(Editor's Note: In this series of articles, we answer the pressing Questions That Matter on the uncertainties that will shape 2024—collected through our interactions with investors and other market participants. The series is aligned with the key themes we're watching in the coming year and is part of our Global Credit Outlook 2024.)

Extreme weather conditions and worsening physical risks continue to increase and influence credit fundamentals. However, we believe companies' and governments' readiness to address these risks, in large part, remains low and could become even more challenging to overcome in an environment of slower growth and tighter financing conditions.

How This Will Shape 2024

Global, extreme weather conditions will continue to increase and influence credit fundamentals.   According to the World Meteorological Organization, there is now a 66% probability the global temperature will exceed the 1.5 C Paris Agreement threshold over the next five years. S&P Global Ratings believes that surpassing this threshold could result in increasingly frequent and severe physical climate hazards, such as heat waves, floods, storms, and wildfires, that could destroy physical capital, lower labor productivity, and increase mortality without additional investment in adaptation and resiliency measures. We believe the physical impact from climate hazards can weigh on the credit quality of some entities more than others. Therefore, we generally analyze these risks against an entity's exposure (location and concentration), comprehensive risk management strategies, financial liquidity and reserves, as well as its capacity for planning and adaptation that could help preserve credit quality.

Higher incidences of heat days and water stress will require additional resiliency and adaptation measures and could affect long-term economic growth.   We find that lower- and lower-middle-income countries are disproportionally at risk of economic losses from physical climate risks under a slow transition scenario (see charts 1 and 2; "Lost GDP: Potential Impacts Of Physical Climate Risks," published Nov. 27, 2023). Developed economies may have resources to cope, but lower- and lower-middle-income countries are most vulnerable to physical risks where exposure is high. More frequent climate risks could pose an additional barrier to economic development while interest rates remain higher for longer, proving that access to funding may be more difficult when considered against a backdrop of slowing global growth. This includes the U.S., which has had 25 events year to date through Nov. 8, 2023, an increase from 18 events in 2022 and 22 in 2021, and losses of at least $1 billion according to the National Oceanic and Atmospheric Administration.

A slowing economic environment and higher interest rates could challenge planning and preparation.   Interest rates are now set to be higher for longer, not only slowing growth as central banks fight inflationary pressures, but also tightening budget constraints for companies and governments. We believe allocating resources in this environment might come at the expense of adapting to climate change, when the focus returns to balancing the books and creating pecuniary value. Deprioritizing investments in adaptation and resilience could increase credit headwinds for entities most exposed to physical climate hazards, including certain governments, in utilities, and transportation-sector entities, as extreme weather events and natural disasters become more frequent and damaging.

What We Think And Why

Reduced availability of insurance coverage and evolving risk-sharing arrangements could leave some entities more exposed.   Rising global insured losses have pressured insurers' profitability and, in some cases, has led to difficulty in obtaining insurance at affordable prices (see chart 3). The recent move by a few major insurers to discontinue writing new homeowners' business policies in California highlights this trend (see "California’s Evolving Insurance Market Has Mixed Impacts: Spotlight On U.S. Public Finance, Spotlight Off U.S. RMBS," published Aug. 2, 2023). To the extent insurance coverage becomes less available, it could limit our view of entities' financial resiliency and preparedness for physical climate hazards. Similarly, public-sector disaster recovery arrangements (such as the U.S. Federal Emergency Management Agency and Canada's Disaster Financial Assistance Arrangements) could come under pressure to absorb increasing losses and costs of recovery and to promote enhanced risk mitigation and resilience. As a result, local and regional governments globally could bear a greater share of risk, including the potential for less financial support following an acute event.

Private and blended finance could play an increasing role to lower institutional risk and help fill the funding gap for adaptation and resilience measures.   Financing adaptation to and recovery from physical risks is more difficult for economies with fewer resources and more restricted access to finance. Private capital can help fill this gap but is often deterred by concurrent political and institutional risks. For example, the Cauchari solar farm in the Argentine province of Jujuy was financed through a provincial green bond and a loan from the Export-Import Bank of China despite the province's fragile fiscal and liquidity positions and limited experience in global markets. Similarly, we may see more financing for adaptation projects where climate finance also targets pro-growth investments (e.g. irrigation systems in agriculture). Multilateral development institutions have a significant role to play in providing concessionary and bridge financing and building capacity to access private capital.

