Climate-related financial impacts are upon us. Firms will either create or destroy value in their positioning for market and technology shifts, physical climate events, carbon pricing, and Government actions. Fast-emerging climate-related factors are causing ambiguities, information asymmetries and inefficiencies in capital asset pricing. Investors are seeking transparent and reliable financial reporting, essential to the operation of efficient markets.
Easier Levels developed climate ratings to crystallise the expected net effects of climate factors on firms, and to catalyse climate-related financial disclosures and derisking. We launched our invention on Earth Day 2020 presenting a pre-assessment of over one thousand equities, covering $50 trillion or almost two thirds of the world’s total market capitalization. For this initial breakthrough work we evaluated ratings for two plausible scenarios in the medium-term, Overshoot and Net-Zero. Scenario planning is essential to the evaluation of climate risk.
Climate ratings indicate that recent investment superstars, passive index funds and some classic ETFs, may be too diversified to continue performing well in the medium-term. Companies that Easier Levels expects to be survivors are rated in the top four threat levels while those we expect to be threatened are rated in the bottom three (see chart below) — comprising the Red List of Threatened Companies. From our pre-assessment ratings, the red list comprises a remarkable 63% of the world's market capitalisation in the Overshoot Scenario, reducing to 27% in the Net-Zero Scenario.
The top-rated sectors — tech, healthcare and communications — have higher proportions of likely survivors while the lower rated sectors — energy and materials — have higher proportions of threatened companies. It is concerning that 230 companies are rated in the Overshoot Scenario at the Endangered level. But its not all bad news. 390 companies are likely survivors in Overshoot whereas under Net-Zero it increases to 820. Climate ratings are dynamic and companies can change levels.
Companies can de-risk to improve climate ratings by repositioning and integrating climate-related financial disclosures into annual reporting. Companies reach higher levels by improving their climate performance. It's easier with Easier Levels.
The Easier Levels climate rating methodology is effective, innovative and sufficiently rigorous. Climate ratings are fair and unbiased, transparent, comparable, dynamic, scaleable, and scenario horizon-based.
Climate ratings of companies are fair and unbiased. The algorithm models climate quality, with sensitivity analyses on multiple variables. Seven summary driver variables for short-term and long-term climate value impacts are objectively scored from 1 to 10. Ratings are weighted to produce neutral/unbiased summary level indicators for any given time horizon. In determining climate ratings, we apply a comprehensive process with pre-assessment, assessment, review, consistency check, submission and publication.
The various climate metrics underpinning climate ratings enable transparency in climate reporting. We are at a tipping point in evaluating the impact of climate quality on firm value, as firms begin to determine materiality and initiate climate-related financial disclosures. Impacts can be wide-ranging and include market and technology shifts, physical climate events, carbon pricing, and Government actions. Climate factors can have financial statement impacts such as asset impairment, changes in the fair value of assets, changes in the useful life of assets, contingent liabilities, increased capital and operating costs, and changes in revenues. Forecasts of impacts are inherently uncertain and drive climate ratings.
Climate ratings indicate the expected net effect of climate factors on free cash flows of firms. Non-financial indicators (NFIs) are key determinants of climate ratings. NFIs such as carbon emissions and physical climate impacts drive firm value and are beginning to affect financial performance. We are at the early stage of applying such data and connections are imperfect. It is unlikely markets have as yet fully factored climate value into capital asset prices. Climate ratings can help overcome ambiguity.
Applying a modified threatened species taxonomy to enable comparability, climate ratings are classified under seven threat levels:
Companies will either survive or be threatened by climate risk, to varying degrees. Companies rated in the first four levels are likely survivors while those in the final three are threatened — comprising the Red List of Threatened Companies. Threatened companies may below investment grade with material climate risks.
Ratings colours represent the likely impact of climate factors on company value from green, an increase in value, down to red, a decrease. Materiality increases towards the upper and lower bounds. Deeper red indicates greater threat to value. Yellow indicates a moderate increase in the value of the firm, and orange, immaterial.
Companies on the Red List are likely to suffer value impairment due to climate risk — from minimal for the least threatened level (BB+) to a near complete destruction of value for those rated at the lowest level (D), Critically Endangered.
Note: A threatened species taxonomy modified to capture upside is applicable given the interrelationship between the sustainability of companies and species, and climate change is a stressor on both. Companies’ actions are a stressor on climate, and biodiversity feedbacks are vital to our sustainability.
Firms’ climate ratings are dynamic, and are revised as climate factors take effect, as competitive positioning changes, and with shifts in underlying climate factors. These factors are constantly changing and climate ratings need to be regularly revised. Fast-emerging climate-related factors can be random in their location, timing and materiality and such unusual and infrequent events can have financial effects. Physical climate impacts such as those from natural disasters for example can be random and far-reaching, and Government interventions and market and technology shifts may also be. Accordingly the Red List of Threatened Companies is dynamic.
