Introduction

Our long-term issuer credit ratings do not have a pre-determined time horizon. However, our rating outcomes typically allocate a higher weight to our expectations over the next several years (including specific financial forecasts for the next two to three years), within which there tends to be a larger amount of certain and actionable information. As projections extend beyond the medium term, judgements about the ability to identify relevant credit drivers, how they will shift, and ultimately their effects on credit quality becomes more challenging.

Nevertheless, we believe it is important to monitor long-dated risks because, while megatrends may be slow moving, they can transform industries, and business processes in fundamental ways.

In this article, we dive into the megatrend of climate change, exploring both transition and physical risks. (For details on all megatrends we are monitoring, see "Evolving Risks In North American Corporate Ratings: An Overview", published Oct. 29, 2024.)

The objective is to contrast and highlight the different ways that various sectors might be affected by climate change. We elaborate on how we provided an overall view of how the megatrends may influence credit quality on a continuum of positive, neutral, some risk, and more risk below (chart 1 and 2).

These risk assessments are largely qualitative and are intended to facilitate cross-sector comparisons within a given risk category. Comparisons across risk categories within the same sector are directional, may differ based on our current forward-looking view of credit transmission channels in North America, and are not meant to capture the absolute level of future ratings risk.

Positive

It is possible a sector could benefit from increased demand for products and services. However, we do not currently assess any sectors as positively affected by climate risks.

Neutral

To classify the overall effect as neutral, we do not expect a material impact to the sector; or, we view the clarity of credit transmission as too low to draw a conclusion.

Some risk

Sectors in this category may have higher-than-average exposure to climate risk. However, the magnitude and clarity of transmission to credit factors remains unclear.

More risk

We categorize sectors as more at risk to transition and physical climate risks if it has or can have a direct impact on credit ratings; or, we view the risk as potentially leading to a change in the competitive landscape of the sector.

In the following sections, we provide background on and our expectations for specific sectors.   We explore every sector that we assessed as positive, some risk, or more risk. In the case of sectors that we assessed as neutral, we may also provide details if we believe there are relevant developments and risks, even if the overall credit impact remains unclear.

Climate Change: Transition Risk

Why it matters

Climate transition risks include policy, legal, technology, and market changes related to efforts in transitioning to a low-carbon economy. Higher climate transition risk could occur if we expect regulations or technologies will have a direct impact on an entity or lead to the transformation of a sector, changing the overall competitive landscape.

Transmission channels

Carbon taxes can have a direct impact on costs and profitability for certain industries, or require additional clean investments, with potential indirect costs for customers. Greater coverage and cost of such regulations could be a significant credit transmission channel.

Regulations can also stimulate the development of certain technologies or restrict the use of existing technologies. This could change the shape of affected sectors and the competitive position of individual companies. Manufacturers of more mature transition technologies could also benefit from such regulations.

Potential credit impact

Structural changes in sectors that affect demand or pricing could ultimately impact revenues, both positively and negatively. Meanwhile increases in carbon taxes and prices of raw materials and energy could impact costs. Both factors could ultimately impact earnings if costs cannot be passed through.

Where changes in regulations or technology trends lead to higher costs or require new investment, funding and leverage could become material credit factors. Creditworthiness could be affected when there is sufficient clarity on how changing regulations and technologies will affect individual companies or a given sector.

Those sectors that contribute more to greenhouse gas emissions or could be directly affected by new regulations and policies--such as oil and gas--are more exposed to climate transition risk. Higher risk sectors could face future credit impacts from changes to their market conditions, resulting in heightened potential for stranded assets or the need for diversification.

Hard-to-abate sectors that could require new investments to meet regulations also face risk, as do those where clean technology trends could result in disruption. This could affect sectors such as automakers, metals and mining, and real estate, where capital investments could be needed to fulfil regulatory demands or remain competitive within their value chains.

Transition Risk: Aerospace & Defense (some risk)

Background:  Several issuers are focused on the production of equipment and parts that may require new or additional investments in systems to adhere to future potential climate-related regulatory changes. This includes companies that produce or procure internal combustion engines for aircraft and exposure to jurisdictions that may implement more stringent climate-related laws, regulations, or policies.

Our expectations:  The future impact of climate transition risks on the aerospace and defense sector is unclear but could eventually affect future profitability both positively and negatively. The industry is led by a limited number of leading players in both commercial aerospace and defense, which can often pass on higher costs through price increases. We believe this would presumably limit the impact on earnings.

Moreover, increased market demand for more fuel-efficient products is a potential way for climate-exposed issuers to mitigate these risks. As an example, there is a significant global order backlog for next generation aircraft and aircraft engines, which can yield fuel efficiency savings of 20%-30% compared to older generation products. For airline customers, improvements in fuel efficiency and lower emissions are key objectives that would presumably increase in importance with greater regulatory scrutiny.

Transition Risk: Agribusiness (some risk)

Background:  Transition risk is likely to both benefit and disrupt the agribusiness sector. One key benefit to the sector is the increasing use of agricultural feedstocks as alternative fuels for the refining and transportation sectors that are looking to reduce their use of fossil fuels. This is in large part because of regulatory mandates, which currently are most material in the U.S. and Western Europe.

Another potential longer-term benefit is higher demand for sustainable food alternatives that agribusinesses can provide at a premium to food manufacturers by changing their product mix to offerings sourced from more sustainable farming practices.

