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CreditWeek®

The Global Authority On Credit Quality | May 28, 2014

SPECIAL REPORT

CLIMATE CHANGE Preparing For The Long Term (p. 4)

Tough Regulatory Times For Mortgage Servicers (p. 87)

Commercial Lenders Weigh On Nonbank Lenders (p. 83)

Nonbank Auto Lenders Face Tougher Competition (p. 74)

Competition Tempers U.S. Finance Companies (p. 66)

SPECIAL REPORT

RATINGS EDITORIALVice President, Editor-in-Chief Bob Arnold

ASIA-PACIFICFelicity Neale, Managing EditorMelbourne: Editorial Managers: Mohammed Mazlan, Jason Mills. Beijing:Translators: Wen Zhen Du, Jun Zhang. Hong Kong: Senior Editorial Manager: AlisonDunn. Mumbai: Senior Copy Editor: Thomas Jacob; Copy Editor: Shweta Koli. Seoul:Editorial Manager: Jiwoo Choi. Singapore: Editorial Manager: Kenneth Chung

EUROPE & MIDDLE EASTChris Fordyce, Managing EditorLondon: Senior Editorial Managers: Claire Evans, Roy Holder, Alexandria Vaughan;Editorial Managers: Glen Carlstrom, Julie Dillon; Senior Editors: Heather Bayly,Emily Williamson; Editors: Hannah Collins, Sam Foster, Rekha Jogia, Joanna Lewin.Madrid: Editorial Manager: Carol Strain-Guzman; Editors: Alisha Forbes, Ana-MariaOliver Diaz. Paris: Features Editor: Rose Marie Burke; Senior Editor: JennyFerguson; Editor: Samantha Shields. Frankfurt: Senior Editorial Manager: JennieBrookman; Editor: Alexander Wolf. Moscow: Editor: Jennifer Howard. Stockholm:Senior Editor: Bernadette Stroeder. Tel Aviv: Editor and Translator: Gary Smith

JAPANKeiji Sunaga, Managing EditorTokyo: Editorial Managers: Kai Ruthrof (Melbourne), Namiko Uchida; Senior CopyEditors: Etsuko Kuratani, Kwee Chuan Yeo; Copy Editors: Leeroy Betti, AkikoIshiwata, Yoshiko Minagawa, David Postilion (Chicago), Takae Saho; Translators:Yukiko Etani, Fumiko Hattori, Kumiko Kimura, Isabelle Nagata, Kazue Peck (New York), Satoko Tanaka

LATIN AMERICACecilia Cárdenas Rubio, Managing EditorMexico City: Copy Editor: Karina Montoya; Translator: Haydee López. São Paulo: Managing Editor, Marcos Viesi; Editor, Celina Moraes

NORTH AMERICA

Corporates & Governments / Structured Finance: David Brezovec, Managing EditorSenior Editorial Managers: Elizabeth Kusta (Chicago), Sabrina Manno, Kathy J.Mills, Greg Paula, Perry Sass, Fatima Tomas; Editorial Managers: Dana Cetrone,Zachary Conway, Margaret Dodge, Lawrence Hayden IV, Alex Ilushik, JeanneKing, Rae Nudson, John Walsh, Samuel Zanger; Features Editor: Jonathan Greene.Senior Copy Editor: Rosanne Anderson; Copy Editors: Davis Chu, Sarah TaylorCook (Mexico City), Maureen Cuddy, Cora Frazier, Georgia Jones, Thomas V. Reilly,Kelliann Volsario, Sara Weber, Hilary Weissman; Assistant Editors: Lynne Evans,Matthew Gardener, Caitlin VenoEditorial Quality: Managing Editors: Larry Dark, Marguerite Nugent; SeniorEditorial Managers: Laura leGrand, Brian Murphy; Manager, Editorial Education:Peter Dinolfo; Senior Features Editors: Ted Gogoll, Joe Maguire, Robert McNatt;Features Editor: Gillian Wong; Senior Copy Editor: Dolores Graham

Public Finance: Clint Winstead, Managing EditorSenior Editorial Managers: Ai Leng Choo, Erika Dyquisto (San Francisco); EditorialManagers: Edward Lazellari, Jo Parker (Toronto); Copy Editors: Peter Burke,Douglas Jacobs-Moore, Michelle Leary (San Francisco), Albert Lim (SanFrancisco), Valerie Lord (Toronto), Miguel Martin-Garcia (Toronto), JenniferOchaba (San Francisco); Assistant Editor: Jonathan Sachs

RatingsDirect: Judy Gordon, Managing Editor

Administrative Assistant: Linda Merizalde

ELECTRONIC PRODUCTION & DISTRIBUTIONCreative Services Senior Managers: John J. Hughes, Stephen Napoles, ElizabethNaughton; Managers: Heidi Dolan, Henry Tom; Designers: Maura Gibbons, BarrieSinger; Production Managers: Terese Barber (Melbourne), Christopher Givler;Electronic Production Specialist: Dianne Darbouze; Production Supervisor:Lori McCaskill; Senior Production Assistants: Stan Kulp, Michele Rashbaum,Jillian Stephens (Melbourne)

STANDARD & POOR’S RATINGS SERVICESPresident Neeraj Sahai

Executive Managing Directors Paul Coughlin, Yann Le Pallec, Ichiro Miyake

Executive Managing Director, Associate General Counsel Adam Schuman

www.standardandpoors.com

PUBLISHINGChief Operating Officer, Global Analytics John Bilardello

Product Management Charles Warburton, Senior Director

Business Operations Jeffrey Simon, Vice President

Regional Management David Pagliaro, Europe; Clemens Thym, Asia-Pacific

CreditWeek®May 28, 2014 | Volume 34, No. 20

EDITOR’SDESK

Perceptions are important. And a widespread perception is that recent cli-mactic events—from typhoons in Asia, to floods in Europe, to “super-storms” such as Sandy in the U.S. — suggest that the effects of a

changing climate are already being felt. What this all may mean for debtissuers, and perhaps even for the global financial system, is the subject of oneof this week’s special reports. Credit analysts and experts from across McGrawHill Financial—including research teams around the world from Standard &Poor’s Ratings Services, Platts, and S&P Dow Jones Indices—have pinpointedthe key themes that businesses, industries, and governments are grappling withas they try to predict the physical and financial impact of climate change.

Our special report coincides with Standard & Poor’s participation in the UnitedNations Environment Programme’s inquiry into a sustainable financial system.A U.N. goal is to support the transition to a green economy by identifying bestpractices and exploring financial market policy and regulatory innovations.

As we note, extreme weather events were responsible for 90% of documentednatural catastrophe loss events in 2013, causing $124.5 billion of overall lossesout of the $135 billion total natural catastrophe losses. Worsening financial per-formance as a result of climate event risk can weaken both short-term liquidityand long-term debt financing positions, leading to an increase in credit risk. Wethink industry regulators and investors are likely to focus more closely on cli-mate and carbon risks as an indicator of company performance and, for thelatter group, value.

In another special report, on financial companies, we look at how a strength-ening U.S. economy, continued access to adequate funding, and the retreat ofbanks from some types of lending, is creating a very competitive environmentfor nonbank financial companies. Credit analyst Vikas Jhaveri says: “We expectthat stiff competition for market share will be especially noticeable in autolending, commercial business lending, and, to a lesser extent, commercial realestate lending. At the same time, because the amount of available business isexpanding, albeit slowly, we expect that most finance companies will continueto turn a profit in 2014, and that we will issue few rating changes.”

For companies that are involved in consumer finance, including payday lenders,money transfer companies, mortgage servicers, and student loan servicers, hesays regulation continues to be a risk from a credit rating perspective. “For var-ious reasons these sectors are facing significant scrutiny from state or federalnonbank regulators, and we can’t be sure how regulatory issues might affectour ratings in these businesses.”

Marguerite Nugent

Managing Editor

CONTENTS

2 www.standardandpoors.com

May 28, 2014 | Volume 34, No. 20

Climate Change: A Long-Term Threat NearsBy Michael Wilkins, London

From flooding in Europe, wildfires and drought in the U.S. and Australia,to devastating typhoons in Asia, it’s hard to escape the recent storiesabout extreme weather. Without action to combat the causes of climatechange, scientists predict that average global temperatures will continueto increase, sea levels will rise, and extreme weather will become morefrequent and severe. These trends will in turn affect resource andenergy use, regulatory environments, and how governments andcompanies measure and mitigate risk—including credit risk.

8 Climate Change Is A Global Mega-Trend For Sovereign RiskBy Moritz Kraemer, Frankfurt

16 Are Insurers Prepared For The Extreme WeatherClimate Change May Bring?By Miroslav Petkov, London

21 Corporate Carbon Risks Go Well Beyond Regulated LiabilitiesBy Michael Wilkins, London

28 Dealing With Disaster: How Companies Are Starting To Assess Their Climate Event RisksBy Michael Wilkins, London

34 Credit FAQ: Assessing The Credit-Supportiveness Of Europe’s Renewable Energy FrameworksBy Michael Wilkins, London

41 The Greening Of The Corporate Bond MarketBy Michael Wilkins, London

GUEST OPINION46 Green Fixed-Income Indices: A Natural Outgrowth

Of The Green Bond MarketBy Anadi Jauhari, CAIA, Managing Director and Founder,

Emerging Energy & Environment Group and Infra Credit

Alpha, and Julia Kochetygova, Senior Director S&P Dow

Jones Indices

52 Limited Visibility For Climate Change’s Effects On U.S. State And Local Government Credit QualityBy Sarah Sullivant, San Francisco

56 Post-Sandy “Storm-Hardening” InfrastructureInvestments Could Factor Into Credit QualityBy David N. Bodek, New York

59 New York-Area Transportation InfrastructureProviders Passed The Superstorm Sandy Credit TestBy Joseph J. Pezzimenti, New York

61 California’s Water System Illustrates The Near-TermImpacts Of Long-Term Climate ChangeBy Tim Tung, San Francisco

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SPECIAL REPORT

SPECIAL REPORTFEATURES


Standard & Poor’s Ratings Services CreditWeek | May 28, 2014 5

From flooding in Europe, to wildfires and drought in the

U.S. and Australia, to devastating typhoons in Asia, it’s

hard to escape the recent stories about extreme weather.

