Key Findings
The increasing exposure of rated debt to environmental risks highlights the importance of climate and other environmental factors in assessing creditworthiness.
High climate risks do not necessarily mean lower credit ratings. Government or parent company support, strong financials, and regulations can offset these risks.
There has not been significant growth in recent years of rating actions driven by environmental, social, and governance (ESG) performance. Social and governance risks have largely determined recent ESG-driven credit rating actions, while environmental factors accounted for a much smaller proportion.
Current methodologies adopted by rating agencies emphasize near-term and visible ESG risks. They overlook longer-term impacts, leaving investors vulnerable to financial shocks. Credit rating methodologies should be refined to capture long-term climate-related financial threats.
Global carbon emissions from fossil fuels hit a record high in 2024. The same year was also the hottest on record, with unprecedented temperatures experienced in the last decade. These trends have fueled extreme weather events, including heatwaves, floods, and droughts. Human-induced climate change is also intensifying wildfires, with studies suggesting that climate warming made the Los Angeles (LA) fires 35% more likely.
These risks have already impacted credit ratings, with S&P downgrading the LA Department of Water & Power by two notches. Meanwhile, Moody’s lowered the ratings for insurers like Mercury General Corporation, whose rating fell a notch and received a negative outlook. Fitch also assigned a negative outlook to Mercury.
Climate risks are pressuring existing credit ratings
Extreme climate events will likely intensify as global emissions fail to decline at the pace needed to limit warming to 1.5°C as many regions continue relying on fossil fuels. Adaptation efforts are progressing slowly, with funding falling well below necessary levels. This financial shortfall is particularly severe in emerging markets, leaving them highly vulnerable to climate risks.
In Asia, where physical climate risks are high, adaptation capacity remains limited due to insufficient funding. Lower-income countries with weaker governance and infrastructure preparedness are particularly disadvantaged. Fitch has previously identified Vietnam, the Philippines, and Bangladesh as the most vulnerable to flooding risks. Failure to manage these risks could become an adverse credit rating driver as climate threats increase.
Pakistan's devastating floods in 2022, which weakened the country's liquidity and funding conditions, led to credit rating downgrades by the Big Three credit rating agencies (S&P, Moody’s, and Fitch). The downgrades also impacted public utility agencies, which had benefited from rating uplifts due to government support. Financial institutions were similarly affected, given their close ties to the state and strong linkages between sovereign creditworthiness and bank balance sheets.
Physical risks and the push for a low-carbon transition to achieve net zero by 2050 are putting downward pressure on many existing credit ratings.
Sector-specific environmental risks are on the rise
Moody’s environmental heat map, which evaluates environmental risks across sectors, highlights rising risks for its total rated debt. In 2024, rated debt in sectors with high or very high overall environmental risk reached USD4.3 trillion (tn) or 5% of the total rated debt, more than doubling from USD2tn (3% of the total rated debt) in November 2015 when the Paris Agreement was unveiled. The number of sectors also grew significantly, rising from 9 in 2015 to 16 in 2024.
According to risk category, physical climate and carbon transition risks pose the most significant threats to rated debt. While no sector has been classified as having very high physical climate risk, 14 sectors face high exposure, collectively holding USD6.2tn in rated debt. The largest sectors by rated debt with high exposure include emerging market sovereigns, regulated and self-regulated utilities with generation, and integrated oil companies.
Meanwhile, 16 sectors with high or very high carbon transition risk accounted for USD5tn in rated debt, up from USD4.5tn in 2020. Integrated oil companies, independent exploration and production, refining and marketing, and coal mining and coal terminals face very high inherent exposure. Sectors classified as highly exposed include regulated and unregulated electric utilities, chemicals, auto manufacturers, midstream energy, and airlines.
High climate risks are not translating into low credit ratings
Despite their materiality, environmental risks have a limited impact on credit ratings due to a long-term horizon and high uncertainty. Additionally, the difficulty of quantifying potential financial losses within the predominantly short-term credit assessment framework undermines impact. Factors such as government support, strong standalone/parent company financials, and regulatory policies also act as mitigating factors for carbon-intensive companies.
For instance, in the Asia-Pacific region, Fitch notes that power utilities deriving over a quarter of their revenue from coal-fired generation face significant pressure on standalone credit profiles due to carbon transition risks. However, rating enhancements, such as government support or a financially strong parent company, can prevent adverse rating action, even as climate-related vulnerabilities weaken the standalone financial position. Among the 18 entities assessed, over 60% benefited from rating uplifts of at least four notches above standalone ratings or had ratings aligned with sovereign ones based on expected government or parental support in times of need. However, while the ratings remained attractive, these actions essentially transfer the real climate-related risks from entities and investors to taxpayers, who will be liable for any sovereign financial support.
Similarly, despite operating in a carbon-intensive industry, leading Asia-Pacific oil and gas producers such as the China National Petroleum Corporation and Malaysia’s Petroliam Nasional Berhad boast strong standalone credit profiles of “AA-” (Fitch rating), supported by large-scale operations, dominant market positions, and solid balance sheets. The oil and gas sector faces growing scrutiny over its emissions, competition from low-carbon alternatives, and policy pressures like carbon taxes. A 1.5°C pathway requires most fossil fuel reserves to remain unburned. However, companies have invested heavily in fossil fuel infrastructure, resulting in high exposure to transition risks.
Climate-related rating actions decreased across agencies
The Institute of Energy Economics and Financial Analysis (IEEFA) previously highlighted that the ESG scores introduced by rating agencies primarily aim to improve the transparency of how these risks are incorporated into credit assessments. However, in most cases, introducing these credit scores has not led to significant rating changes, including in the Asian sectors. Limited score integration, reflected by a broad-based decline in ESG-driven rating actions in recent years, continues to be challenging amid growing climate and sustainability concerns. In 2023, S&P discontinued publishing these indicators in their rating rationales, further complicating ESG risk tracking.
Social factors, driven by the severe impact of the pandemic, were the primary drivers of ESG-related credit rating actions — dominating S&P’s actions from 2021 to 2023 and Moody’s in 2022. As these risks subside, ESG-related rating actions have declined for both agencies. S&P reported a 44% drop in ESG-related actions in 2023 and a further 26% decline in 2024, while Moody’s saw the share of rating actions driven by ESG considerations fall from 25% in 2021 to 15% in 2022 and 2023.
In 2024, governance factors overtook social factors, accounting for 77% of S&P’s ESG-related rating actions. Key drivers included risk management, corporate culture and oversight, transparency and reporting, and governance structures. Similarly, governance considerations dominated Moody’s ESG-related rating actions, cited in 86% of cases in 2022 and 93% in 2023. Financial strategy and risk management were the most frequently mentioned governance factors for private-sector entities. Meanwhile, for governments, budget management and credit policy and effectiveness influenced a substantial portion of rating actions in both years.
Among the three categories, environmental risks have historically had a limited impact on credit decisions. At S&P, physical climate and climate transition risks accounted for nearly one-fifth of ESG-related credit rating actions in 2024. At Moody’s, these risks were cited in a quarter of rating action announcements where ESG factors were a key driver in 2022 and 2023.
Conclusion
Current methodologies adopted by rating agencies, with a limited focus on near-term and visible ESG risks, overlook longer-term impacts, leaving investors vulnerable to financial shocks. Credit rating agencies should refine their methodologies as climate risks grow to capture long-term financial threats. Clear guidance and transparent frameworks are essential to avoid underestimating these risks and ensure credit ratings reflect climate realities, strengthening financial system resilience.