Our expectations:  We believe this latter example is likely to cause significant disruption to a large segment of the industry. Livestock farming and associate feed production are two areas that would face significant disruption from any future changes in diets away from animal-based diets. These risks could be further compounded by increased regulatory restrictions on carbon-intensive farming practices, which in addition to curbs on livestock farming and land use, could include costly restrictions on fertilizer use.

We believe disruption to the sector will over time increasingly weigh on credit risk. Still, we believe these are long-term risks that are not likely to take hold until at least ten years from now. In our view, that is because the political appetite to regulate farmers remains muted while the outlook for feed and livestock demand remains favorable at least over the next five years. Growing demand for livestock and feed is underpinned by the increasing wealth of emerging market middle classes that continue to shift to more protein-based diets.

Transition Risk: Autos (some risk)

Background:  The transition to electric vehicles to meet commitments by a vast majority of countries toward net zero carbon emissions (albeit at a varying pace) is a key credit risk for most global automakers and suppliers. Climate transition risks can be closely linked to economic concentration and policy. This is likely to weigh on both the business strength and financial position of legacy players, testing the ability of OEMs and their legacy suppliers to roll out competitive EV models and secure market share amid intensifying competition, while achieving targeted returns on invested capital.

Our expectations:  The transmission of these risks directly to credit quality is still evolving as auto issuers prudently manage allocation of billions of dollars toward rapidly changing battery technology. There is also intense competition and heavy reliance on public policy around charging infrastructure and tax credits to induce higher demand. We believe the pace of EV adoption by consumers will ultimately determine the impact on credit quality.

Due to the recent slowdown in EV adoption, we believe automakers and suppliers will benefit from positive product mix due to higher sales of more profitable internal combustion engine (ICE), which will also help fund their transition needs. However, we view the short-term benefit to cash flows from delays in EV product development spending and related capital commitments as a credit negative long term. This is because it will lead to delayed scale benefits and manufacturing efficiencies, making it harder for them to reduce costs and attract the next wave of buyers.

This would further widen the gap between incumbents and first movers like Tesla and BYD Auto. It could also introduce potential missteps on product rollout strategies around hybrid vehicles, tooling allocations away from EVs, and capital allocation decisions around ICE platform refreshes.

On the other hand, a scenario of rapid transition to electrification would also be a credit negative for most due to large research and development (R&D) investments, which will likely hinder profitability and the sector's ability to defer capital expenditure (capex). Weaker profit margins will also stem from higher EV manufacturing costs and battery component-related bottlenecks, negatively impacting product mix. In addition, there is the risk of market share losses for automakers that do not launch competitive products in a timely manner.

We believe there is the potential for positive credit implications for automakers that can leverage scale and vertical integration to sustain a competitive advantage. For example, S&P Global Ratings upgraded Tesla multiple notches within a short-time frame.

We assume moderate credit risk for some auto suppliers that don't currently have EV products despite their portfolios being materially exposed to ICE. In contrast, most other auto suppliers of non-powertrain linked components will remain agnostic to the EV transition. Over time, we expect some auto suppliers could also enhance their relative competitive position through profitable market share gains as the global auto industry transitions to more electric vehicles.

Transition Risk: Chemicals (some risk)

Background:  The chemical sector faces transition risk from its use of hydrocarbons as a raw material and for fuel. In a sector where the cost of goods sold can form a basis of competitive advantage, chemical companies have sought to lower costs by optimizing their manufacturing processes and supply chains based on their decades long use of hydrocarbon feedstock. A combination of tighter and more restrictive regulatory requirements around emissions, and the anticipation of changing customer preferences are prompting some producers--especially those of high emitting chemicals like nitrogen, and petrochemical production--to reduce their carbon footprint.

Our expectations:  Transitioning to alternative feedstock is likely to be disruptive, requiring changes to manufacturing processes, supply chains, and logistics. This will increase operating costs. Additionally, capital costs are also likely to rise, further pressuring cash flows. In particular, we expect lower-rated, highly leveraged issuers will have limited room to incur additional capital spending at a time when margins are trending down.

Somewhat moderating the negative credit impact on smaller companies is the fact that many lower-rated issuers tend to be specialty or intermediate chemical producers and not particularly high greenhouse gas (GHG) emitters relative to large commodity chemical producers.

Therefore, we expect transition costs will be higher at subsectors like petrochemicals, fertilizer producers, and industrial gas producers, many of whom tend to be rated in the investment-grade category with relatively stronger balance sheets that will likely help them navigate some of these risks. We expect transition risks will rise beyond 2030 when regulatory requirements around decarbonization get more onerous around the world.

Transition Risk: Hotels, Gaming and Leisure (neutral)

Background:  Although climate transition risks have a material impact on the cruise sector, it is a small subset of the hotels, gaming, and leisure sector. Cruise operators are exposed to increasingly complex regulations, including on carbon emissions, given their heavy use of fuel.

The International Maritime Organization (IMO) imposed reduced global limitations on the sulfur content of emissions emitted by ships operating worldwide to 0.5% as of Jan. 1, 2020, and established more stringent limitations in certain geographical areas. Other initiatives will require cruise ships to reduce GHG intensity of the fuels they consume by certain percentages over time and require the use of shore power by certain dates.

Our expectations:  Given the smaller size of the cruise sector, the impact on the overall sector will be less. However, increasing regulations could increase costs and require significant investment in more environmentally friendly ships.

For example, to address regulations limiting the sulfur content of emissions, cruise operators added technology to existing ships to reduce the sulfur content of emissions. They also designed new ships with those increasing regulations in mind, and in some cases, with the ability to use alternate fuels.

