Increasingly frequent and severeweather events are symptomatic of a wider shift in global weatherpatterns. The uncommonly destructive Atlantic hurricanes Harvey,Irma, and Maria are a few examples from the past year.

As the damages resulting from global weather trends compoundyear by year, international credit markets have begun to takeclimate change more seriously. Environmental and climate (E&C)risks—as well as opportunities—may affect an entity's capacity andwillingness to meet its financial commitments. Therefore, S&PGlobal Ratings incorporates these considerations into our ratingsmethodology and analytics. We factor projected short-, medium-, andlong-term E&C impacts into various analytical inputs used inour credit analysis methodology. And where these factors have amaterial impact, they can result in a change to the rating.

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Material Impact

Over the past two years, E&C factors have affected corporatecredit ratings with a marked increase in frequency. At S&PGlobal Ratings, environmental and climate concerns were materiallyrelevant in 717 cases from July 2015 to August 2017. These casesaccounted for a little under 10 percent of the corporate ratingsassessments we undertook in that time period; given the myriadrisks that can impact credit quality, this is a significantproportion of assessments. It is especially noteworthy consideringthat in the prior two years—among ratings analyses we undertookbetween November 2013 and October 2015—E&C factors wererelevant in only 299 cases.

Moreover, among the 717 recent cases in which S&P GlobalRatings found climate change to be materially relevant, an E&Cfactor was the key rationale for a rating change—such as anupgrade, downgrade, outlook revision, or CreditWatch placement—in106 of them.

What does the increase in corporate credit ratings' referencesto E&C factors mean? It could indicate that environmentalconcerns are having an increasingly significant impact on creditquality. If so, this trend could result from changes inenvironmental policies, or from the heightened frequency of severeweather events as witnessed around the world in the past year—fromwildfires in Portugal, Greenland, and California to the Atlantic'scostliest hurricane season on record.

While some of S&P Global Ratings' 106 E&C-related ratingactions from mid-2015 to mid-2017 were triggered by specificevents, others were based on developments that we see as likely tooccur over a longer time horizon. This reflects two considerations:first, that natural catastrophes such as droughts, floods, andstorms are likely to occur more frequently as the planet warms; andsecond, that climate change is causing the earth to experiencelonger-term shifts in the variability of weather patterns. Asglobal warming continues, we expect to see more instances in whichan E&C risk factor proves material to credit quality.

It is worth noting that S&P Global Ratings' researchindicates that the industries in which ratings are most likely tobe affected by climate factors are oil refining and marketing,regulated utilities, and the unregulated power and gas subsectors.This may not be surprising, given these sectors' exposure to bothenvironmental regulations and the physical effects of climatechange. However, it's also worth noting that although policy andweather events tend to have a more direct impact on credit qualityin some sectors than in others, E&C risks factor into ourratings criteria—to some degree—for most industries.

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A Different Direction

Another trend that S&P has noted is growth in the number ofE&C rating actions that are positive. Among research updates inthe 2013–2015 review period that listed an E&C factor as a keydriver of a rating change, 79 percent of those changes werenegative. Only 21 percent of E&C-driven changes took a positivedirection. In contrast, in the 2015–2017 period, 56 percent ofE&C-driven rating changes were negative, while 44 percent werepositive—a considerably more balanced outcome. (See Figure 1.)

This trend might reflectimprovements in businesses' management of E&C risks in recentyears. The Financial Stability Board's (FSB's) Task Force onClimate-related Financial Disclosures (TCFD) has identified“resource efficiency” as one of several definitive categories forclimate-related risks and opportunities. Resource efficiencyinvolves reducing operating costs by improving efficiency acrossproduction and distribution processes, buildings, machinery, andtransportation use. Many of these changes relate to energyefficiency, but resource efficiency also includes policies arounduse of materials, water use, and waste management. Suchinitiatives, and the innovative technologies used in them, canresult in direct cost savings for a company over the medium to longterm, at the same time they contribute to global efforts to curbemissions. S&P Global Ratings believes resource efficiency andthe TCFD's other categories help explain the diversity of risks andopportunities that can be captured under the broad umbrella ofclimate and environmental factors.

For example, when West China Cement Ltd, a prominent cementmanufacturer operating in Northwestern China, was upgraded to B+ inMarch 2017, the key rationale was improved liquidity andprofitability. These improvements resulted, in part, from anefficiency initiative that aligned with the TCFD's concept ofresource efficiency. West China Cement implemented strategicchanges in the form of a waste-heat recycling system as acost-reduction effort—which resulted in a 4.5 percentsavings on electricity costs.

Meanwhile, in October 2016 in the United States, DarlingIngredients Inc.—a company focused on turning by-products fromother businesses into sustainable ingredients for food andenergy—had its ratings outlook revised from “negative” to“stable.” One of the key drivers of this revision was the U.S.expansion of lower-carbon fuel standards, which are beneficial tobiofuel sales. As such, Darling Ingredients was expecting anincrease in dividends from the company's joint venture in biofuelsales, Diamond Green Diesel. This contributed to an expectedimprovement in the company's EBITDA. It also fits into TCFD'sdefinition of climate opportunities under “Products and Services,”a category that covers innovation and development of newlow-emission products and services which may improve competitiveposition as a result of capitalizing on shifting consumer andproducer preferences.

