As scientists predict climate change will exacerbate the impact of natural disasters, Miroslav Petkov and Michael Wilkins suggest that companies should prepare to be tested and existing protection measures could soon prove inadequate
Climate change is becoming more of a concern for businesses around the world.
Its impact has not been a major consideration for us (at Standard & Poor's) when rating corporate credit quality in the past, but it is clear that exposure to this type of risk is becoming increasingly relevant. This is because scientific evidence suggests the world will experience more frequent and extreme climatic events, in which companies' existing insurance and overall disaster risk management measures could prove ineffective.
We believe companies should improve disclosure to allow for a more thorough assessment of the risks they face to natural catastrophes. This increased transparency should incentivise companies to strengthen their resilience to the impact of climate change. The end result will be that the international community, as a whole, is better sheltered.
Mitigating tactics have worked for most, but not for all
Of course, businesses can experience property loss or damage, as well as production and market disruptions as a result of natural disasters.
But, so far, the number of companies affected in this way remains relatively small. Of the 6,300 corporate credit downgrades since 2005, natural catastrophes were the main or material contributing factor for negative rating actions on less than 60.
Companies should improve disclosure to allow for a more thorough assessment of the risks they face to natural catastrophes
In addition, we revised our outlook on less than five companies to 'stable' from 'positive' as a result of natural disasters.
Indeed, most businesses have been able to mitigate their impact through a combination of strategies, including liquidity management, insurance protection, disaster risk management, and post-event recovery measures – despite the economic cost of natural catastrophes increasing significantly over the past 10 years (see chart 1).
Nonetheless, it is a risk that must not be overlooked – especially by companies involved with consumer products and energy production.
Of course, no sector is immune but data collected over the past decade suggests that these sectors are most exposed to this type of risk – together representing more than one-half of our negatively affected sample (see chart 2).
Generally, affected companies in the consumer products sector were hit by supply chain and market disruptions, while energy companies suffered more from a direct impact on production and distribution facilities. A notable example is Tokyo Electric Power Co. Inc. (TEPCO), the owner of the Fukushima nuclear power plant which was severely damaged by flooding following the Tohoku earthquake and subsequent tsunami in 2011. Shortly afterwards, the Japanese government's request to shut down its nuclear reactors for safety inspections led to further production losses, exacerbating the tsunami's effect on TEPCO's business. These significant setbacks led S&P to downgrade its long-term credit rating on TEPCO to 'B+' from 'AA-'.
Natural catastrophes are a risk that must not be overlooked – especially by companies involved with consumer products and energy production
Other rated power companies with nuclear operations in Japan suffered similar multi-notch downgrades as a result of the shut-downs of their nuclear reactors following the disaster.
The Tohoku earthquake and tsunami, alongside Hurricane Katrina in the US in 2005, together constitute the two biggest natural disasters of the past 10 years – responsible for triggering almost 50% of negative rating actions in which natural catastrophes were a factor. Katrina, in particular, was behind almost all of the cases that ended in default.
Climate change raises the stakes
That said, situations of this extreme nature are rare at present. But scientific consensus – as summarised in the Intergovernmental Panel on Climate Change (IPCC) 2014 Report – is that global warming will lead to more heat waves and droughts. With warmer air – which has a greater capacity to retain moisture – the likelihood of extreme rainfall and flooding increases. What's more, rising sea levels are likely to increase the impact of coastal flooding during storms and high tides.
In essence, the effects of climate change look set to cause an increase in the frequency and severity of natural disasters. Couple this with significant growth in business exposure in high risk areas and increased economic integration through complex global supply chains, and the future looks uncertain.
In essence, the effects of climate change look set to cause an increase in the frequency and severity of natural disasters.
As such, existing disaster risk management measures – such as insurance protection – are likely to be challenged. What's more, when the magnitude of a natural disaster exceeds the levels assumed in the design of protective measures, the consequences can be disastrous – as the Japanese tsunami demonstrated.
Further, certain risks may become difficult and costly to insure as the likelihood and cost of natural catastrophe events increases.
Although natural catastrophes do not always have a negative effect – companies can reap the rewards of higher prices in the wake of reduced market competition if their peers suffer losses, for example – in general, we consider that those positive effects are rare.
Preparing for the future
Therefore, companies would be wise to prepare sooner rather than later. Especially as in our increasingly interconnected world, a major local catastrophe – however localised in effect – could easily damage a crucial link in the global economy, having a widespread and long-lasting impact on far-away economies.
In addition, we believe it is unlikely that any company can acquire adequate risk mitigation or purchase sufficient insurance to fully protect itself in the event of an extreme natural catastrophe. Therefore, a more holistic approach should be adopted. It is our view that the entire international community must work to improve the resilience of the global economy to extreme natural disasters – ultimately making their impact on individual companies manageable.
Going forward, we believe the main concern for companies should be improving their level of disclosure regarding their exposure to such events.
We believe it is unlikely that any company can acquire adequate risk mitigation or purchase sufficient insurance to fully protect itself in the event of an extreme natural catastrophe.
In this respect, we consider the 1-in-100 Initiative to be particularly beneficial. The initiative is a drive by an alliance of public and private sector organisations to integrate natural disaster and climate risk into financial regulation and was announced at UN Secretary-General Ban Ki-moon's September climate summit in New York. By encouraging the disclosure of the maximum probable annual financial loss that a company can expect once in a hundred years – that is, with a 1% chance of occurring each year – the initiative aims to aid investors and analysts in their assessment of natural catastrophe risk for the companies in their portfolios.
The hope is that industry initiatives such as this will help companies, and consequently the global economy, bolster resilience to the impact of climate change over the coming years – something we believe is set to be sorely tested.
Michael Wilkins is a managing director of infrastructure finance and Miroslav Petkov is a director of ERM financial services group: EMEA at Standard & Poor's Ratings Services.