Additionally, cruise operators are working to mitigate transition risks in a manner that complies with increasing regulations. Large cruise operators have articulated long-term goals to reduce carbon intensity and emissions and increase shore power capability, which would remove emissions when ships are docked. Therefore, we assess the credit risk as neutral for this sector overall.

Transition Risk: Metals and Mining (more risk)

Background:  The energy transition cuts across the metals and mining industry in favorable and unfavorable ways. Copper, nickel, lithium, and cobalt are critical for the energy transition; aluminum is a lightweight and recyclable material used to boost fuel efficiency in transportation; and coal-consuming blast-furnace steel faces an unknown path to decarbonization. Mining operations are energy-intensive and difficult to electrify, while the production of primary steel and aluminum are among the world's most energy-intensive industrial activities.

Thermal coal miners have the highest exposure to energy transition risk in the sector, as evidenced by the expected decline in coal demand for electricity, especially in North America and Europe. Even with long-term commitments around the world to reduce coal-fired electricity production, the International Energy Agency (IEA) reported coal consumption set new records in 2022 and 2023, and industry credit quality has rebounded as a result.

Producers of steelmaking coal are less exposed to climate transition risks because viable substitutes still do not exist. Nevertheless, decarbonizing steel is an important ambition for an industry that accounts for an estimated 8% of global GHG emissions. Most other mining companies are exposed to climate transition risks for energy usage; however, we expect demand for metals like copper, nickel, lithium, and cobalt will benefit from a secular boost in demand.

The production of aluminum consumes even more energy than steel, and uses carbon anodes, which emit significant GHGs. Once produced, however, aluminum can be easily recycled with 90% less electricity than primary metal, and electric arc furnaces (EAF) recycle steel. The Aluminum Association indicates that electric power represents about 20%-40% of the cost of producing aluminum. Output from the U.S. has been declining for about 20 years, and the six remaining smelters in the U.S. consume about 5% of the country's electricity to produce less than 2% of the world's aluminum.

Our expectations:  We believe the long-term path to reducing the carbon footprint of metals production is unclear and likely costly. About 70% of the steel around the world is still produced with carbon-intensive blast furnaces, releasing large amounts of CO2, nitrogen oxide, and particulate matter.

Some steel companies around the world are trying to reduce their carbon footprint by shutting older capacity and improving their raw materials mix, for example through using higher quality ore. Direct reduced iron (DRI) allows companies to make steel without coal, using natural gas to produce pig iron (with 90%-94% iron content) as feedstock for EAFs. The use of DRI could reduce the steel industry's total energy consumption by 40%-50%, but it needs access to low-cost natural gas.

The transition to EAF steel from blast furnaces would reduce the overall Scope 1 emissions from steelmaking, but many of the most advanced and efficient mills in the world are in the U.S. and rely on coal-fired electricity. These EAF mills appear well positioned to reduce Scope 2 emissions by transitioning to lower-carbon electricity as their utility suppliers phase-out coal.

Other electricity solutions like solar-plus-storage will require a steady pace of investments to decouple from fossil-fuel-fired electricity grids. The use of hydrogen as a power source for steel production can address part of the emissions issue, but the technology and assets for that are in their infancy.

Transition Risk: Oil and Gas (more risk)

Background:  The oil and gas industry has and will continue to face stricter regulations, substitution, increasing adoption and transition to renewable energy, and secular shifts in industry supply and demand fundamentals. We expect these factors will contribute to a more difficult operating environment for fossil fuel producers and will likely augment the risk of stranded assets and significant asset write-downs.

Our expectations:  We believe oil and gas will ultimately have a place in the global energy lexicon. However, market share encroachment of renewable energy and electric vehicles over time will have broad implications for hydrocarbon demand, prices, and producers of fossil fuels.

Indeed, S&P Commodity Insights forecasts peak oil demand in 2027 due to the ever-increasing penetration of electric vehicles. We believe natural gas has a better runway due to energy security, growing liquefied natural gas (LNG) demand, and its use in power generation as more utilities globally switch from coal to natural gas to generate electricity.

In our view, the transition and the timing of peak hydrocarbon demand is uncertain but inevitable due to the growing adoption of environmental, social, and governance (ESG) investment mandates among global investors and financial institutions. As such, we believe the risk of disinvestment and capital market access may become more challenging and costly for hydrocarbon producers, especially smaller, high-yield issuers.

We also believe hydrocarbon prices will remain under pressure over the coming years and will continue to exhibit volatility as the industry's demand profile goes into a permanent structural decline.

Transition Risk: REITs, Homebuilders and Building Materials (some risk)

Background:  Energy use in buildings is a major contributor to climate change, representing a third of global GHG emissions according to IEA. As landlords, REITs can pass through increases in utility costs to tenants, mitigating this risk. That said, increasing regulations and tenant shifting preferences for energy efficient buildings are exerting greater pressure to upgrade assets to meet climate goals. REITs have increased investment into green assets (many carrying certifications such as LEED, BREEAM, FEED, and NABERS) to reduce emission and support tenants' sustainability goals to enhance the competitive position of its portfolio.

Climate transition is also a material factor for the building materials sector because it remains a major contributor to global greenhouse gas emissions, with the cement subsector alone accounting for about 7% of carbon dioxide (CO2) emissions, according to IEA. Cement manufacturing has a high carbon emission intensity due to natural calcination and heat requirements during manufacturing.