Each new event adds to a growing perception that the effects of

a changing climate are already being felt—concerns that are

shared in many recent reports from the scientific community.

The Intergovernmental Panel on Climate Change recently

released its fifth assessment, finding that: “Warming of the

climate system is unequivocal, and since the 1950s, many of the

observed changes are unprecedented over decades to

millennia.” Similarly, this month’s U.S. National Climate

Assessment states: “Impacts related to climate change are

already evident in many sectors and are expected to become

increasingly disruptive across the nation throughout this century

and beyond.”

CLIMATE CHANGEPreparing For The Long Term

Overview● Increasingly, governments and corporations have left behind the question of whether

climate change will affect them, and instead are focusing on when and how.● The corporate bond market's appetite for bonds that promote environmental

sustainability is growing.● We think investors will focus more on climate and carbon risks as an indicator of

company value.

These warnings highlight the risks tosocieties and their economies. Withoutaction to combat the causes of climatechange, particularly the greenhousegases that are held as a common culprit,scientists predict that average globaltemperatures will continue to increase,sea levels will rise, and extreme weatherwill become more frequent and severe.These trends will in turn affect resourceand energy use, the regulatory environ-ments governing business and financepractices, and how governments andcompanies measure and mitigate risk—including credit risk.

The issue of climate change isclouded by the politics of the debate.Despite emphatic warnings of the conse-quences of global warming, a clear con-sensus has yet to emerge on its source,speed, and the scope of the transforma-tions that could affect our natural world.This creates uncertainty among votersand dilemmas for governments in devel-oping coordinated action plans. Theresult can be fragmented policies glob-ally that may miss opportunities to gen-erate the best benefits in terms of emis-sions reductions, or to develop cost-effective clean energy. For both govern-ment and industry, the lack of clear sig-nals means that risk mitigation strategiesmay be delayed or lose out to moreimmediate problems, leaving businessesand investors vulnerable to rapid policyshifts and the weather itself.

What this all may mean for debt issuers,and perhaps even for the global financialsystem, is the subject of this special reportby analysts and experts from acrossMcGraw Hill Financial. Research teamsaround the world from Standard & Poor’sRatings Services, Platts, and S&P DowJones Indices, have pinpointed the keythemes that businesses, industries, andgovernments are grappling with as theytry to predict the physical and financialimpact of climate change.

Our special report also coincides withStandard & Poor’s participation in theUnited Nations Environment Programme’s(UNEP) inquiry into a sustainable financialsystem. A U.N. goal is to support the transi-tion to a green economy by identifyingbest practices and exploring financial

market policy and regulatory innovations.As part of the inquiry, Standard & Poor’sPresident Neeraj Sahai will join a round-table discussion co-hosted by UNEP onMay 29. Standard & Poor’s is also amember of the UNEP Finance Initiative“E-RISC” project working group, which isassessing the role of environmental factorsin sovereign credit risk, and is participatingin the U.N.’s “Ascent” program, which aimsto prepare proposals ahead of climatesummits in New York this September andin Paris in November 2015.

We understand that one of the initia-tives the Ascent working group is consid-ering is a new extreme weather disclosurerequirement for public companies, as hasbeen the norm in the insurance industry.For many years, insurance groups havedisclosed the likely impact of natural cata-strophic losses on their balance sheets,such as by using models to predict theimpact of an event with a once-in-200-year likelihood of occurrence. We under-stand that leading companies now takeweather-related risk into consideration aspart of their risk management disciplines,which in turn influences their purchases ofinsurance protection. Typically they drawon the modeling expertise of insurers orinsurance brokers. Under the Ascent pro-posal, corporations might be asked to dis-close the potential impact on their balancesheets, with the expectation that this mightcreate an incentive to plan for climatechange, and ultimately reduce losses andsave lives. In our view, these disclosurescould benefit investors, since they wouldprovide new insights into the resilience ofcompanies to climate change.

A connected thread in all of ourreports, outlined below, is the need fordeeper, more quantifiable information onboth climate scenarios and the actionsthat businesses, industries, markets, andgovernments are taking to prepare forthem. As the threat of climate changebegins to look more acute, this need willlikely become more urgent.

Climate Change Is A Global Mega-Trend For Sovereign RiskFor governments, climate change—andspecifically global warming—will be thesecond-most important mega-trend to

affect sovereign credit risk through thiscentury, after the effects of aging popu-lations. Key points from our report arethat the impact on creditworthiness willmostly be negative and probably be feltvia drags on economic growth andpublic finances. The impact will not bedistributed evenly: poorer and lowerrated sovereigns will typically be hithardest, we think, which could con-tribute to rising global rating inequality.

Are Insurers Prepared For TheExtreme Weather ClimateChange May Bring?The frequency of extreme weather eventshas increased in recent years, but insuranceand reinsurance companies have copedwell so far. We think the industry has beenwell prepared to deal with natural catastro-phes of the magnitude the world has beenexperiencing recently, and thus the ratingsimpact has been limited. Many of theinsurers and reinsurers (re/insurers) werate have processes in place to monitor thepotential impact of climate change. Thatsaid, while understanding of climatechange is still evolving, we believe asudden spike in the number and severity ofextreme events could test the industry.

The Greening Of The Corporate Bond MarketThe corporate green bond market, cur-rently at $10.4 billion, is gainingmomentum, and we estimate that, basedon year-on-year growth trends, it willgrow to around $20 billion globally in2014. In our view, corporate green bondissuance is accelerating not only becauseit diversifies investor pools for issuers,but also because of investors’ growinginterest in promoting environmental,social, and governance goals. So far, cor-porate green bonds have mostly beenissued in Europe, generally with invest-ment-grade ratings of ‘A+’ or ‘A’, withthe oversubscription of many issues todate. We believe this trend is likely tocontinue, as green issuance shifts frommultilateral development banks towardmainstream corporations. In the future,the green project bond market couldsupport the aggregation of environ-mental projects to form debt obligation




instruments and also refinance existingenvironmental projects.

Guest Opinion: Green Fixed-IncomeIndices: A Natural Outgrowth OfThe Green Bond MarketAccording to S&P Dow Jones Indices,the nascent green bond market hasreached an inflection point and is poisedfor take-off. This reflects a number ofconverging trends:● Growing investor and public aware-

ness of climate change, and of itspotential impact on businesses,human life, and asset values;

● The recognition that a low-carbonpathway for the global economy tokeep global temperatures withinacceptable limits likely will requirevast amounts of long-term cost-effec-tive capital, which only institutionalinvestors can provide via fixed-incomeinstruments that are rated at leastinvestment grade; and

● The development of voluntary criteriaand standards for green bonds.

Corporate Carbon Risks Go WellBeyond Regulated LiabilitiesOver the next five years, carbon emis-sion regulation likely will extend to cover40% of global greenhouse gas emissionsfrom 21% currently. In our view, focusingsolely on a company’s direct liability toregulation may not accurately reflect itsfull carbon price risk. We believe that acomprehensive analysis of carbon pricerisk should incorporate both direct andindirect exposure due to the cost of acarbon liability being passed down thesupply chain or changing demand forproducts and services. We have analyzedthe impact of carbon pricing on corpo-rate credit from four risk aspects:● Environmental regulations,● Emissions market pricing,● Business risk across the value chain, and● Financial risk to profitability, cash

flow, and asset and liability valuation.Carbon pr ice r isk management

strategies that companies haveadopted are also helpful in evaluatingthe net impact of carbon price risk oncorporate creditworthiness.

Dealing With Disaster: HowCompanies Are Starting ToAssess Their Climate Event RisksClimate events can hurt profits, impairasset value, and constrain cash flow. Thiscan weaken a company’s liquidity andcompromise its ability to raise money andservice debt over both the short and longterm. In Standard & Poor’s opinion, cor-porate credit quality may suffer if compa-nies fail to implement adequate risk man-agement regarding climate events. Wethink regulators and investors will start tofocus more on climate and carbon risks asan indicator of company performanceand value.

Guest Opinion: Climate PolicyAnd The Rise Of Carbon MarketsAccording to Platts, the world’s policyresponse to climate change has so far beenfragmented, resulting in a mix of taxes, cap-and-trade programs, environmental legisla-tion, incentives for renewable energy, and ahost of other policies and measures at thelocal and national level. The policy frame-works—market-based or otherwise—thatmay work best over the next few years arelikely to provide the blueprint for managingemissions for decades to come. This couldhave implications for long-term investmentsin energy and manufacturing. In Europe, theworld’s largest cap-and-trade marketappears to be achieving its aim of limitingCO2 emissions at a comparatively low cost.However, the true cost to Europe’seconomy is unclear, given state subsidiesfor renewables and other incentives.

