With COP21 on the horizon, countries are kicking their commitments to reduce carbon emissions into high gear. Despite these national commitments, many financial actors are carrying on as though it’s business as usual—in other words, financing projects under the presumption that the current drivers of anthropogenic climate change (the largest being the burning of fossil fuels) will continue unchanged. In June, CIEL issued a report, (Mis)Calculated Risk and Climate Change: Are Rating Agencies Repeating Credit Crisis Mistakes?, highlighting how one set of financial actors—credit rating agencies—have yet to functionally transition from a “business as usual” approach. The report found that many rating methodologies appear to model a world in which the global community fails to respond to climate change and fossil fuel consumption increases. (Mis)Calculated Risk highlights how this status quo modeling does not make sense in the context of a dynamic climate change trajectory and could repeat mistakes that led to the global credit crisis of 2008.
What is a dynamic climate change trajectory and what are its risks?
Although the science behind climate change is now irrefutable, the human response to climate change—and thus the total amount of warming—remains uncertain. We face a dynamic climate change trajectory in which the total amount of warming could vary widely depending on how much action we take—and how rapidly.
Dynamism is important because if climate change proceeds on its status quo (do nothing) trajectory, average temperatures around the globe may rise by greater than 4°C above pre-industrial levels (“≥4°C climate scenario”). As a recent study in Nature outlined, the status quo trajectory, or ≥4°C climate scenario, will have even more dramatic costs to people, ecosystems, and the global economy than previously anticipated
Yet, as discussed in (Mis)Calculated Risk, it is imperative—and increasingly certain—that the world will respond to the climate threat and change the status quo. Within the next 3-5 years (the typical time horizon for a rating action), three possibilities emerge for the rate of global warming:
- business-as-usual continues and the status quo of catastrophic ≥4°C climate scenario is unmodified;
- regulatory, legal, consumer, social, and market action modifies the status quo dramatically to be consistent with a 1.5°C or 2°C climate scenario; or
- regulatory, legal, consumer, social, and market action modifies the status quo less dramatically.
(Mis)Calculated Risk finds that, given the recognized costs associated with the status quo trajectory, there is a much greater chance that the latter two scenarios will occur. Thus, the global warming trajectory is likely dynamic rather than static.
The uncertainties that arise from climate change and its possible trajectories present a variety of risks to investments—especially those within the fossil fuel industry. These risks include environmental impacts, changing resource landscapes, new government regulations, competitive pressure, decreasing demand, evolving social norms and consumer behavior, falling clean technology costs, and liability risk from evolving interpretations of fiduciary and tortious duties of care.
What are rating agencies doing to incorporate a dynamic climate change trajectory?
Rating agencies, such as Standard & Poor’s Ratings Services and Moody’s, have made public market reports related to the climate crisis generally. And while these reports are helpful, it appears that the rating agencies have yet to fully incorporate the climate risks they highlight into the methodologies the agencies use to evaluate capital projects and security issuances. If rating agencies disregard a dynamic climate change scenario, they cannot accurately appraise risk and, consequently, may misinform investors. Since the June 2015 release of (Mis)calculated Risk, events surrounding the case study within the report illustrate the recklessness of this inaction.
Since (Mis)Calculated Risk’s publication, one of the world’s major new coal developments is floundering – the Australia Galilee Basin coal project near the Great Barrier Reef. A key organization in that coal development, Adani Group, featured in (Mis)calculated Risk, halted work on the project in June (the same day our report was released) and dissolved its project team in July as critical partners have withdrawn. The dissolution of the project team comes as the demand for coal continues to decrease. Coal imports from major consumers such as India and China are falling beneath projected demand.
Moreover, the warnings about carbon asset risk from high profile figures continue to grow. Within the last month, Mark Carney, the Governor of the Bank of England, warned that investors face “potentially huge losses,” reiterating last year’s warning that commitment to climate change mitigation will inevitably lead to a “carbon bubble.” Put simply, global efforts to reduce carbon emissions will make it impossible for fossil fuel companies to burn all of their discovered coal, oil, and gas reserves. Yet, rating agencies have not adequately revised their methodologies to adapt to a carbon-constrained future and respond to a dynamic climate change trajectory.
Within the next couple of days, we’ll blog about Adani’s coal export terminal in Australia’s Galilee Basin—the case studied in (Mis)Calculated Risk. As will be explained in the next post, recent events raise questions about the robustness of the export terminal’s investment grade rating and further demonstrate the flaws with credit rating methodologies that do not incorporate a dynamic climate change trajectory.
Read Part 2 of this blog series: Update on the Adani Coal Export Terminal