Our expectations:  Decarbonation can be achieved through significant investments to improve cement plants' thermal efficiency and greater use of alternative fuels, such as biomass; however, we estimate the sector is still far from carbon neutrality.

Increasing industrywide requirements to comply with environmental regulations may weigh on margins. Higher capital spending to upgrade assets to meet required local energy efficiency and emissions standards, or address tenant shifting preferences could also pressure cash flows.

We would expect real estate portfolios with a greater proportion of assets with low-carbon credentials to achieve greater cost efficiencies and attract premium rents; this would enhance the portfolio's value. Assets with high emissions or worse energy efficiency could be more exposed to regulations and therefore require greater capex, experience pressure in asset values, and a growing refinancing risk for property level debt.

There could also be material credit impacts in high-emitting subsectors such as cement, where potential carbon taxes and changes in energy prices, could have material cost impacts over the medium term.

Transition Risk: Transportation Cyclical (some risk)

Background:  The use of carbon-intensive modes of transporting people and goods is the key source of exposure for the sector. Many issuers within the industry have adopted lower GHG emissions targets, with strategies aimed at achieving net zero by 2050.

Airlines--which account for about 2.5% of global energy-related carbon dioxide emissions--are increasingly focused on operating more fuel-efficient aircraft fleets. New aircraft often require significant incremental capital but also materially improve fuel efficiency and emissions. There is also growing adoption of sustainable aviation fuel (SAF); some airlines target a 10% replacement of conventional jet fuel with SAF by 2030. However, the current cost of SAF is prohibitive, mainly due to its limited scale of production. This is a potential headwind for future earnings.

For the railway and trucking-related sectors, we expect a comparatively limited impact. Any shift away from internal combustion engines (ICE) of notable scale is unlikely for many years. This is particularly the case for railroads, which utilize long-life diesel locomotives with significant power required to move bulk commodities, and a key component of global supply chains.

Changing customer demand in the context of climate change is more likely in the trucking and logistics sectors. However, alternative powertrain commercial vehicles (such as battery-electric, hybrid, or hydrogen fuel cell) are likely many years away from becoming viable alternatives to ICE trucks.

Our expectations:  We expect climate transition risks will increasingly affect the broader corporate transportation sector (which excludes infrastructure), but credit implications are likely to be modest for at least the next several years.

In our view, future regulations are unlikely to include substantial compliance-related costs, at least through this decade in North America.

Transition Risk: Unregulated Power (some risk)

Background:  Over the next five years, we expect about 190 gigawatts (GW) of generation added to the supply mix in North America. We expect as much as 165 GW of this to be renewables, with solar dominating new additions. We estimate about 40 GW-45 GW of battery storage. On the other hand, we think coal-fired generation (about 180 GW of currently operating assets) will decline by about 50 GW through 2028.

Despite Environmental Protection Agency (EPA) mandates, we expect gas-fired generation additions to be about 35 GW through 2038. On April 25, 2024, the EPA finalized new source performance standards (NSPS) for new gas-fired plants (those with capacity factors greater than 40%). These plants now must meet detailed NSPS requirements based on high efficiency combined cycle combustion technology immediately upon start-up and will then install carbon capture and sequestration (CCS) by Jan. 1, 2032. The CCS equipment must capture 90% of all CO2 emissions.

The inevitable effect of this capacity factor cut-off will be to substantially reduce the chance that new base-load gas plants can be built. Opponents of the EPA power plant rule are asking the Supreme Court to freeze the regulation as courts decide whether the agency overstepped its authority.

Our expectations:  We expect these new requirements to present headwinds for new gas-fired plants. We see the potential for extensive litigation, especially after the recent strike-down of the Chevron deference doctrine, which poses headwinds for baseload gas-fired generation build.

Overall, we assess transition risk as a moderately negative long-term risk for North American merchant power, especially for companies with fossil generation as part of their portfolio.

Transition Risk: Utilities (some risk)

Background:  Over the past decade the utility industry reduced its reliance on coal-fired generation by more than 50% and more than doubled its generation from renewable energy. We expect coal will be fully phased out by about 2035 and be primarily replaced with renewables. In 2023, electricity generated from coal-fired generation represented only about 16% and renewables made up about 21%. Additionally, nuclear generation represented about 19% and gas-fired generation was about 43%.

Our expectations:  For North America's regulated utility industry, we assess transition risk as a moderately negative long-term risk. Specifically, we view the transition from gas-fired generation and the replacing of natural gas local distribution companies with full electricity as a very long-term risk that will transition at a considerably slower pace than the phase-out of coal-fired generation. Currently, replacing natural gas with hydrogen for generation would increase costs from two to five times or more. As such, we do not view such a replacement as feasible in the near term. Furthermore, considerable cost synergies are required for hydrogen to compete with natural gas.

Currently, more than half of the U.S. states disallow a natural gas ban for new customers. Accordingly, we expect natural gas distribution businesses will be needed for the very long term. Only a few states (Colorado, New York, and Washington) and many cities (mostly in California) have a natural gas ban on new customer connections. Even in these areas, we anticipate that such a transition to full electrification will likely take many decades.

These developments reflect the utility sector's high capital investments needed for this transition; the high customer cost of switching to electric appliances; and the overall impact on the customer bill. Our base case assumes cities and states that eventually move to full electrification will do so very gradually, avoiding unintended consequences that could harm credit quality.

Climate Change: Physical Risk

Why it matters

Physical climate risks stem from the increasing incidence and severity of climate hazards such as storms, floods, and wildfires. These may be acute isolated events or chronic risks that develop over the medium to long term, including changes to precipitation and temperature patterns, as well as sea level rise.