Limited Visibility For Climate Change’s Effects On U.S. State And LocalGovernment’s Credit QualityIn the U.S., municipal and state govern-ments have historically been able tomanage the risk of natural disasterswithout diminishing credit quality. Withthe exception of catastrophic events,such as Hurricane Katrina, the creditimpact of most natural disasters hasbeen limited. Nevertheless, increasinguncertainty caused by changing climatepatterns represents a growing risk forlocal governments that can be difficultto quantify. This risk could result in

more credit pressure for local govern-ments if Washington were to not pro-vide timely and sufficient financial relief.The same could be true if a local gov-ernment’s ability to prepare for disas-ters—for example, through strategiesthat protect infrastructure and trans-portation, and control flooding—comesat the cost of financial flexibility andincreased leverage.

California’s Water SystemIllustrates The Near-Term ImpactsOf Long-Term Climate ChangeGiven the length and severity ofCalifornia’s three-year drought, plus thepotential long-term effects of climatechange, the state’s water agencies aretrying to prepare for persistent watershortages. To meet current and futureneeds, they are developing capital planswhose costs they’re assuming now. Weexpect that funding for these projectswill largely come from higher water ratesand, to a lesser extent, proceeds fromnew bonds.

Assessing The CreditSupportiveness Of Europe’sRenewable Energy FrameworksIn this Credit FAQ, we address investors’questions regarding how policy frame-works for renewable energy sourceshave developed across the EU and rankthem according to our view of their sus-tainability and economics. Recentannouncements by the U.K. andGermany indicating lower support forsome types of renewable energy havefuelled investor uncertainty, which wethink could impede renewable energyinvestment in the EU.

At the moment, there are more uncer-tainties than answers about the financialand credit impact of global warming. Yetincreasingly, governments and corporationshave left behind the question of whether cli-mate change will affect them, and insteadare focusing on when—and how. CW

Analytical Contact:

Michael WilkinsLondon (44) 20-7176-3528

For more articles on this topic search RatingsDirect with keyword:

Climate Change

SPECIAL REPORT


FEATURES

Since the turn of the century, two mega-trends have

emerged to dominate public discussion on global

economic risks. The first, global aging, is comparatively

well-understood and the consequences relatively clear. The

second, the impact of climate change, is far hazier and the

potential outcomes much more challenging to predict.


Climate Change Is AGlobal Mega-Trend ForSovereign Risk

Overview● Climate change is likely to be one of the global mega-trends impacting sovereign

creditworthiness, in most cases negatively.● The impact on creditworthiness will probably be felt through various channels,

including economic growth, external performance, and public finances.● Sovereigns will probably be unevenly affected by climate change, with poorer and

lower rated sovereigns typically hit hardest, which could contribute to rising global

rating inequality.

For over a decade, Standard & Poor’sRatings Services has been regularlyassessing the impact that demographicchange is likely to have on sovereign

creditworthiness. Our conclusion is thatover a multi-decade time horizon thefinancial consequences of aging soci-eties are likely to overshadow all other

economic trends for most sovereigns (see

“Global Aging 2013: Rising To The

Challenge,” published March 20, 2013 on

RatingsDirect). We also expect advancedeconomies will be more negativelyaffected than sovereigns in emergingmarkets. In contrast, while most sover-eigns will feel the negative effects of cli-mate change to some degree, we expectthe poorest and lowest rated sovereignswill bear the brunt of the impact. This isin part due to their reliance on agricul-tural production and employment, whichcan be vulnerable to shifting climate pat-terns and extreme weather events, butalso due to their weaker capacity toabsorb the financial cost.

Another key difference is time frame.The impact of aging societies is alreadybeing felt in several advancedeconomies, most notably Japan, and willsteadily increase through the next fewdecades. For most sovereigns, theirdemographic profile is such that the fullimpact of aging on economic perform-ance and public finances will be felt fromthe mid-2020s or soon after (note: this iswell beyond the time-horizon that can bereasonably applied to a sovereign creditrating). Our understanding of climatechange, on the other hand, is still devel-oping and we lack sufficient reliable datato make precise predictions on if andwhen the effects of a warming planetand changing weather patterns will over-shadow other factors. This does notimply we should be complacent in devel-oping a clearer view, however. By itsvery nature of complex and inter-con-nected ecological systems, weather isinherently unpredictable and the picturecan change suddenly and dramaticallyfor an individual country or region.

Climate Change Is More Difficult To Control ThanDemographic ChangeWe believe that alongside aging, climatechange, and specifically global warming, isgoing to be the second global mega-trendaffecting sovereign credit risk. We alsobelieve that it will put downward pressureon sovereign ratings during the remainderof this century. However, in our view thereare three noteworthy differences that may



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Chart 1 Lower Rated Sovereigns Are More Vulnerable To Climate Change

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Chart 2 Vulnerability To Climate Change Is Inversely Related To Prosperity

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make climate change an even more chal-lenging problem to grasp than the world’sshifting demographic.

1. The science is complex.The economic and financial conse-quences are much less-well understoodthan those of aging societies. Thereremains significant uncertainty abouthow climate change will impact indi-vidual national territories and economies.For example, the fifth assessment reportof the Intergovernmental Panel onClimate Change (IPCC) published in2013 estimates that the average wintertemperature in Northern Europe couldrise between +2°C to +7°C by 2100. Butthere is also a chance that the warming inwinter will remain within the bounds of astandard deviation of present-day naturalvariability. Not so in summer, however,where the IPCC estimates that warmingis all but unavoidable.

The wide array of possible outcomescan confuse politicians and voters alike andcan lead to procrastination and inaction.Even in the case of aging, where financialconsequences are generally well-studiedand documented, we have seen that reme-dial action has in most countries been slowand difficult. This is usually because thebenefits lie in the distant future whereassome of the unpopular consequences arebeing felt immediately, conspiring againstrobust action, especially in societies whereleaders need to renew their legitimacy reg-ularly through elections. In addition, asmany of the beneficiaries do not yet have apolitical voice, either because they are tooyoung to vote or they have not been bornyet. While this argument can be madeequally about the difficulty of enactingmeasures that might curb greenhouse gasemissions, the political impasse is exacer-bated by the much higher uncertaintyabout future climatic conditions.

2. A global, collective action problem.The degree to which individual countriesand societies are going to be affected bywarming and changing weather patternsdepends largely on actions undertaken byother, often far-away societies. Unlike in thecase of aging, individual societies cannotby themselves meaningfully reduce theimpact they will feel as the climatechanges. This is the global collective actionproblem that has been characterizing cli-mate negotiations ever since the seminalRio summit in 1992. A society may chooseto reduce its carbon emissions unilaterallyto reduce the risk of the potential conse-quences of global warming, but due to theglobal character most of the benefits ofthat society’s sacrifice will accrue to othernations. In game theory, this is the famousprisoner’s dilemma: each society would beworse off if it were to act alone to mitigateclimate change: the society would have allthe pain for negligible gain. On the otherhand it would be better-off if it shirked aninternational concerted mitigation effortthat all other societies undertook: thesociety would have to take no sacrificewhile it benefits from the improvementscaused by the actions of others. Typicallysuch an incentive structure leads to unco-operative outcomes and to no effective riskmitigation. This is fundamentally differentfrom tackling the aging challenge: a pen-sion reform, for example, will accrue to thesociety that enacts it and to that societyalone. The spillover benefits for other coun-tries are negligible.

3. The impact falls disproportionatelyon poorer countries.Despite the complex and sometimes con-troversial science underlying estimates ofglobal warming, we believe that poorer andgenerally lower rated sovereigns will bedisproportionately hit. In contrast, theaging problem is expected to impact highly

rated sovereigns more than those withlower ratings. Our aging simulations sug-gest that in a no-action scenario, the netgeneral government debt ratio of theadvanced economies will rise by 150 per-centage points between 2010 and 2050 toreach 216% of GDP. Emerging market sov-ereigns will experience an average increaseof just under 120% points to reach a netgeneral government debt ratio of 149%. Inother words, the sovereigns that should bebest able to address the aging challenge arehit by it more than proportionately. Theopposite is likely to be true in the case ofclimate change. The most affected can beexpected to be poorer and to have lessclout in international negotiations, exacer-bating the international coordinationproblem described above.

How Climate Change Can Impact Sovereign RatingsExtreme weather events, such as tropicalstorms or floods, seem to have been onthe rise since the early 1980s. Data col-lected by MunichRe, a reinsurer, suggestthat weather-related loss-events haverisen in all continents, most significantlyin Asia and North America, where theyincreased more than fourfold. In EasternAsia overall losses (insured and non-insured) used to be below $10 billion peryear, but have regularly surpassed $20billion during the last decade with a peakof over $50 billion (1). Typhoon Haiyanhitting The Philippines in November2013 has been a powerful and hugelydestructive reminder of this trend.

Despite the grave loss of life and thedevastation caused by extreme weatherevents, Standard & Poor’s has notrevised the rating of a sovereign as aconsequence. We have taken a view thatthe size of the devastation, while large inabsolute terms, has so far not been suffi-cient to impact the rating overall.However, assuming that extremeweather events are on the rise in termsof frequency and destruction, how thistrend could feed through to our ratingson sovereign states bears consideration.

We analyse sovereigns by applying our rat-ings methodology (see “Sovereign Government

Rating Methodology And Assumptions,” pub-

lished June 24, 2013). This incorporates the


The economic and financial consequences are much

less-well understood than those of aging societies.

specific assessment of five key factors:institutional and governance effectiveness,economic structure and growth prospects,external liquidity and international invest-ment position, fiscal performance and flexi-bility, and monetary flexibility. Unless envi-ronmental disasters undermine nationalinstitutions and governance to an unprece-dented degree (e.g. through massive popu-lation migration or political instability), webelieve that the main factors through whichclimate change could feed through to sov-ereign creditworthiness are economic,fiscal, and external performance.

