The European Central Bank (ECB) published a paper that examines how credit rating agencies accepted by the Eurosystem, as part of the Eurosystem Credit Assessment Framework (ECAF), incorporate climate change risk in their credit ratings; the paper also analyzes how rating agencies disclose their assessments of climate change risks to rating users.
The paper develops an analytical framework to perform a systematic and consistent assessment of the methodologies and disclosure by credit rating agencies on climate change risk. The framework is based on 11 criteria that form a holistic approach to classify the level of disclosure from the perspective of a credit rating user. These 11 criteria map to five disclosure areas: climate change risk methodologies and definitions, climate change risk assessment models and methods, data and metrics, assessment of relevance and materiality of climate change risk, and impact of climate change risk on the credit rating. The paper uses the analytical framework to assess methodologies and disclosure practices of the four rating agencies accepted by the Eurosystem as External Credit Assessment Institutions (ECAIs), based on the practices of ECAIs in Spring 2022. These four credit rating agencies are DBRS Morningstar, FitchRatings, Moody’s, and Standard & Poor’s.
The findings show that despite significant progress with the disclosures and methodologies around environmental, social, and governance (ESG) in recent years, the level of disclosure around climate change risk differs across ECAIs and, for each ECAI, across asset classes. For most ECAIs and asset classes, the current level of disclosure does not allow a user to conclude on the impact of individual climate change risk subcategories like transition risk and physical risk. The magnitude of the impact of material climate change risk on credit ratings is rarely disclosed; similarly, it is not clear how sectoral assessments inform entity-specific climate change risk assessments. The paper identifies three areas for improvements in transparency and disclosure practices:
- Transparency about definition and assessment of climate change risk
- Disclosure of the magnitude of adjustment to the credit rating stemming from material climate change risk
- An explanation of the methods and models used for climate change risk assessments
The ECAIs are gradually and continuously enhancing their methodologies and disclosure practices and further developments can be expected in the near future. Going forward, European Union regulators could consider requiring more granular disclosure by rating agencies on climate change risks and their incorporation in credit ratings. Such granular disclosure requirements could be informed by the three improvement areas identified in this paper.
Related Link: Paper (PDF)
Keywords: Europe, EU, Banking, ESG, Climate Change Risk, Disclosures, Credit Rating Agencies, Transition Risk, Physical Risk, ECAIs, Credit Ratings, ECB
Dr. Denton provides industry leadership in the quantification of sustainability issues, climate risk, trade credit and emerging lending risks. His deep foundations in market and credit risk provide critical perspectives on how climate/sustainability risks can be measured, communicated and used to drive commercial opportunities, policy, strategy, and compliance. He supports corporate clients and financial institutions in leveraging Moody’s tools and capabilities to improve decision-making and compliance capabilities, with particular focus on the energy, agriculture and physical commodities industries.
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