Transmission channels

Physical climate risks can impact the credit factors of a company or sector in different ways. For example, acute risks--like storms or flooding--can damage assets and cause business disruption, including to supply chains, while chronic risks may increase operating or capital costs.

Emissions are already locked in, with little divergence until about 2050. The implication is that entities will continue to face worsening climate hazards in the coming decades, and certainly before the middle of this century, regardless of efforts to limit greenhouse gas emissions. From about midcentury--and as policies to reduce greenhouse gases are rolled out--warming trajectories in each scenario may diverge. This will influence the extent of warming and the frequency and severity of climate hazards attributed to man-made warming. This reflects the relative impact of policy choices taken now and in the short term.

Potential credit impact

Creditworthiness could be affected when there is sufficient clarity on how physical climate risks will affect individual companies or a given sector. For example, capital is destroyed when acute risks--such as storms and flooding--materialize, and productivity is impaired when chronic risk events--such as heatwaves or droughts--occur. These types of acute physical risks have direct impacts on a company's operating costs. It can damage infrastructure and assets and cause operational disruption.

Physical climate risks also can indirectly affect companies through supply-chain disruptions and resulting short-term inflationary pressures; reduced access to capital; and higher cost of debt. Furthermore, physical climate risks can affect demand indirectly by eroding wealth levels (such as when real estate value drops), inflationary pressures (like food shortages caused by drought), and changes in the geographic distribution of economic activity (for instance, due to tourism moving elsewhere).

Worsening climate hazards are increasing the need for investments in adaptation and resilience, but progress on adaptation varies (see "Risky Business: Companies' Progress On Adapting To Climate Change," April 3, 2024).

Long-term relative losses in market shares and income levels could materialize where the impacts of climate hazards cannot be prevented. In situations where there is no climate adaptation or where there are limits to adaptation--such as inability to avoid sea-level rise due to economic and physical limitations--productive capacity is likely to weaken the most (see "Is Climate Change Another Obstacle To Economic Development?" Jan. 16, 2023). This could also result in policy changes that may affect asset value. For example, there may be areas where construction is prohibited due to flood risk.

Physical Risk: Agribusiness (some risk)

Background:  Worsening climate hazards--in the form of more frequent or severe acute and chronic events, such as floods, wildfires and heat waves-- will not have a uniform impact across the sector. Physical risks are more pronounced for upstream farming activities, particularly when concentrated in one region. Agribusinesses that operated further down the agricultural food supply chain, however, will be less exposed to regional farm-level environmental risks. For example, merchants or wholesalers of agricultural commodities often benefit from broad geographic diversification and can generate higher margins during periods of dislocation because they control supply.

Moreover, several companies that process agricultural commodities have large scale operations that enable them to minimize the impact of input cost volatility; they can also pass through pricing during inflationary cycles and leverage procurement economies. In addition, businesses with greater exposure to farm-level production often have sufficient regional diversification to adapt to the physical impacts of climate change; or, they may have other factors that limit risks related to regional concentration. Examples of mitigating factors include favorable agronomic conditions that result in more cost-effective production, or a favorable regulatory framework.

Our expectations:  Physical climate change risk is a key credit risk for agribusinesses that periodically leads to cash flow and earnings volatility. Companies partially mitigate the effects of these physical risks through scale and geographic or product diversification.

We believe the sector will continue to benefit from largely inelastic demand and ongoing regulatory support, including a long track record of price subsidies during times of stress across many jurisdictions and other forms of disaster insurance.

Physical Risk: Autos (neutral)

Background:  Over the past couple of decades hurricanes, tornadoes, winter storms, flooding, hail, and wildfires have all caused extensive amounts of damage to automobiles and the infrastructure that contributes to manufacturing, transporting, storing, selling, and repairing them. The nature of the inventory is such that it is often outside or in areas where it is otherwise vulnerable; vehicles are generally stored tightly together, which often amplifies the damage that occurs in extreme weather events.

Even minor direct damage can have far reaching and costly consequences if it delays the delivery of inventory while spare parts and repairs are pending. Based on the increasing frequency and severity of these weather events, we conclude that the magnitude of physical risks on the auto industry is significant. However, the extent to which these risks will translate to credit impact remains less clear.

Our expectations:  To date, the auto industry has been resilient, and the impact of weather events has not reached a threshold of credit materiality. Some of this is due to the sheer scope and scale of the industry, which is able to absorb even several localized events. The sector also benefits from the transfer of some of these risks to a broad and mature sector of insurers and reinsurers. These insurers in turn underwrite broad and diversified types of risks. It is also worth noting that the damage to existing sold stock represents an opportunity for repair or even new purchase revenue.

As such, we stop short of identifying distinct transmission channels that would result in credit impact in the longer term.

These views assume insurance markets continue to function as they have been, which we believe will be the case.

Physical Risk: Chemicals (some risk)

Background:  The chemical sector has a history of dealing with extreme weather events such as hurricanes, although such events have been few and far between. A rise in the number or magnitude of extreme weather events could create new challenges for most chemical companies. Physical risks could not only create costly disruptions around the production and supply of chemical products, but also contribute to liabilities arising out of hazardous accidents caused by extreme weather events.

Our expectations:  Chemical companies tend to have immovable assets such as large continuously run manufacturing plants or mines, which leave them vulnerable to weather events that could directly damage assets and thereby affect credit quality. They also have long and established supply chains that are vulnerable to disruption.