Economic performance.There are multiple channels through whichclimate change can affect the growthprospects of national economies and even-tually levels of prosperity. Some of themost potent may be changing patterns ofrainfall that can reduce agricultural yieldsvia repeated and prolonged droughts, heatwaves and wildfires, or floods. The produc-tivity of the broader workforce could alsobe negatively impacted if weather eventsaffect sanitary conditions negatively,spreading pests or diseases, increasingmorbidity. This may become a particularburden for populations living in low areasclose to sea-level, where rising sea-levels inthe context of global warming will not onlyflood agricultural and densely populatedurban areas, but where a rising water tablecould lead to salinization of the popula-tion’s water supply.

Extreme weather events, especiallyfloods, can be expected to increasingly takea toll on a country’s infrastructure and thusproductivity, exacerbating weakeningendowment of productive infrastructureobservable in a number of countries (see

“Cracks Appear In Advanced Economies’

Government Infrastructure Spending As Public

Finances Weaken,” Jan. 14, 2014). The mostdirect and tragic economic cost is of coursethe loss of life, such as the more than 6,000deaths estimated in the Philippines in theaftermath of typhoon Haiyan. In China, anaverage 3,000 flood-related deaths are esti-mated to have occurred each year since1980. During the 1990s, flood losses oscil-lated to 2% of Chinese GDP per year,before dropping to below 1% as a conse-quence of enhanced flood management (2).

How climate change will impact GDPgrowth is highly uncertain. Some researchestimates the annual consumption loss

in 2100 as a fraction of global GDP wouldbe around 2%, but jump to well over 5%should the annual global temperature



—Population living below —Agriculture as share —GAIN Vulnerabilityfive meters altitude (2000)— of GDP (2012)— Index (2012)—

Overall ranking Sovereign Rank (%) Rank (%) Rank Index

116 Cambodia 90 10.6 113 35.6 106 0.500

115 Vietnam 112 42.8 103 19.7 90 0.381

114 Bangladesh 98 14.0 100 17.7 104 0.495

113 Senegal 100 14.8 96 16.7 100 0.472

112 Mozambique 71 6.5 109 30.3 109 0.513

111 Fiji 91 11.0 91 13.2 97 0.422

110 Philippines 89 10.5 87 11.8 91 0.382

109 Nigeria 46 3.0 111 33.1 108 0.503

108 Papua New Guinea 35 2.0 114 35.9 107 0.502

106 Indonesia 92 11.2 92 14.4 70 0.335

106 Suriname 116 68.2 77 9.3 61 0.306

105 Ethiopia 22 0.4 116 46.4 115 0.547

103 Albania 81 8.2 101 18.3 68 0.333

103 Kenya 29 1.4 108 29.9 113 0.530

101 Congo (Democratic Republic of) 17 0.0 115 44.9 116 0.572

101 India 51 3.8 99 17.5 98 0.427

100 Egypt 110 25.6 93 14.5 44 0.284

99 Thailand 96 13.8 88 12.3 62 0.308

97 Ghana 39 2.3 105 22.7 101 0.473

97 Grenada 105 21.7 57 5.7 83 0.355

96 Cape Verde 97 13.8 69 7.8 78 0.349

95 Belize 102 15.8 90 13.1 50 0.293

94 Pakistan 27 1.3 106 24.4 99 0.430

92 Malaysia 86 9.5 81 10.1 63 0.310

92 Morocco 50 3.8 94 14.6 86 0.365

91 Honduras 38 2.2 95 14.8 95 0.402

90 Burkina Faso 1 0.0 112 35.3 114 0.533

88 Angola 36 2.1 80 10.0 110 0.516

88 Cameroon 20 0.3 104 19.7 102 0.474

87 Lebanon 84 9.1 61 6.1 80 0.350

86 Rwanda 1 0.0 110 33.0 111 0.521

85 Uganda 1 0.0 107 25.9 112 0.522

82 China 80 8.1 82 10.1 57 0.303

82 Ecuador 76 7.3 79 9.9 64 0.316

82 Jamaica 68 5.8 66 6.7 85 0.362

80 Azerbaijan 111 29.8 56 5.5 50 0.293

80 The Bahamas 113 46.5 27 2.1 77 0.348

79 Sri Lanka 66 5.4 83 11.1 67 0.332

78 El Salvador 33 1.7 86 11.8 92 0.384

Vulnerability To Climate Change

rise twice as fast as in the current scien-tific baseline scenario (3). The estimatesfor specific regions or even countries

are even more variable, as the IPCC’s“Atlas of Global and Regional Climate

Projections” illustrates. But the evidence

suggests that it is probably safe toexpect that for most nationaleconomies, other things being equal,climate change will negatively impactnational welfare and economic growthpotential. Observations corroboratingthis expectation could lead Standard &Poor’s to lower sovereign ratings on themost affected sovereigns.

Fiscal performance.The potential negative impact on growthwill by itself weigh on public finances astax revenues are likely to lose buoyancy ifthe underlying national economy falters.Government budgets could come underadditional pressure as disaster recoveryand emergency support for affected popu-lations is likely to fall on the state in mostcases. The same can be expected for thereconstruction of economic and socialinfrastructure. This can be a large burdenfor the public budget and, contrary to thefiscal impact from aging societies, it can hitthe budget without much prior notice. Anextreme example of a natural disaster(although not weather-related) over-whelming the government’s financial capa-bilities has been the violent volcanic erup-tion on the small Caribbean island ofMontserrat in July 1995, which renderedhalf of the island uninhabitable. The island,being an overseas territory of the U.K., wasable to cope due to extremely significantforeign grants, which continue to con-tribute roughly half of its GDP for budgetsupport and infrastructure investment (see:

“Montserrat,” published Nov. 8, 2013). Largereconomies would not be able to count onexternal support on the same scale, espe-cially if climate-related fiscal pressureswere to increase in many countries simulta-neously. National budgets would invariablycome under additional strains, potentiallyputting downward pressure on sovereignratings as debts and deficits mount.

External performance.Some nations depend on exports of agri-cultural products for foreign currency.With erratic weather patterns or increas-ingly frequent droughts or floods under-mining the export base, the adequacy offoreign reserves may become threatenedas trade imbalances rise. Of course




77 Zambia 1 0.0 102 19.6 105 0.497

76 Gabon 69 5.9 50 3.9 83 0.355

74 Barbados 101 15.7 17 1.5 81 0.352

74 Latvia 109 23.9 51 4.1 39 0.263

73 Dominican Republic 45 3.0 60 6.1 93 0.399

72 New Zealand 94 12.6 65 6.6 36 0.259

71 Mongolia 1 0.0 97 17.1 93 0.399

70 Iceland 95 13.1 68 7.3 27 0.236

69 Bahrain 115 66.6 3 0.0 71 0.339

68 Peru 32 1.7 67 7.0 88 0.370

67 Guatemala 21 0.3 85 11.6 78 0.349

66 Bolivia 1 0.0 89 13.0 89 0.378

65 Georgia 47 3.3 72 8.5 59 0.304

62 Korea, Rep. 64 5.0 36 2.6 76 0.347

62 Kuwait 107 22.8 4 0.1 65 0.321

62 Singapore 93 12.1 2 0.0 81 0.352

61 Paraguay 1 0.0 98 17.4 75 0.345

58 Argentina 61 4.5 75 9.1 37 0.262

58 Panama 53 4.0 49 3.9 71 0.339

58 Uruguay 62 4.7 70 8.4 41 0.274

57 Brazil 63 4.9 55 5.2 53 0.296

56 Congo (Democratic Republic of) 25 1.0 41 3.4 103 0.489

55 Japan 103 16.2 13 1.2 48 0.290

54 Malta 106 21.8 23 1.9 33 0.256

52 Qatar 108 23.1 1 0.0 52 0.294

52 Serbia 19 0.1 73 9.0 69 0.334

51 Costa Rica 24 0.8 62 6.3 74 0.343

49 Estonia 74 7.2 52 4.1 31 0.253

49 Greece 88 9.9 40 3.4 29 0.246

47 Jordan 58 4.2 39 3.1 59 0.304

47 Turkey 40 2.4 74 9.1 42 0.277

46 Venezuela 49 3.7 58 5.8 46 0.285

45 Colombia 34 2.0 64 6.5 54 0.298

44 Ukraine 37 2.1 76 9.3 37 0.262

41 Israel 82 8.3 34 2.5 33 0.256

41 Kazakhstan 52 3.9 53 4.7 44 0.284

41 Netherlands 114 61.3 22 1.7 13 0.191

40 South Africa 23 0.5 35 2.6 87 0.366

39 Oman 67 5.5 12 1.0 65 0.321

Vulnerability To Climate Change (continued)

national currencies could depreciate to anextent to recalibrate imports and exports,but this would in many cases come at theprice of rising inflation and falling levels ofprosperity. Should episodes of bad har-vests increase, emergency food importsmay be required, once again putting pres-sure on the country’s external accounts.Should global food production stagnate asclimate conditions change, prices for agri-cultural goods would permanentlyincrease. Terms of trade of net foodimporters would worsen, putting pressureon their external accounts, which in turncould increase the downside risks for sov-ereign ratings.