It is difficult to draw definitive conclusions about why theproportion of positive ratings actions has increased. However, inlight of the Paris Climate Agreement's goal of keeping the increasein global temperatures this century below 2 degrees Celsius andcontinued decarbonization initiatives, the ratings trend couldsignal that corporates are increasingly benefiting from energytransition opportunities. It may also indicate that corporates aredeveloping a more acute understanding of E&C risk and aretherefore mitigating it more effectively than before. A finalcontributing factor may be that some corporates are benefiting fromchanges in environmental policy, such as low-carbon and energyefficiency standards.

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Environment in Analysis

Measuring a business's resilience to E&C risks, as well aspotential E&C opportunities, is part of S&P Global Ratings'analytical methodology. In our corporate ratings analysis, weevaluate the impact of material, known credit risks that couldreduce the company's creditworthiness. These credit risks includeenvironmental, social, and governance risks—collectively known as“ESG risks.” Within our corporate criteria framework, the areasmost likely to reflect ESG risks are industry risk, competitiveadvantages, cash flow/leverage, and management/governance (seeFigure 2).

In particular, management and governance is a category ofanalysis whose guiding framework explicitly referencesenvironmental and social risk. The section regardingcomprehensiveness of risk management standards and tolerancesstates: “Corporate enterprises with a deliberate, consistent,articulated, resourced, and integrated approach that effectivelyidentifies, selects, and prudently mitigates risks are more likelyto build long-term credit strength as compared to enterprises witha casual, opportunistic, or reactive approach. Business managersdemonstrate proficiency by institutionalizing comprehensivepolicies that recognize the complex interdependencies of the riskstheir businesses face, the trade-off between risk and reward, andthe interplay between business and financial risk. The managementof environmental and social risk is included under thissubfactor.”

S&P Global Ratings' assessment of management and governanceacts as a modifier in our corporate criteria framework and can,therefore, influence an issuer's credit rating. This is because webelieve that material management, environmental, social, andgovernance risks can harm a company's creditworthiness if they arenot managed properly.

Another category in which ESG risk factors could affect S&PGlobal Ratings' view of the creditworthiness of corporate entitiesis industry risk. For example, if we consider that emerging orincreasing environmental or social risks are likely to causeindustry-specific growth trends to deteriorate, or the level andtrend of industry profit margins to weaken, we may review ourassessment of industry risk for that market sector. This, in turn,could weigh on the business risk profiles of rated corporates inthat industry.

Complex Climate

Although our ratings comprehensively incorporate E&C risksas part of ESG factors, analyzing climate change risk is astill-developing science. Climate change is a global reality thataffects the magnitude and frequency of extreme weather events, bothchronic and acute. Nevertheless, there is no broad, systematicagreement about the precise quantitative impact. It's alsoextremely difficult to know whether climate change actually causedany specific weather event.

Take Hurricane Harvey as an example. The first major hurricaneto move from the sea and strike the U.S. in 12 years, Harvey causednearly US$200 billion worth of damage, earning it the title of mostdamaging tropical cyclone ever. Harvey might have happened evenwithout climate change, but it is possible that climate change isincreasing the likelihood of events of this magnitudeoccurring.

So, while climate change might make events like Hurricane Harveymore likely, these disasters would not be impossible without it. Ifclimate change continues to expand, it could potentially generatemore E&C risks pertinent to our analyses, which S&P GlobalRatings would then factor into our corporate credit ratings.

Ultimately, we will continue to monitor the impact of climateand environmental factors on companies' credit risk profiles, as weconsider all relevant factors. And our view can be expected toevolve as new information, including that related to climate changeand environmental science, becomes available.

Michael Wilkins isthe head of sustainable finance within S&P Global Ratings'infrastructure practice, based in London, where he has globalresponsibility for environmental finance research and the GreenEvaluation. Previously, as head of infrastructure finance ratings,he covered utilities, project finance, PPPs, and transportation inEMEA. Wilkins is a frequent guest lecturer at the London BusinessSchool, Cambridge and Oxford Universities, and UCL and King'sCollege London. He is also a member of the FSB's TCFD, the G-20Green Finance Study Group (GFSG), the advisory council of the SmithSchool Sustainable Finance Programme, and the Climate BondsInitiative.

Peter Kernan is amanaging director and the global criteria officer for corporate andinfrastructure ratings at S&P Global Ratings, where he overseesthe development of all corporate and infrastructure criteriaglobally. He was previously the head of S&P Global Ratings'EMEA utilities team and the chairman of S&P Global Ratings'global government related entity focus team. Kernan has also heldroles as the head of S&P Global Ratings' EMEAtelecommunications team and EMEA diversified industries team, whichprovided ratings and analytics for the investment holding company,forest products, business services, paper and packaging,transportation, and building materials sectors.