“Our two-tier framework addresses these challenges by using outputs from our NGFS-aligned Macroeconomic Climate Stress Test tool and tracking the relationship between macroeconomic aggregates and corporate credit risk,” said Olivier Toutain, executive director in Scope Ratings’ structured finance team.

Scope’s Macroeconomic Climate Stress Test (MCST) tool supports financial market participants by modelling exposure to climate risks, with an explicit focus on countries and economic sectors. “By using the NGFS’s three climate scenarios – orderly, disorderly, and hot-house – the MCST projects output losses from physical risks i.e. the impact of rising temperatures and extreme weather events, and transition risks, which are the abatement costs of scope 1, scope 2, and scope 3 emissions,” said Hazem Krichene, senior director of Scope ESG Analysis.

Stress testing can be performed top-down or bottom-up. By stress-testing a borrower’s key financial metrics using different climate-change scenarios, users can assess the vulnerability of each corporate borrower to climate-change risks. Using the top-down approach, the impact on individual obligors is inferred and stresses can be derived on their credit-risk metrics.

“The top-down approach is particularly suitable for assessing the credit-risk impact of climate change on a portfolio of corporate exposures, as with several securitisation types. Thus, we developed a top-down approach for corporate borrowers as part of our effort to integrate climate risks in structured finance,” Toutain said.

Climate impacts on structured finance transactions

Scope’s approach shows that while climate risks can seriously impact corporate borrowers across all climate scenarios, portfolios exhibit material geographical and sectoral divergences. For European CLOs, the impact of climate change on credit quality between the least and most climate-sensitive portfolios is more than two and a half notches for the longest maturities. The impact on pan-European CLO portfolios is smaller than for portfolios based on a single geography, because of country-specific risks.

In the short term, CLOs may experience a moderate decline in portfolio credit quality of about half a notch across all climate scenarios. SME transactions with strong concentrations may exhibit slightly higher impacts, with a level of around 1 to 1.5 notches. However, as issuers face refinancing risk, transactions with a short time horizon should incorporate long-term climate risks.

Impacts compound with maturity. In the long-term, CLOs suffer portfolio credit climate related risks deterioration of between 1.5 and 2.5 notches. SME transactions with concentrated portfolios in warm countries and/or sectors most exposed to transition risks experience similar credit deterioration but over shorter term horizon. The disorderly scenario has the largest credit climate related risks deterioration, due to the consequences of both strong physical risk over the medium term and higher abatement costs driven by a delayed transition afterwards.

The results for transactions backed by SME portfolios in France, Spain and Italy vary by jurisdiction. For a deal with a five-year maturity, the average deterioration is less than one notch for France in the orderly scenario, and up to 1.5 notches for Italy and Spain in the disorderly scenario. For the longest maturities, the impact varies by country, with a deterioration of around two notches for France and up to 2.5 notches for Italy and Spain.

Source of climate risks breakdown for a French, Italian and Spanish SME ABS

Source: European Data Warehouse, Scope Ratings

“Physical risk is the main driver of credit quality deterioration in all countries considered,” Krichene explained. “Countries with relatively high temperatures are more affected. Transition risks across European countries are mainly driven by the industry distribution of the portfolios and national factors. For example, the importance of nuclear power in the French energy mix leads to lower abatement costs compared to Spain or Italy.”

By considering loan portfolios in 2022, the short-term impacts are relatively moderate (around one / one and a half notch for transactions with five-years maturity). However, with the ongoing climate change, similar portfolios originated in the future will be more severely exposed to short-term climate risks.

Download the report here.

This report is the second in a series on climate-change risk in structured finance using the outputs of Scope’s MCST. Download the first report in the series here.