Lower-Rated Sovereigns Appear More ExposedGreat uncertainty still remains about if,how, and when various economies couldbe af fected by climate change.Nevertheless, there are various waysthrough which we can attempt to gaugethe vulnerability of individual sover-eigns. While there is no single bestmeasure to measure the degree to whichvarious economies are exposed to therisks, we can use a composite of threedifferent variables to capture differentfacets of potential vulnerability andarrive at a crude ranking:1. Share of the population living in

coastal areas below five meters of alti-tude. The livelihood and economicproduction of that population may beat risk should sea levels rise in thecourse of global warming (World

Bank, World Development Indicators).2. Share of agriculture in national GDP.

This measures the risk to the sectorthat is typically most dependent on cli-matic conditions. (World Bank, World

Development Indicators, Food And

Agriculture Organization Of The United

Nations Statistical Yearbook 2012)

3. The vulnerability index compiled byNotre Dame University GlobalAdaptation Index (ND-GAIN), whichmeasures the degree to which asystem is susceptible to, and unable tocope with, adverse effects of climatechange. The index includes threecomponents: exposure, sensitivity andadaptive capacity.

For each of the three variables, we rankthe 116 rated sovereigns for which allthree variables are available. A rank

number of 1 indicates lowest vulnera-bility, a rank of 116 the highest. Finally,we assign an overall rank of vulnerability





38 Macedonia 1 0.0 84 11.5 57 0.303

36 Trinidad and Tobago 78 7.5 6 0.6 56 0.302

36 United Arab Emirates 77 7.3 9 0.7 54 0.298

35 Russian Federation 43 2.9 48 3.9 47 0.289

34 Cyprus 87 9.7 26 2.1 24 0.227

32 Botswana 1 0.0 38 2.9 96 0.421

32 Mexico 42 2.7 45 3.6 48 0.290

31 Australia 75 7.2 31 2.4 28 0.239

30 Romania 44 2.9 59 6.0 30 0.251

29 Lithuania 55 4.0 42 3.5 35 0.257

28 Bosnia and Herzegovina 18 0.1 71 8.4 40 0.272

26 Saudi Arabia 26 1.0 28 2.2 73 0.341

26 Spain 72 6.6 33 2.5 22 0.214

24 Belgium 99 14.3 10 0.7 17 0.205

24 Portugal 65 5.2 29 2.3 32 0.255

23 Italy 79 7.5 25 2.0 21 0.212

22 Denmark 104 18.5 16 1.4 2 0.145

21 Croatia 48 3.4 54 5.0 19 0.207

20 Chile 31 1.6 46 3.6 43 0.282

19 Bulgaria 30 1.5 63 6.4 23 0.223

18 Finland 59 4.4 37 2.7 12 0.189

16 Ireland 73 6.6 19 1.6 14 0.194

16 Norway 85 9.3 14 1.2 7 0.162

15 Sweden 70 6.3 18 1.6 17 0.205

14 Belarus 1 0.0 78 9.7 25 0.230

13 Canada 54 4.0 21 1.6 26 0.234

12 U.K. 83 8.6 7 0.7 8 0.165

10 Poland 41 2.5 44 3.5 3 0.150

10 U.S. 57 4.1 15 1.2 16 0.199

9 France 56 4.0 24 2.0 5 0.151

8 Germany 60 4.4 11 0.8 3 0.150

7 Slovenia 28 1.3 32 2.5 10 0.171

6 Hungary 1 0.0 43 3.5 20 0.211

5 Slovak Republic 1 0.0 47 3.9 11 0.188

4 Czech Republic 1 0.0 30 2.4 9 0.168

3 Austria 1 0.0 20 1.6 15 0.195

2 Switzerland 1 0.0 8 0.7 6 0.156

1 Luxembourg 1 0.0 5 0.3 1 0.129

GAIN—Global Adaption Index.

Vulnerability To Climate Change (continued)

which is derived by ranking the sum ofthe three ranks for each of the three indi-cators. For example, the average of thethree variable-specific ranks of Cambodiais 103. This is the highest average ranknumber of any of the rated sovereignsincluded. Therefore, we assign Cambodiathe highest possible overall rank of 116,being the most vulnerable to climatechange by this measure, followed byVietnam, Bangladesh, and Senegal.

All of the sovereigns in the Top-20most vulnerable nations are emergingmarkets, and almost all of them are inAfrica or Asia. In contrast, in theBottom-20 least vulnerable advancedeconomies dominate, with Luxembourg,Switzerland, and Austria the least vulner-able in the whole sample (see map for a

simplified geographical representation).As we can see from chart 1, lower-rated

sovereigns tend on average to be morevulnerable than higher-rated sovereigns.The average vulnerability rank of ‘AAA’-rated sovereigns is 18; that of the ‘B’-ratedsovereigns 84. This indicates that over along time horizon, climate change couldcontribute to diverging ratings. Sovereignratings could diverge further if the lowest-rated sovereigns do in fact experience thegreatest impact from changing weatherpatterns and rising sea levels. The morevulnerable sovereigns also tend to bepoorer (see chart 2), which makes it espe-cially challenging for them to invest in mit-igation measures that would help them toadapt to changing climate patterns.

Upcoming negotiations under theUnited Nations framework could alterthe picture for global action on climatechange. The Paris conference scheduledfor the end of 2015 is aimed at achievinga legally binding and universal agree-ment, while a leader’s summit in NewYork in September 2014 is likely to markthe starting point for a year of intense

political manoeuvring. It’s too early tosay whether these forums will produce aclearer consensus on global policy orsignificant changes to emissions targets.Either way, we expect the significance ofthis mega-trend in assessing sovereignrisk to only increase over comingdecades, as evidence of the economicimplications of climate change andextreme weather events becomes evermore visible. CW

NOTES(1) MunichRe (2013): “Severe Weather in

Eastern Asia: Perils, Risks, Insurance”(Figure 5).

(2) Cheng X. and Zhang D. (2011): “RecentTrend of Flood Disasters andCountermeasures in China”. InChavosian A./Takeuchi K.: “Large ScaleFloods Report,” ICHARM, Tsukuba,Japan. (p. 192-196).

(3) Nicolas Stern (2013): “The Structure ofEconomic Modelling of the PotentialImpacts of Climate Change: GraftingGross Underestimation of Risk ontoAlready Narrow Science Models,” Journalof Economic Literature 51(3), p. 839-859.

Under Standard & Poor’s policies, only a

Rating Committee can determine a Credit

Rating Action (including a Credit Rating

change, affirmation or withdrawal, Rating

Outlook change, or CreditWatch action). This

commentary and its subject matter have not

been the subject of Rating Committee action and

should not be interpreted as a change to, or affir-

mation of, a Credit Rating or Rating Outlook.


All of the sovereigns in the Top-20 most vulnerable

nations are emerging markets, and almost all of

them are in Africa or Asia.

Analytical Contacts:

Moritz KraemerFrankfurt (49) 69 3399-9249

Liliana NegrilaFrankfurt (49) 69 3399-9248


Climate Change

SPECIAL REPORT


FEATURES

Whether or not a direct result of climate change, the

number and frequency of extreme weather events

have increased, but insurance and reinsurance

companies have coped well so far. Standard & Poor’s Ratings

Services believes the industry has been, and remains, well

prepared to deal with natural catastrophes of the magnitude the

world has been experiencing recently. For that reason, the

ratings impact of these natural catastrophes has been limited.

Our view is that many of the insurers and reinsurers

(re/insurers) we rate have processes in place to monitor the

potential impact of climate change. That said, while the

understanding of climate change is still developing, we believe a

sudden spike in the frequency and severity of weather events

could test the industry.

Are Insurers Prepared ForThe Extreme WeatherClimate Change May Bring?


Overview

● Weather volatility and frequency, whether or not a direct result of climate change,

are on the rise, and so are losses for insurers and reinsurers.● The ratings impact of weather-related natural catastrophes so far has been limited,

because re/insurers have comfortably absorbed the losses associated with them.● We take a favorable view of re/insurers that are considering the additional

challenge that climate change poses in modeling extreme weather events, and its

implications for exposure management. ● An increase in the severity and number of extreme weather events could trigger

negative rating changes, especially if they severely weaken a re/insurer's capital.

Many Insurers Are AlreadyWatching Out For Climate ChangeWe’ve observed an increase in theoccurrence as well as in the economicand insurance impact of extremeweather events in past decades. Whileclimate change may be one factor,others are amplifying this trend: theaccumulation of wealth, inflation, andthe ef fects of population growth inhigher-risk locations.

More recently, we’ve observed aseries of unusual weather events, suchas the record-breaking typhoon in thePhilippines; floods in Central Europe, theU.K., and Canada; and SuperstormSandy. Despite the major economic andsocial impact of these events, the insur-ance industry was able to comfortablyabsorb the losses associated with them.

Still, many re/insurers are monitoringthe possible implications of climatechange for their businesses as a part oftheir emerging risk management.According to the 2013 climate survey bythe California insurance regulator of the1,069 re/insurers responding (whichincludes subsidiaries of the major inter-national groups) around 75% considerthe impact of climate change on theirbusiness. However, even those that haveinvested the most in understanding theimpact of climate change currently don’texplicitly allow for it in their pricing andmodeling. One reason: They expect theimpact will be felt only five or 10 yearsor more down the road.

Industry Would Like MoreClimate Change CertaintyWe agree with some of the views of theindustry that if climate change is hap-pening, it may have a widespread impact inthe long term, but isn’t likely to contributesignificantly to the size of the weather-related claims the industry expects in thenext few years at least. Moreover, webelieve the non-life insurance business, typ-ically based on yearly contracts, is wellpositioned to gradually factor in any costsrelated to climate change as they emerge.We consider that re/insurers have theprocesses in place to ensure that they canadjust premiums for any gradual increasein weather-related claims.