The fixed location of assets operated by utilities and transport infrastructure may be less able to adapt to physical risks in the near term.   Despite generally above-average preparedness, utilities' electric overhead networks are more exposed than other utilities to physical risks, including wildfires, hurricanes, and storms. This increases replacement and insurance costs and affects their safety and reliability (see "ESG Credit Indicator Report Card: Regulated Utility Networks," published Nov. 18, 2021). Power generators, airports, and ports also have elevated vulnerability to physical risks due to their localized, fixed-asset nature; S&P Global Ratings has downgraded more investor-owned utilities due to physical risks over the past six years nearly 10 times more than across the previous 13 years (see "A Storm Is Brewing: Extreme Weather Events Pressure North American Utilities' Credit Quality," published Nov. 9, 2023). While benefiting from generally protective regulated revenues, higher interest rates and insurance premiums could crowd out or delay big-ticket investments in infrastructure replacement, adaptation, and resilience in these sectors, leading them to remain exposed to physical risks for longer.

What Could Go Wrong

The adaptation gap could widen due to tighter financing conditions.   According to the United Nations' 2023 report, the adaptation finance gap is 10–18 times above current international flows. Estimated annual adaptation needs range from $215 billion-$387 billion (i.e. 0.6%-1% of developing countries' GDP) per year for this decade. Higher interest rates are already set to weigh on investments in emerging markets and developing markets (the most vulnerable to physical risks) as the growth outlook remains subdued. At the same time, higher yields in advanced economies, especially the U.S., could lead to stronger outflows from emerging markets, which are mostly in the higher-risk speculative-grade ratings category. As a result, vulnerable countries could continue to fall behind their higher-rated and wealthier counterparts, leaving their population and economic development efforts exposed to accelerating physical climate risks.

Extreme weather and natural disasters could disrupt supply chains and dampen growth.   Acute physical risks often have a localized impact, but heat waves, storms, and wildfires can hamper output and mobility of goods, cascading through global supply chains. Many large companies have a moderate degree of diversification in their operating assets and can potentially divert supply chains through alternative channels to avoid sizeable operating disruptions; however, more frequent and severe physical climate hazards may require greater adaptation efforts of our rated issuers, regarding their own assets and supply chains, to minimize disruptions. To the extent tighter financing conditions and slow growth lead companies to postpone adaptation efforts, the risk of supply chain disruption could continue unabated.

Credit quality could diverge.   We could see credit quality deteriorate for sovereigns and governments in places where worsening physical risk exposure coupled with a lack of resources, capacity, or support to adapt erodes our view of their fiscal performance, economic strength, and growth prospects. For example, high and increasing exposure to water stress in some Mexican states poses risks to public health and economic growth, and the cost of investing in adaptation and resilience could weigh on state finances and credit quality (see "More Mexican States Could Face Water Stress By 2050," published April 4, 2023). Places with already-vulnerable economic and fiscal assessments coupled with high exposure to physical risks could be the most susceptible (see "Weather Warning: Assessing Countries’ Vulnerability To Economic Losses From Physical Climate Risks," published April 27, 2022). For corporate entities with exposure to physical risks, a lack of insurance or changing liability landscape could make these risks more financially material to creditworthiness.

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Read More

• Lost GDP: Potential Impacts Of Physical Climate Risks, Nov. 27, 2023
• A Storm Is Brewing: Extreme Weather Events Pressure North American Utilities' Credit Quality, Nov. 9, 2023
• More Mexican States Could Face Water Stress By 2050, April 4, 2023
• California’s Evolving Insurance Market Has Mixed Impacts: Spotlight On U.S. Public Finance, Spotlight Off U.S. RMBS, Aug. 2, 2023
• Weather Warning: Assessing Countries’ Vulnerability To Economic Losses From Physical Climate Risks, April 27, 2022
• ESG Credit Indicator Report Card: Regulated Utility Networks, Nov. 18, 2021