The report is founded on the premise that climate transition scenarios carry reputational, legal, and financial risks that can ultimately affect credit quality and should be considered by investors.

Energy transition risks and materiality for a fixed income investor

The report shows that energy transition risks have material impacts on the credit quality of high-emitting companies, underscoring the need for scenario analysis in credit risk assessment.

Incorporating scenarios into credit risk analysis: Methodology and model selection

The study used a bottom-up approach and a financial model that generates climate transition scenarios represented in financial terms. These scenarios are applied to each company by using quantitative credit quality modelling. The report recommends this approach to investors seeking to assess how a company’s credit quality may respond to current and future environmental risk factors.

Incorporating scenarios into credit risk analysis: Key findings

The study shows that companies that fail to mitigate potential risks and seize opportunities associated with the low-carbon transition may face credit implications. In most cases, credit consequences were worse for companies under the ‘Frozen’ adaptive scenario. The credit quality of the three companies assessed in the cement sector showed the opposite pattern to those assessed in the utility and steel sectors.

Looking at credit quality implications under a limited climate transition (LCT) scenario versus an ambitious one (ACT), representing a 2.7°C or 2°C temperature rise, respectively. Credit quality is consistently estimated to be better under a 2°C scenario for all six companies assessed in the utilities and steel sectors.

Conclusion and implications

The report concludes that granular company-specific scenario analysis differentiates potential forward-looking credit outcomes of climate change. It highlights the need for investors to engage with regulators on climate policy, as well as with issuers that seek more forward-looking indicators, to be at the forefront of climate reporting and analysis.

The report suggests that with active management of transition risks, there is potential value to investors in actions that seek to achieve lower climate impacts. It further states that ESG scores in widespread use by investors are not explicitly forward-looking or do not incorporate specific climate-related scenario analysis recommended by the TCFD and others.

Limitations to results and directions for future research

While the report focusses on ESG factors and credit risk, studies often find correlation between the two but not necessarily causality. The literature is relatively sparse and reliant on historical data, which is typically only available for very limited historical periods, potentially not including a full market cycle, let alone multiple market cycles.

The study underscores the relevance of climate transition scenarios to credit quality and the importance of scenario analysis in assessing credit risks. It also highlights the need for more in-depth data on climate-related factors at the company and asset level. Investors need to actively manage transition risks and seek lower climate impacts, through engagement with regulators, issuers, and more precise ESG analysis.