Some scientists believe that climatechange may lead to an increase in boththe size and frequency of extremeevents. However, due to the complexityof climate systems, there is significantuncertainty about the exact impact. Untila consensus emerges, we don’t expectthe industry to directly allow for theimpact of climate change. Such a con-sensus may be achievable if the scien-tific evidence becomes stronger. It ispossible that the industry may incorpo-rate it explicitly into their pricing andexposure management only after climatechange clearly leads to a series ofextreme events. This may neverthelessprove to be too late for some of themore weakly capitalized players or thosewith limited reinsurance protectionagainst extreme events.

Our view is that climate change isanother factor contributing to the chal-lenges of modeling extreme weatherevents. For that reason, we take a favor-able view of re/insurers that considerhow climate change, despite its uncer-tainties, may affect extreme events incapital modeling and exposure manage-ment. Disregarding the possible impactof climate change may lead re/insurersto accept higher catastrophic risk thantheir risk appetite would usually allow.This could result in large losses and cap-ital depletion if it turns out that climatechange is indeed increasing the likeli-hood of extreme events.

Exposure Management HelpsMitigate Weather RiskRe/insurers generally have been able tomanage the impact of the extremeweather events over the past two yearsbecause of their risk diversification, aswell as their effective underwriting, riskmanagement, and risk mitigation prac-tices. That said, while the events wereextreme, they were not of historic pro-portions, and the related losses werewell within the re/insurers’ risk appetiteand excess capital.

Even though variations exist, most ofthe re/insurers we rate are typically welldiversified across several lines of busi-ness and geographies. As a result, only apart of their business, typically their




property and motor books, are likely tobe exposed to extreme weather-relatedclaims. In addition, it is highly unlikelythat extreme weather events will involvea significant proportion of a geographi-cally diversified re/insurer’s business atany one time (but this may not be thecase for smaller, less diversified insurers).Furthermore, the reinsurance processensures the sharing of risk across manycompanies and geographies.

Through their underwriting, re/insurersselect or reject risks. In that way, they canrefuse to take on what they may consider tobe excessive exposure to the impact ofextreme weather events, for example, flood-prone properties. Depending on their juris-diction, re/insurers may be able to applyexclusions, limits, excesses, or deductiblesto control their exposure to extreme events.In addition, they can quickly adjust pricesfor observed and expected changes inweather patterns. That’s because most ofthe business exposed to extreme weather isrenewable annually.

Many re/insurers have sophisticatedrisk management systems in place. Thisallows them to quantify and managetheir exposure to extreme weatherevents within their risk appetite.Typically, risk appetite depends on riskpreferences, capital position, andstrategic focus. The risk appetite forextreme weather events usually relatesto the amount of losses a re/insurer iswilling to accept at different levels ofseverity relative to earnings and risk-adjusted capital.

The main risk mitigation tool forre/insurers is active risk selection andreinsurance. Reinsurance helps protecttheir balance sheets in the event ofextreme events. In addition, some insurersuse reinsurers to reduce the volatility oftheir earnings in the event of major butless extreme catastrophic events.

Some re/insurers have a comprehen-sive framework for emerging risk man-agement in place, which allows them tomonitor new risks, such as those in thearea of climate change. Such processesallow them to take steps to manage theirrisk exposure by adjusting their risk pro-file and pricing before fully experiencingthe impact of the changes.

Excessive risk selection and the appli-cation of exclusions can constrain theindustry’s ability to provide protection.We see this happening for extremeweather events, where the economiccosts of extreme weather are increasingfaster than insurance costs. The insur-ance industry may have an opportunityto close the gap through expansion intoless understood geographies, takingsteps to boost demand for insurance pro-tection, and product innovation. Whilethe opportunity appears obvious, carefulrisk management is crucial for success.

How We Analyze Weather RiskOur ratings incorporate our assessmentsof a re/insurer’s business and financialprofiles. As part of the business profileassessment, we analyze the company’sdiversification and the inherent risk ofthe insurance markets where it operates,where we include an allowance for theexposure to and possible severity ofextreme weather events.

Our assessment of the financial profileincludes our prospective view of capitaladequacy, which incorporates one-in-250-year annual catastrophe losses (that is,the amount of annual losses with a proba-bility of 0.4% of being exceeded) in ourcapital model as well as our averageexpectations for the impact of catas-trophe losses on earnings. Although cli-mate change may affect the magnitude orfrequency of such extreme weatherevents, there is no scientific agreementabout the precise quantitative impact,which the industry could use in its naturalcatastrophe models. Therefore, duringour rating discussions with a re/insurer,we look to understand whether and howthe company may reflect that uncertaintyin its capital and exposure management.

In addition, we perform an extensivecatastrophic risk survey, which gives us

insight into a re/insurer’s exposure toextreme weather events and how thecompany models and manages its expo-sure. The analytical tools we employinclude our analysis of catastrophic riskcontrols and modeling, benchmarking ofa company’s risk exposure relative tocapital and earnings on a relative andabsolute basis, and benchmarking ofactual against modeled losses after anevent. We also reflect the sensitivity of are/insurer’s capital position to majorevents in our risk position assessment.

Furthermore, in our ratings we incor-porate our view of a re/insurer’s capa-bilities to manage its exposure toextreme events, as we discussed above:quality of underwriting, adequacy ofpricing and modeling of exposure toextreme events, quality of risk manage-ment, and effectiveness of reinsuranceprotection.

Extreme Events Could TriggerRating ChangesSince 2012, we have not taken any ratingactions on re/insurers as a direct resultof weather events as their impact waswithin risk tolerances for moderate cata-strophic events. Nevertheless, we haveslightly raised our assumptions aboutexpected catastrophic loss in someregions as a result of increased averageannual losses from weather-relatedactivity. For example, in the U.S., wehave revised upward our expectationabout the weight of natural catastrophelosses on the combined ratio in anaverage year to around 4 to 5 percentagepoints from 3 points. (The combinedratio is the industry’s main profitabilitymeasure comparing claims costs to pre-mium revenue where 100% and aboveindicates profitability.)

We don’t expect that weather events,on a similar scale to those in the past

While the opportunity appears obvious, careful risk

management is crucial for success.



two years, will lead to rating changes.We believe that even a gradual increasein weather losses won’t affect the rat-ings because most re/insurers we ratehave the processes in place to factorsuch a change into their underwriting.However, if there is an increase in theoccurrence of extreme weather events,this could trigger negative ratingactions, particularly if they weakenre/insurers’ capital positions.

In determining whether there is arating impact after an event, we assesscapital adequacy for the current andnext two years, al lowing for theprospect of typically higher naturalcatastrophe margins to regenerate cap-ital. To assess the extent to which com-panies can benefit from rate hardening(or higher prices on policies), we con-sider their competitive position andability to raise sufficient capital to takeadvantage of those opportunities.

So, what weather events may causerating changes? Generally speaking,those where the capital impact forinsurers goes beyond their reinsuranceprotection, or that result in defaults ofreinsurers that provide a significant pro-portion of their reinsurance protection.As an insurer’s reinsurance protectionstypically cover it against the annualimpact of events as severe as those itexpects to experience once every 200 to250 years or even less frequently, weexpect that only very extreme weatherevents can cause rating changes in andof themselves. For reinsurers, the poten-tial for a downgrade depends on theircurrent capital levels and any threat totheir own reinsurance protection.However, widespread rating changes ofglobal reinsurers are unlikely unless thewider industry racks up total losses thatexceed those we expect to occur nomore frequently than once in 250 years(see “Earnings Tolerance Is Key To

Assessing Reinsurers’ Catastrophe Risk

Exposure,” published Sept. 10, 2013, on

RatingsDirect).In the past decade, the biggest losses

from weather events occurred in 2005 fol-lowing hurricanes Katrina, Wilma, andRita. Those losses were either the mainreason or a contributing factor to our

downgrades of four of more than 130reinsurers that we rate. However, despitethe severity of the losses, we affirmed ourratings on the vast majority of the affectedreinsurers because the capital they raised,along with favorable pricing conditions,offset the impact of the losses on theircapital. More recently, the 2011 flood inThailand, which was a very extreme eventin the region, led to rating changes on sev-eral Asia-based re/insurers.

The impact of only very severeweather events is likely to lead to ratingchanges in and of themselves. However,major but less severe weather eventsmay still upset the financial markets, andsubsequent financial losses, together withthe direct weather losses, may weakenthe capitalization of some re/insurersenough to warrant a rating change.

We consider that the re/insuranceindustry is well prepared to deal withpossible gradual increases in extremeweather events, whether or not they’relinked to climate change. As such, wedon’t expect climate change per se tohave a ratings impact over the next threeto five years, unless it causes a suddenincrease in the number and magnitude ofextreme events. Meanwhile, we will con-tinue to follow developments in the fieldof climate change. If needed, we’ll reviseour base case assumptions and capitalstresses for weather-related losses andreflect them in our rating process.





Outlook change, or CreditWatch action).

This commentary and its subject matter

have not been the subject of Rating

Committee action and should not be inter-

preted as a change to, or affirmation of, a

Credit Rating or Rating Outlook. CW


Miroslav PetkovLondon (44) 20-7176-7043

Volker KudszusFrankfurt (49) 69-3399-9192

Tracy DolinNew York (1) 212-438-1325


Climate Change

Corporate Carbon RisksGo Well BeyondRegulated Liabilities


EDITOR’S NOTE: Please see the full version of this article, published May 22, 2014, on RatingsDirect.