Additionally, the agricultural sector--itself directly impacted by worsening climate hazards--is an important customer for several chemical companies. Weather events that reduce the availability of arable land or depress farmer income could reduce demand for agricultural chemicals such as fertilizers or crop protection chemicals.

Mitigating some of these risks is the fact that most companies have multiple manufacturing locations, and the sector has, in general, maintained at least some diversity in procuring raw material from multiple sources.

Physical Risk: Health care (some risk)

Background:  The increasing frequency and severity of climate hazards can increase operational costs for health care companies by putting a strain on patient care resources during severe weather events. It can also cause supply chain disruption.

Our expectations:  Health care service providers with key facilities located in areas hit by severe weather could see treatment capacity significantly reduced, leading to financial strain. Providers could also be saddled with high capex needs as they seek to relocate infrastructure and facilities that are in areas vulnerable to flooding. The pharmaceutical and medical products companies that have key manufacturing facilities located in areas exposed to severe weather could also see shortages of products.

Greater instances of extreme weather, such as extreme high temperature, would also increase health care costs and put a strain on the health care infrastructure to meet increased demands for medical care. Costs would increase as more patients develop climate-related health conditions and suffer from heat-induced illnesses and respiratory diseases.

Climate change can also exacerbate issues on health equity, as it may disproportionally affect more marginalized populations given the gaps in access and affordability. This could lead to increased legislative and regulatory risk from government initiatives seeking to close those gaps.

Physical Risk: Hotels, Gaming and Leisure (some risk)

Background:  Extreme weather events can periodically pose a significant risk to cash flow for rated leisure issuers with a single asset, or limited diversity portfolios, sometimes for a prolonged period. This is true even when the issuer has adequate insurance coverage to rebuild physical assets and to make a claim to receive business interruption proceeds to replace lost cash flow.

Our expectations:  As extreme weather events become more frequent and intense, risks to cash flow could increase. Additionally, significant changes to long-term business and capital allocation strategies could occur, in currently unpredictable ways.

For example, if assets in certain hard-hit leisure markets become uninsurable, and underwriters pull out altogether, the resulting need to self-insure would remove a meaningful and beneficial mitigant to the risks that climate disasters present to assets and cash flow. We acknowledge industry-led or government-sponsored insurance models could evolve, but the changeover could be volatile.

If the destruction from acute physical climate risks were severe enough, the loss of infrastructure in affected markets could alter tourism and leisure demand volumes for years. In either of these scenarios, rated leisure issuers may choose significant and costly changes in business and capital allocation strategies that might involve an attempt to rapidly diversify the asset base using leveraging mergers and acquisitions (M&A) or development spending.

Physical Risk: Metals and Mining (some risk)

Background:  Assets in metals and mining are usually large, sometimes remote, and almost always exposed to physical climate risks (particularly extreme precipitation and floods). For example, mines almost always have large exposed outdoor operations like conveyors, materials storage, and waste handling. Severe weather can also affect metals production or transportation infrastructure, which has resulted in months of tight supply and price spikes for key items like iron ore or steelmaking coal.

Tailings storage facilities (which contain the residue following extraction of valuable material from metal ore processing) are particularly exposed to extreme precipitation that could cause unexpected tailing overflow or even collapse. These tailings facilities endure for decades after mining has ceased, and risk overflow or collapse if not appropriately tended. Problems with tailings dams are generally infrequent (thousands of tailings dams exist around the world), but failures can be devastating to human life, the local ecology, and company finances.

Compared to mines, steel and aluminum facilities are less exposed to physical climate risks because they're usually located closer to other manufacturing capacity and population centers. However, almost every asset in metals and mining consumes enormous amounts of water for cooling, leaching, or transporting slurries.

Our expectations:  We expect companies will continue investing in the most exposed assets like mining roads, power plants, and rail lines. Further, we expect regulators and local stakeholders will demand more investment to protect against the rising risk of environmental damage like toxic spills induced by extreme weather.

Steel mills, aluminum smelters, and other downstream assets will make small investments to protect against physical risks like river and coastal flooding, but these are within an envelope of ongoing maintenance spending in this capital-intensive industry.

Physical Risk: Oil and Gas (some risk)

Background  The oil and gas industry is prone to production, operational, and supply chain disruptions from climate hazards. Historically, rating actions caused by such events has been muted because the physical and operating disruptions have been limited in time and magnitude. However, climate hazards are likely to increase in frequency and intensity in the future, potentially augmenting the risk of more extensive and severe physical damage and financial ramifications, absent adaptation.

Our expectations  Storms and floods caused by severe storms can damage onshore and offshore production as well as hydrocarbon pipelines and refineries. Many refineries globally are located along the coast or major shipping channels, making them prone to flooding or physical damage from hurricanes. Indeed, almost half of U.S. refining capacity is located in the Gulf of Mexico.

Some oil and gas facilities and production are also exposed to wildfires. For instance, the wildfires in Fort McMurray in 2016 led to the temporary shut in of 1 million barrels per day of oil production. Moreover, some oil and gas producing fields, particularly in the U.S., rely heavily on water access for fracking. Chronic events, like changing temperature patterns, could put pressure on oil and gas operations that are water intensive. This could potentially lead to lower or possible curtailment of hydrocarbon production and significant financial losses, in severe cases.

