Credit Rating Agencies: Integrating Climate Change Risks & Liabilities in the Finance Sector

In light of the role that credit rating agencies played in the collapse of global financial markets in 2007-2009 by overestimating the value of sub-prime mortgages, CIEL is examining how credit rating agencies analyze climate change in their rating assessments, especially those that assess investments in fossil fuels.

With regards to the credit crisis, the Financial Crisis Inquiry Commission appointed by the US government called rating agencies “essential cogs in the wheel of financial destruction” because rating agencies awarded high ratings to securitized debt instruments that were far riskier than the ratings suggested. Now, rating agencies may again be artificially inflating the credit ratings and financial value of companies, but this time rating agencies may be overestimating the value of fossil fuel assets.

All known fossil fuel assets cannot be used if global average temperature is limited to 1.5°C above pre-industrial levels. Indeed, it is universally recognized that only a small percentage of fossil fuel assets can be consumed to stay below this threshold, and yet these “assets” are still accounted for as viable, burnable assets in the global financial system. In particular, fossil fuel companies have stated that they expect to exploit their fossil fuel reserves, and they continue to invest in acquiring yet more. Moreover, much of the finance behind the fossil fuel industry (energy infrastructure projects, coal export terminals, transmission lines) has not yet integrated the demand-limits placed by a 1.5°C limit.

Thus, CIEL is in the process of investigating and educating financial markets about whether and how rating agencies integrate the demand-limits of the global warming threshold and other climate risks into their credit ratings. In the context of climate change, rating agencies cannot and must not assume that future credit risks of investments (especially those in the fossil fuel industry) mirror their past credit risk. Indeed, if rating agencies fail investors, individuals, and financial regulators again, credit rating agencies could face potentially significant legal risk.

Accurate credit ratings in the climate change context are important because overstated credit ratings threaten not only investors and markets, but ultimately the global economy. Inaccurate credit ratings also contribute to over-investment in activities that cause climate change, threatening our ecosystems and the people who depend on them.