Investors are paying increasing attention to the impact of

carbon and climate risk on corporate credit quality, yet their

focus has largely been on regulated liabilities that reflect

direct risks from regulations such as emissions trading schemes

and other carbon pricing mechanisms. Outside of highly

polluting industries, however, few companies recognize or

account for the cost of carbon on their operations. Standard &

Poor’s Ratings Services believes that investors can address this

shortcoming with a more thorough assessment of carbon price

risks—from the raw materials supply to end demand—giving

management and investors greater insight on the effects of

carbon price risk across the business.

Overview● Over the next five years, carbon

emissions regulation will extend to

cover 40% of global greenhouse

gas emissions, from 21% currently.● In our view, focusing solely on a

company's direct liability to regula-

tion may not accurately reflect its

full carbon price risk.● We believe that a comprehensive

analysis of carbon price risk should

incorporate both direct and indirect

exposure due to the cost of a

carbon liability being passed down

the supply chain or changing end

demand for products and services.● We have analyzed the impact of

carbon pricing on corporate credit

from four risk aspects: environmental

regulations, emissions market pricing,

business risk across the value chain,

and financial risk on profitability, cash

flow, and asset and liability valuation. ● Carbon price risk management

strategies that companies have

adopted are also helpful in evalu-

ating the net impact of carbon price

risk on corporate creditworthiness.



A Comprehensive View Of Carbon Price RiskWe believe that focusing solely on acompany’s direct liability to emissionsregulation may not fully reflect its truecarbon exposure because such a narrowfocus ignores the indirect carbon pricerisk that affects almost all companies tosome degree.

A more complete analysis assessescarbon price risk across all of a com-pany’s operations (an approach thatRepuTex Carbon Analytics, an inde-pendent research firm, refers to as thevalue chain). This takes account ofdirect and indirect carbon risks, the lattercovering changes in supply and demandfor products and services, and potential

increases in input costs due to changingmarket prices. It results in a more com-prehensive assessment of a company’scarbon exposure and can also identifypotential business opportunities. Themain factors influencing a company’sfinancial exposure to carbon risk operatethrough regulation, supply chains(upstream emissions), and changes indemand for products and services(downstream emissions).

Regulation RiskRegulation across the globeEmissions trading is the most wide-spread form of carbon regulation gov-ernments have applied to meet green-house gas (GHG) emissions reductiontargets in line with their obligationsunder the Kyoto Protocol. So-calledcap-and-trade schemes require compa-nies to operate under a GHG emissionscap, and source permits to cover theiremissions output. Companies canacquire emissions permits via free allo-cations from regulators, by purchasingthem at auction, or by accessing sec-ondary markets.

The European Emissions TradingScheme (ETS) is the world’s largest andmost established carbon market, cov-ering over 2 billion tonnes of GHGemissions across more than 11,000installations in 31 countries. Since theEU ETS launched in 2005, emissionstrading regulation has spread world-wide, with 17 countries currently plan-ning or running a carbon price mecha-nism. According to the World Bank,emissions trading regulation currentlycovers approximately 10 billion tonnesof GHG emissions—equivalent to 21%of global emissions. By 2020, it esti-mates that emissions trading policy willcover more than 40% of global emis-sions, equivalent to 19 billion tonnes ofGHG emissions.

Outside the EU, emissions tradingoperates in the U.S., China, Australia,and Canada (see table 3). More marketsare likely to be created by govern-ments, for example Washington State inthe U.S. just launched a new CarbonEmissions Reduction Task Force topropose legislation in 2015. Market

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© Standard & Poor’s 2014.Source: RepuTex Carbon Analytics.

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tCO2e—Tonnes of CO2 equivalent.

© Standard & Poor’s 2014.Source: RepuTex Carbon Analytics.

Downstream carbon intensity Emissions intensity resulting from consumption of electricity(scope 2)

Direct carbon intensity (scope 1) Supply chain carbon intensity

Chart 2 Breakdown Of Carbon Intensity By Industry

integration is another trend. Forexample, China is working to establisha nationwide emission trading schemeby 2015 following its successful opera-tion of emissions trading market pilotsin several major cities.

Emissions market trading price,pricing mechanism, and riskWhile some countries favor carbontaxes on emissions output, most majorjurisdictions have adopted a form ofemissions trading. The current averagecarbon price worldwide is $10 pertonne of CO2 equivalent (CO2e), withAustralia’s fixed carbon price of $22per tonne the highest and that inChina’s Hubei and the North AmericanRegional Greenhouse Gas Initiative thelowest at $4 (see chart 1, which depicts

forecast trading range of carbon price by

market from 2015 to 2020 based on spot

price information and RepuTex forecasts.

Marker represents trading price as of

May 5, 2014).The degree to which carbon trading

and prices operate as market-basedmechanisms dif fers by countr y. Inestablished markets such as Europeand California, the price is largely free-f loating, determined by supply anddemand and regulator y pol icy. Inthese markets, the price of carbon isset by a defined quantity of emissionsallowances (supply), which is fixed,versus company emissions (demand),which vary based on a range of factorssuch as weather conditions and tem-perature, economic conditions, indus-trial production, and energy prices,notably for gas and oil.

Other emissions trading markets,such as China’s pilot schemes, operatein a different economic context, wherepolitical, regulatory, and financial con-ditions may differ from a traditionalWestern sett ing. For example, inChina, capital markets have not playeda large role given government restric-tions on participation. Furthermore,market transparency is low, with littleinformation on company emissionsand energy usage data, which arehighly sensitive. As a result, whileChina’s pilot schemes are free-floating,

they are not traditional market-basedmechanisms as in Europe.

This is also the case in Australia,which has adopted a hybrid carbon tax-emissions trading scheme, where regu-lations fix the domestic carbon price inthe initial years, rising from A$23 pertonne of CO2e in 2012 to 2013 toA$25.40 per tonne in 2014 to 2015,before converting to a floating carbonprice from 2015 to 2016. That said, cur-rent government policy in Australia is toabolish this system and replace it with adirect action scheme, about whichdetails are scant. The government isunlikely to be able to do this until July1, 2014, when the new senate convenes.

As a result, while most global carbonprices are free-floating, many remainsubject to policy settings, trading rules,and market structures. This means that,unlike traditional commodities markets,governments are more likely to controlcarbon prices to ensure an effectiveenvironmental outcome, which means


A luminum producers are directly exposed to emissions trading regulation, but

they also face indirect carbon price exposure through the purchase of elec-

tricity and the increased cost of raw materials such as coke and caustic soda, as

well as through their logistics costs. However, aluminum producers can take

advantage of downstream business opportunities arising from carbon regulation,

such as developing lighter, more fuel-efficient cars. This increases the demand for

aluminum and supports higher margins for products that are less carbon-intensive

than conventional alternatives.

How Carbon Prices Cut Both Ways In The Aluminum Industry

In the electric power sector, the carbon cost incurred in generating a megawatt

hour (MWh) of electricity becomes part of the marginal cost of electricity pro-

duction, much like the cost of gas or coal. The carbon cost per MWh is determined

by the level of emissions: Brown coal generators have the highest emissions inten-

sity and as such face the largest carbon cost per MWh, followed by black coal and

gas generators.

Less-carbon-intensive generators will benefit as power prices rise with the

increase in carbon costs per MWh, potentially resulting in a windfall profit, and

the converse will happen for more carbon-intensive generators.

Risk Or Opportunity? Carbon Cost Pass-Through InPower Generation

both market and regulation risks couldaffect liable entities.

Upstream And Downstream RiskIn many industries, exposure to carbonpricing is more likely to occur through acarbon liability being passed through thesupply chain (upstream) or throughchanging demand for products and serv-ices (downstream).

Value Chain Emission Profile By SectorCollectively, each industry’s “valuechain” emissions profile identifies itscarbon price exposure to both upstreamand downstream risks, as well as itsdirect carbon liabilities (see chart 2).

A potential analytical approach couldbe to measure carbon intensity by cali-brating the average GHG emissions per

million dollars of revenue across a spe-cific business activity. By measuringcarbon intensity in revenue terms, suchan approach can determine the businessmodel dependence of each sector toGHGs and each sector’s exposure to therising cost of carbon.

Not surprisingly, the energy, mate-rials, industrials, and utilities sectorshave the highest direct carbon inten-sity, and therefore the largest regula-tory exposure to emissions complianceschemes. The energy sector has thehighest overall carbon intensity, withthe direct and downstream combustionof oil, gas, and coal accounting fornearly 80% of the total. The propertyand financial services sectors also havelarge downstream risk profiles, due tothe l i fe cycle of buildings and thenature of financial services companies’investments (covering equity, debt, andproject finance).

So, while only the energy, materials,industrials, and utilities sectors may bedirectly exposed to emissions regulation,all sectors are likely to be affected, albeitto varying degrees, in line with theiremissions profiles.

Risk Management And AdaptationRisk management practices can repre-sent both a means to mitigate carbonrisk and an opportunity to generatereturns, with the potential for firms toincrease revenues above the cost of theinitial carbon liability.

Risk management techniques will ulti-mately depend on geographic and policyconsiderations such as exposure to cli-mate events, local regulation, andcarbon market prices. The mostcommon carbon risk management prac-tices companies adopt are:● Cost pass-through to customers and

negotiation with suppliers, taking intoaccount product price elasticity andcompetition;

● The development of permit tradingand hedging strategies to minimize theimpact of direct emissions liability; and

● Investment in emissions abatement,where this cost is lower than the cost ofcompliance with a regulatory scheme.