Physical Risk: REITs, Homebuilders and Building Materials (some risk)

Background:  Physical climate risk can be material at the asset level for real estate operating companies such as REITs, but this varies by location. Risks are both acute (such as wildfires, floods, and storms that are becoming more frequent and severe) and chronic (such as long-term changes in temperature and precipitation patterns and sea level rise). These could cause direct damage to properties or place tenant health and safety at risk, as well as require investments to manage potential effects, including--in severe cases--relocation of tenants. For the most part, overall stakeholder impact is moderate, since the type, number, and magnitude of these risks varies by region.

Our expectations:  Despite increased risks to specific locations, issuers generally own a geographically diversified portfolio of assets that, along with insurance coverage, could largely mitigate operation disruptions at affected properties. Still, it is becoming costlier and more difficult to secure insurance for the most exposed assets in the future. Some properties could be subject to removal of coverage depending on location.

We expect portfolios with a greater proportion of assets in more highly exposed regions could be vulnerable to operational disruptions if they do not adapt. This could cause asset values to decline and for the company to lose revenue. This could also make securing insurance increasingly difficult and expensive, further impairing profitability. Therefore, we currently view the sector as facing some risk.

Physical Risk: Retail and Restaurants (neutral)

Background:  Abnormal weather patterns have long had an impact on retailers' results, from storms that keep consumers and staff out of stores to warm autumns that reduce sweater sales. In contrast, inclement weather can also increase sales in the sector as consumers stock up on staples in advance of impending storms. As climate change results in more volatility, risk of disrupted shopping patterns will increase.

The direct impact to credit has been negligible. In most cases, retailers have been able to absorb these relatively minor bumps in normal spending patterns because the events typically occur within a limited geographic area and are short-lived.

Most rated issuers have geographic footprints that diversify the physical risk of volatile weather or natural disasters. Even events that have impacted a relatively large region--such as the Great Texas Freeze in 2021--have not had a credit impact on those with operations concentrated in the respective area.

Our expectations:  We expect the sector will remain resilient, largely due to issuers' geographic diversity, and due to incremental investment in supply chains, such as redundant distribution centers, which can limit the impact of climate-related disruption. We believe e-commerce operations and the elongation of important shopping seasons, such as the holidays, will also soften unpredictable swings in demand related to weather.

Physical Risk: Telecom & Cable (neutral)

Background:  Telecommunications companies routinely experience service outages due to damage to telecom infrastructure (such as cellular towers or aerial networks strung on telephone poles) as the result of physical climate risks.

Our expectations:  We believe the impact on credit metrics and credit ratings is negligible for most rated telecom companies due to their geographic diversity and ability to quickly remedy any outages. Most outages are geographically localized or brief in nature. For example, if a tree downed by a storm takes out a handful of telephone poles and knocks out service to a neighborhood, the poles may be replaced within hours. In addition, telecom companies build in network redundancies and can quickly route service around localized outages.

However, a few companies we rate have exposure to single or geographically concentrated markets, and there could be an increased risk to the credit ratings on those companies as climate hazards become more frequent and severe, and absent adaptation.

Physical Risk: Transportation Cyclical (some risk)

Background:  Acute risks--like storms, wildfires, droughts and floods--can make operations too hazardous and immobilize assets such as planes, trains, and vessels. Acute risks may also limit the accessibility of essential infrastructure the industry relies on, including roads, ports, and rails. It can also increase the risk of accidents. For railways, the shipment of bulk commodities may be impaired due to the impact of these acute risks on certain customers.

Our expectations:  Over time, both acute and chronic risks--changing temperature and precipitation patterns and sea level rise--may shorten the useful life of vehicles and infrastructure. While the industry may not bear the capital costs associated with restoring infrastructure, the interruption of service can undermine earnings and hence, credit quality.

Physical Risk: Unregulated Power (some risk)

Background:  We see increasing instances of disruptions from stronger weather events. Two recent events that resulted in significant physical impact were Winter Storm Uri (ERCOT February 2021) and Winter Storm Elliott (Mid-Atlantic December 2022). Counterintuitively, winter events have been more damaging despite most markets being summer peaking loads when demand and supply are tighter. The growing proportion of renewable generation on the grid also increases sensitivity to worsening physical climate risk because renewables perform weaker during some climate hazards, like storms.

Our expectations:  We believe there are negative physical climate change risks to the unregulated power industry, though the magnitude of the disruption of these potential events remains unclear. This is because new assets are now constructed to meet stronger weather events and existing equipment has been aggressively weatherized to meet harsher winter storms. We have seen construction costs increase about 35% over the past three years, some of which relates to hardening of the system and building redundancies.

Physical Risk: Utilities (more risk)

Background:  Because of climate change, a growing number of places across North America have seen prolonged dry conditions. As temperatures rise, vegetation dries up and the landscape becomes more combustible. When high winds and a spark are added, the probability of a catastrophic wildfire significantly escalates. As such, areas designated as high-fire-risk have grown across North America.

Additionally, most Western U.S. states have experienced an increasing number of structures damaged or destroyed by wildfires since 2020. As a direct result of wildfires, third-party claims, plaintiff damages granted, and settlements have all materially increased, raising the credit risks for the industry.

Our expectations:  To reduce these physical risks, we expect the industry will implement wildfire mitigation plans that include system hardening; situational awareness; vegetation management; the automatic shut-off of a power line when it contacts with debris; communication enhancements with state agencies; and an approved plan to proactively de-energize power lines when necessary.

Because of the diverse topographies across North America, we don't expect wildfire mitigation strategies will be uniform across the industry. However, we do expect a utility's customized comprehensive wildfire mitigation plan will drastically lower wildfire risk.