Climate ratings are scaleable to many levels, for example to the industry, sector, fund, index, country, region, and world levels. Similar to scientific climate models, climate ratings are less accurate at higher levels of resolution. Scientific forecasts of physical climate impacts are more accurate at the world than at regional levels, which are more accurate than country-level, then city-level results, and so forth. Corporate level forecasting requires an even higher resolution again. For corporate climate risk modelling, climate quality results aggregated at the world level are more accurate than country-level results, which are more accurate than sector results, then industry, and then firm results. Due to significant uncertainties, more granular resolutions have higher associated error bands.
The algorithm enables ratings across a range of scenarios and time horizons. The time horizon influences the scenario’s climate ratings. We define ‘short-term’ as less than one year, ‘medium-term’ as one to ten years and ‘long-term’ as more than ten years. Applying different weightings to each climate metric results in scenarios ranging from a very high emissions pathway through to a zero carbon world. At one extreme, a high emissions pathway threatens firm value for most firms with many endangered while the other extreme, zero carbon, has upside for most firms. Less extreme scenarios are based on generally accepted medium-term outcomes with respect to transitioning to net-zero emissions. Scenarios and ratings can be tailored to suit a particular user’s scenario and time horizon preferences.
Even though Easier Levels climate ratings use a credit rating nomenclature, they have more differences than similarities. Our climate ratings apply to the climate-related riskiness of a firm's value including both its equity and debt securities, whereas credit ratings pertain to the riskiness of a firm's or country's debt securities. At the country level, Easier Levels climate ratings pertain to the climate-related riskiness of government's shares in state-owned enterprises (or equivalent) and the country's fixed income securities. Credit rating agencies could apply Easier Levels climate ratings to tilt and reframe credit ratings.
Credit ratings help investors decide the level of riskiness of a security or country and the ratings indicate the likelihood of default on an issuer's fixed income security. Credit rating agencies provide independent assessments of creditworthiness of issuers and assign credit ratings to short-term and long-term obligations. To arrive at their ratings the credit ratings agencies have treated climate-related risks as a subset of the overall risk. Climate ratings require a fundamentally different approach to climate risk assessment; climate risk is more of a mega-risk than a micro risk..
In contrast climate ratings help investors decide the level of climate-related riskiness of a firm's value under various horizon-based scenarios. Due to the fundamental nature of climate-related disruption and the inherent uncertainties involved, understanding climate-related riskiness necessitates scenario planning over short-, medium- and long-term horizons. A company has a different climate rating in each horizon-based scenario, and this is a key difference from credit ratings.
The need for climate ratings across horizon-based scenarios illustrates how they can fundamentally impact credit ratings. With intergovernmental negotiations failing to coalesce into meaningful policy actions that would achieve Paris Agreement aims, we seem to be meandering along the Overshoot pathway. In an Overshoot scenario there will likely be an increase in the frequency and severity of physical climate events (traditionally known as 'natural disasters') due to increasing risks which can manifest randomly. Credit ratings therefore become less reliable for investors and this is where climate ratings come in. When natural disasters occur, credit rating agencies downgrade ratings while climate ratings could conceivably remain unchanged. That is precisely the riskiness they seek to indicate.
Credit ratings are a rating agency's opinion on the ranking of the relative risk of default for a given fixed income security. Rating agencies considered opinions are based on facts and information available about the issuer at the time the rating is determined.
Climate ratings are Easier Levels opinion on the relative ranking of the net financial effect of climate-related risk on the firm. Similarly Easier Levels considered opinions are based on facts and information available about the issuer at the time the rating is determined. However, in addition they are based on wider inherently uncertain risk factors such as geopolitics and planetary physics.
Neither credit nor climate ratings predict gains or losses occurring in the term covered.
Neither credit nor climate ratings are recommendations to investors to buy, sell or hold a certain security. Investors' preferences and expectations of climate scenarios over time may be one of the factors influencing their investment decisions. Credit and climate ratings do not take into consideration investors' individual preferences, market prices, liquidity and other matters and risks.
Investors and issuers are not protected by ratings as provided by rating agencies; there is no privity of contract between a rating agency and an issuer or an investor. Investors and issuers are free to accept or reject an agency's ratings in their decisions.
Ratings are no guarantee of gains or losses occurring in the time horizon covered.
Firms assigned the lowest level climate rating, D, Critically Endangered, should correspond with equivalent credit ratings for firms with distressed debt when a material downside climate risk manifests, irrespective of the climate scenario our rating is based upon.
Firms assigned the top level climate rating, AAA, Sustainable, will likely correspond with equivalent credit ratings for the highest investment grade debt should the Net-Zero outcomes broadly eventuate.