where certain industries exhibit heightened risk, Fitch analysts are providing the firm’s ratings committees with discussion materials to help build out more detailed ratings reports.

While all Fitch-rated corporates are now subject to a Climate.VS, the roll-out of individual signals is not expected to change investors’ minds in isolation. However, Griffiths believes these to be an essential part of today’s dynamic approach to climate and credit risk assessment.

Indeed, having filtered down from ESG specialists into the everyday language and thinking of regular credit analysts around the world, it is, he comments “now part of a globally changed investment environment, bringing a different aspect to the discussion,” adding that Fitch is “delighted to play our part in that change”.