Furthermore, several utilities have switched to a self-insurance model, reducing the risk of rising insurance premiums and deductibles, and have established a large wildfire fund, which reduces the risk of high third-party wildfire related claims.

Earlier in 2024, Utah passed legislation that effectively caps third-party wildfire claims and establishes a wildfire fund. We assess this development as supportive of credit quality and expect other states will similarly follow this path to reduce wildfire risks.

Related Research

• Evolving Risks In North American Corporate Ratings: An Overview, Oct. 29, 2024
• Evolving Risks In North American Corporate Ratings: Artificial Intelligence, Cyberattacks, And Blockchain, Oct. 29, 2024
• Evolving Risks In North American Corporate Ratings: Supply Chain Disruption, Oct. 29, 2024
• Energy Transition: U.S. Investor-Owned Regulated Electric Utilities Face Hurdles With The EPA's Finalized Rules For Fossil-Fueled Power Plants, Oct. 17, 2024
• Global Business And Tech Services Outlook: Unveiling Risk And Resilience Across Subsectors, July 31, 2024
• White Paper: Scenarios Show Potential Ways Climate Change Affects Creditworthiness, July 25, 2024
• Credit FAQ: Inflation, China, And EV Transition Risks Casts Long Shadow On North American Auto Suppliers, July 22, 2024
• Evolving Risks For Credit Quality In U.S. Capital Goods, June 18, 2024
• White Paper: Assessing How Megatrends May Influence Credit Ratings, April 18, 2024
• Risky Business: Companies' Progress On Adapting To Climate Change, April 3, 2024
• North American Wildfire Risks Could Spark Rating Pressure For Governments And Power Utilities, Absent Planning And Preparation, Nov. 29, 2023
• Sustainability Insights Research: Lost GDP: Potential Impacts Of Physical Climate Risks, Nov. 27, 2023
• U.S. Inflation Reduction Act Highlights Diverging Approaches With Europe, March 1, 2023
• Is Climate Change Another Obstacle To Economic Development?, Jan. 16, 2023
• Agriculture Industry Is Still Sweating This Year's Droughts, Oct. 13, 2022

Appendix

Table 1

Author Directory
Sector Coverage	Contributor
Aerospace & Defense, Transportation Cyclical	Jarrett Bilous
Autos, Business and Technology Services	Nishit K Madlani
Capital Goods, Metals and Mining	Donald Marleau, CFA
Chemicals	Paul J Kurias
Consumer Products	Chris Johnson, CFA
Health care	Arthur C Wong
Hotels, Gaming and Leisure	Emile J Courtney, CFA
Hotels, Gaming and Leisure	Melissa A Long
Media and Entertainment, Telecommunications and Cable	Naveen Sarma
Oil and Gas	Thomas A Watters
REITs, Homebuilders and Building Materials	Ana Lai, CFA
Retail and Restaurants	Sarah E Wyeth
Technology	David T Tsui, CFA, CPA
Unregulated Power	Aneesh Prabhu, CFA, FRM
Utilities	Gabe Grosberg
Megatrend
Climate	Pierre Georges
Climate: Transition Risk	Terry Ellis
Climate: Physical Risk	Paul Munday

Primary Credit Analysts:	Alison M Sullivan, CFA, New York + 1 (212) 438 3007; alison.sullivan@spglobal.com
	Chiza B Vitta, Dallas + 1 (214) 765 5864; chiza.vitta@spglobal.com
Secondary Contacts:	Jarrett Bilous, Toronto + 1 (416) 507 2593; jarrett.bilous@spglobal.com
	Emile J Courtney, CFA, New York + 1 (212) 438 7824; emile.courtney@spglobal.com
	Terry Ellis, London +44 20 7176 0597; terry.ellis@spglobal.com
	Pierre Georges, Paris + 33 14 420 6735; pierre.georges@spglobal.com
	Gabe Grosberg, New York + 1 (212) 438 6043; gabe.grosberg@spglobal.com
	Lapo Guadagnuolo, London + 44 20 7176 3507; lapo.guadagnuolo@spglobal.com
	Chris Johnson, CFA, New York + 1 (212) 438 1433; chris.johnson@spglobal.com
	Paul J Kurias, New York + 1 (212) 438 3486; paul.kurias@spglobal.com
	Ana Lai, CFA, New York + 1 (212) 438 6895; ana.lai@spglobal.com
	Gregg Lemos-Stein, CFA, New York + 212438 1809; gregg.lemos-stein@spglobal.com
	Melissa A Long, New York + 1 (212) 438 3886; melissa.long@spglobal.com
	Nishit K Madlani, New York + 1 (212) 438 4070; nishit.madlani@spglobal.com
	Donald Marleau, CFA, Toronto + 1 (416) 507 2526; donald.marleau@spglobal.com
	Paul Munday, London + 44 (20) 71760511; paul.munday@spglobal.com
	Aneesh Prabhu, CFA, FRM, New York + 1 (212) 438 1285; aneesh.prabhu@spglobal.com
	Naveen Sarma, New York + 1 (212) 438 7833; naveen.sarma@spglobal.com
	David T Tsui, CFA, CPA, San Francisco + 1 415-371-5063; david.tsui@spglobal.com
	Thomas A Watters, New York + 1 (212) 438 7818; thomas.watters@spglobal.com
	Arthur C Wong, Toronto + 1 (416) 507 2561; arthur.wong@spglobal.com
	Sarah E Wyeth, New York + 1 (212) 438 5658; sarah.wyeth@spglobal.com
Editor:	Annie McCrone