Climate change and credit risk

Report at a glance

Moody’s credit analysis of climate change risks considers both longer-term climate trends, such as rising sea levels and temperature increases, as well as short-term climate shocks, such as extreme weather events like floods, droughts and wildfires. These challenges are addressed in the existing approach of analyzing credit factors, including economic strength and diversity, capital asset management, fiscal strength and governance.

Moody’s defines four key credit risks associated with climate change:

1. Economic disruption (e.g., property loss/damage; lower revenues; increased debt; and higher insurance costs);
2. Physical damage (e.g., property loss/damage; loss of utilities, transportation and communication networks);
3. Health and public safety (e.g., loss of life; jeopardized critical emergency service provisions); and
4. Population displacement (e.g., short term displacements and longer-term population migration).

Issuers that face higher climate change risks were asked by Moody’s analysts to discuss their preparedness to absorb climate shocks, and activities to adapt to longer-term climate trends.

In analyzing issuers’ exposure to climate change, Moody’s distinguishes between coastal and non-coastal climate risks. To this end, it measures the following metrics:

1. GDP Coastal Counties/Total State GDP, 2016
2. Tropical Cyclone Damage (1980-2017)/State GDP, 2016
3. Coastal Dwelling Units in 100/500 Year Floodplains/Total Coastal Dwelling Units
4. Damage from Non-Tropical Cyclone Weather Events (1980-2017)/State GDP, 2016
5. Non-Coastal Dwelling Units in 100/500 Year Floodplains/Total Non-Coastal Dwelling Units
6. Agricultural, Forestry, Fishing and Hunting/Total State GDP, 2016

Moody’s notes that measures to mitigate physical exposure to climate risks weight heavily into credit ratings. For example, Moody’s looks at the availability of FEMA funding for natural disasters and the establishment of special reserve funds for hurricanes and other natural disasters.

What does it mean for Canadian issuers?

Consistent with the global climate trends noted in Moody’s report, climate-related natural disasters and extremer weather events are on the rise in Canada. According to Public Safety Canada, the number of natural disasters for which provinces and territories required and obtained federal assistance under the Disaster Financial Assistance Arrangements (DFAA) increased dramatically between 1970 and 2015 (Figure 1), well in excess of population growth. As per the Office of the Auditor General of Canada, from 2009 to 2015, the DFAA’s spending was more than in the previous 39 fiscal years combined. Notably, in Canada, DFAA spending on floods is highest, representing 75 percent of all weather-related expenditures.

As a proxy for growing costs of natural disasters in Canada, catastrophic insurable losses in Canada are also on the rise. According to the Insurance Bureau of Canada, “property and casualty insurance payouts from extreme weather have more than doubled every five to 10 years since the 1980s.” While insurable payouts averaged $400 million per year over the period of 1980 to 2008, for the last seven of eight years leading up to 2016, extreme insurance payouts exceeded $1 billion in Canada.

Worse yet, the state of preparedness to flooding, Canada’s costliest and most common natural disaster are suboptimal across the country. According to research by the Intact Centre on Climate Adaptation, University of Waterloo, Canada scores C- for preparedness to limit flood damages relative to current and future major rainfall events. Notably, the scores are particularly weak across Canada’s coastal communities.

It is therefore plausible that provinces and local governments in Canada, along with other issuers located in the areas of the country that are particularly vulnerable to climate risks, will see their credit scores impacted in the future, unless proactive action is taken to limit these risks.

Climate change adaptation initiatives in Canada

In 2016, the Government of Canada issued the Pan-Canadian Framework on Clean Growth and Climate Change, of which Chapter 4 is dedicated to climate adaptation and actions to build resilience to climate change across Canada. In August 2017, the Expert Panel on Climate Change Adaptation and Resilience Results was set up to establish indicators to assess progress on adaptation and Canada’s resilience to climate change, with concrete metrics expected for public release in August 2018. Performance against these metrics may inform climate risk analysis and credit rating decisions.

Moreover, the Government of Canada made a commitment to integrate climate resilience into building design guides and codes. As part of this commitment, the National Research Council of Canada (which publishes the National Building Code of Canada), Standards Council of Canada and standards development organizations work to update existing standards or create new ones to reflect climate change challenges.

In the spring of 2017, for example, CSA Group (Canada’s largest standards development organization) undertook the following initiatives to incorporate climate change adaptation into standards:

• Development of climate change adaptation solutions within the framework of the Canadian Electrical Code Parts 1, 2 and 3;
• Climate change adaptation provisions for the Canadian Highway Bridge Design Code (CSA S6 – Canadian Highway Bridge Design Code);
• Climate change adaptation for the durability of buildings (CSA S478);
• Flood proofing and flood prevention measures to protect basement flooding (new guideline);
• Green infrastructure to support flood mitigation and surface water protection (new standards); and
• Climate change adaptation for wastewater treatment plants (new standard).

In September 2017, the Standards Council of Canada announced the creation of a new National Standard of Canada for building new residential communities that are more flood-resilient.

The extent to which these new or updated standards are adopted by the provinces, territories, local governments and industry can – and indeed should – become a factor in credit rating analyses. Canada’s largest P&C insurance provider, Intact Financial Corporation, has also been advocating to build stronger communities, stating:

“Severe weather events caused by climate change are increasing and impacting communities across Canada.  Water damage is now the leading cause of personal property claims. Over the last 10 years, water losses for personal property claims have doubled to 40%. There are several improvements that Canadians can take to better protect their homes and communities against water damage. By taking these steps, Canadians could lower their annual premiums – anywhere from 5 to 15%. Those who live in municipalities who make climate resilient infrastructure a priority could also benefit from more affordable premiums, higher coverage limits and enhanced insurance coverage.”

Recognizing that climate change is both real and irreversible – and that the impacts of extreme weather will get more challenging going forward – it is incumbent upon credit rating agencies that they incorporate extreme weather impacts into analytics. In so doing, credit rating agencies may be the force to limit what might otherwise may be a nationally debilitating impact.

Natalia Moudrak is director of the Infrastructure Adaptation Program at the Intact Centre on Climate Adaptation.