Sector: Oil and gas

Invest into renewable energy sources: Large U.S. integrated oil and gas companies such as ExxonMobiland Chevron are making modest investments in the research and development of renewable energysources that emit significantly lower amounts of carbon in power generation than even natural gas.However, we believe these sources are still several years away from full commercial application.

Benefit in consumer demand switching from fossil fuel to gas: Natural gas burned for power generationproduces half as much carbon dioxide relative to coal. With recent technological advances andexploration and production companies' ability to produce natural gas from previously unproductiveshale and tight-sand formations, we believe U.S. natural gas supply will be sufficient to meet thepotential growth in demand from continued fuel-switching from coal to gas in the industrial andpower sectors. The potential increase in natural gas demand should improve the profitability ofnatural gas producers.

Auto

Improve efficiency of the internal combustion engine and vehicle weight: Many auto manufacturershave reduced engine sizes to improve fuel efficiency while maintaining performance through theuse of turbochargers. Another example is using lightweight materials such as aluminum in place ofsteel. Ford claims this strategy has reduced the weight of its new F-150 full-size pickup by as muchas 700 pounds.

Small cars gain popularity: While stable in recent years, gasoline prices remain high relative tohistorical averages, and this has caused a shift in consumer preference to smaller and more efficientvehicles. Small cars have recently accounted for about 20% of all light-vehicles sales, up from about15% in 2006 and 2007.

Transportation

Replace older vehicles with more fuel-efficient ones: Airlines have the largest fuel bill, and the long-termincrease in oil prices has prompted them to replace older planes with newer, more fuel-efficient ones.Buying new planes reduces operating expenses but requires a large capital commitment. Othermodes of transportation similarly favor new engine technologies, but must weigh the trade-off ofoperating cost versus capital cost.

Trend toward fuel efficiency creates winners and losers: Aircraft manufacturers benefit if airlinesorder new planes. Railroads benefit at the expense of trucking companies, because they can movemore weight per gallon of fuel and thus charge less to do so.

Natural resources

Enhance production energy efficiency and switch to cleaner alternative fuels: Weyerhaeuser has agoal to cut GHG emissions 40% by 2020. It is consolidating its manufacturing operations into itsmost efficient paper and cellulose fibers mills, and is replacing fossil fuels with carbon-neutralbiomass fuels. Steelmaker Nucor recycles steel using electric arc furnace technology, which it saysproduces 67% less carbon equivalent emissions than making steel from iron ore. Alcoa says it hasreduced emission intensity in its upstream business by 23% after repositioning to take advantage ofhydroelectric power.

Chemical

Gas as a raw material to reduce emission and cost: U.S. chemical companies can reduce their carbonemissions as they are likely to switch to low cost shale gas, which is considered cleaner relative toits substitutes. For example, ammonia producers stand to benefit from low-cost natural gas becausethey use gas as their key raw material (and not as a secondary raw material or solely as fuel).

Capital goods

Efficiency bolsters demand: Fuel efficiency improvements, emissions reduction to meet governmentmandates, and other efficiency strategies (i.e. building efficiency) are creating new demand for manycapital goods companies. Honeywell (building efficiency), Cummins (engine technology), and GE(wind turbines) are just some examples. Practices range from “smart grid” technology-based products,such as smart power generation, and energy-efficient electrical products, such as LED lighting, andother electrical products and fixtures that go into both new construction and renovation projects.

Table 1 | Emission Reduction Effort And Business Opportunities

Carbon cost pass-through is the mostcommon form of carbon risk manage-ment, where companies aim to recoverdirect and indirect carbon costs fromtheir customers, who in turn will attemptto recover those costs from their owncustomers. Carbon pass-through levelsare primarily determined by the emis-

sions intensity of the product or service,supply and demand elasticity, the eco-nomics of using substitute products, andthe bargaining position of each firm.

The introduction of emissionstrading through spot and futures con-tracts has created a new source ofcommodity and investment risk, and


The still-evolving policies regarding carbon prices create

uncertainty, particularly for industries with long asset

lives such as power generation. To counter this risk, many

firms incorporate a “shadow carbon price” into their calcula-

tions for investment and strategic planning.

Shadow carbon prices applied by companies differ by

sector, ranging between $6 and $60 per tonne of CO2e

emitted, according to the report from CDP (see Note). In

carbon-intensive sectors such as the energy and utilities sec-

tors, corporates apply shadow carbon price ranging from $20

to $60 per tonne, which is generally higher than the top of the

carbon price trading range and significantly higher than the

average price displayed in chart 1. Such a premium on carbon

prices may incorporate other direct costs such as carbon tax,

costs of indirect upstream and downstream carbon exposures,

policy risks from changing environmental regulation during

the investment period, market risk from carbon trading price

increases, and greater volatility. Examples include:● BP Energy. When carbon costs form a significant part of a

project, BP applies a carbon price of $40 per tonne to pro-

jected emissions over the life of the project.● Xcel Energy. In its forward planning, it applies a carbon

proxy cost of approximately $20 per tonne to determine

the expected future costs of emissions.

Incorporating Carbon Prices Into Investment And Strategic Planning

Exposure Profitability impacts Asset valuation impacts Cash flow impacts

Direct exposure Carbon permit trading Sale of excess permits may Excess carbon permit inventory Operating cash flow can beincrease income can add value, however, the affected depending on the holding

valuation may be subject to market position of the company and price volatility market price of carbon permits

Purchase of carbon permits may Expected obligation to purchaseincrease the cost of production carbon permits can be and reduce profit off-balance-sheet

Carbon permits trading and hedging affects profit in either direction

Risk management Actions to abate emissions may Investment to protect assets may While companies spend additional increase expenses have a positive effect on asset operating cash outflow to manage

valuations risk, the cash inflow from such management may not incur at the same period, causing a short-termcash balance reduction

The pass-through of compliance costs to downstream customers may mitigate impact on profitability

Indirect exposure Supply-chain cost Supply-chain cost increases could The costs flowing through the supply Cash net flow may fall if higher raise the cost of production, leading chain could increase inventory costs, supply chain costs cannot be to gross margin decline which may be higher than market passed through suppliers and

price, and such over-valuation can customerslead to inventory impairment

The “shadow liability” is off-balance-sheet

Fixed and overhead costs (transportcosts, for instance) could increase and reduce net profit

Source: RepuTex Carbon Analytics.

Table 2 | Financial Effects Of Carbon Costs

therefore, risk management activity.Carbon price regulations remain themost material carbon exposure facinghighly polluting companies, with eachcompany’s cost of compliance deter-mined through the cost of carbon per-mits (or offsets), less the sale of excesspermits and cash received from cus-tomers. In markets such as Australia,the allocation of free permits may leadto a surplus of emissions allowances,allowing companies to generate short-term returns above their emissions lia-bility through the sale of excess per-mits. The banking of permits (that is,holding a carbon unit from one compli-

ance period to sell it in a future period)enables companies to trade, hedge, andarbitrage against forward contractswith greater flexibility. Combined withother risk management strategies, suchas cost-positive emissions abatementand cost pass-through to consumers, acarbon liability may therefore result inshort-term revenue gains.

The increasing cost of emissionsbrings an added incentive to investmentsin emissions reduction and energy effi-ciency, beyond direct cost savings.Companies are starting to take measuresto reduce emissions incurred from directproduction, upstream, and downstream

exposures. This cross-value-chain efforttakes up business opportunities incurredfrom changes in production input, con-sumer preference, and competitivemarket dynamics (see table 1).

Financial Effect Of Carbon Price RiskConventional financial impact analysis ofcarbon price risk focuses on the regulatedliability and thus overlooks the “shadowliability” caused by potential carbon priceobligation from indirect exposures in theupstream and downstream process.

The “shadow liability” is hard toobserve due to limited availability of



Largest to smallest, established and expected schemes

2013 Allowance Current price Market budgets (million High (US$ per Low (US$ per (US$ per

Market start Type of market Sector coverage metric tonnes) metric tonne) metric tonne) metric tonne)

EU 2005 Mandatory cap-and Electricity, heat and steam production, 2,039 18.2 4.6 9.6trade; absolute target and five major industrial sectors (oil,

iron and steel, cement, glass, and pulp and paper). Plus, CO2 from petrochemicals,ammonia, aviation, and aluminium; N2O from acid production; and PFCs from aluminum

Guangdong ETS 2013 Mandatory cap-and- Power, iron, steeel, cement, and 388 11.0 3.8 9.8trade; intensity target petrochemcial sectors. Expand to include

ceramics, textiles, nonferrous metals, plastics and paper production, public buildings, and transport industries

Australia 2012: Tax Mandatory cap-and- Cement, chemicals, energy, metals, 364 23.1 0.0 22.02015: trade; absolute target mining, paper, and powertrading

Regional Greenhouse 2009 Mandatory cap-and- Fossil fuel-fired power plants 165 8.0 2.0 3.9Gas Initiative (RGGI) trade; absolute target (does not include imports) (short tons)

California 2013 Mandatory cap-and- Electricity (including imports) and 162.8 15.5 10.3 11.9trade; absolute target industry in 2013. Plus, ground

transportation and heating fuels in 2015

Shanghai 2013 Mandatory cap-and- Energy-intenstive industries, airports, 160 11.0 3.8 4.3trade; intensity target commercial buildings

Tianjin 2013 Mandatory cap-and- Electricity, iron steel, chemical, 78 11.0 3.8 4.5trade; intensity target petrochemical oil and gas exploration,

and large buildings

Beijing 2013 Mandatory cap-and- Electricity, manufacturing, and major 50 11.0 3.8 8.3trade; intensity target public buildings

Shenzhen 2013 Mandatory cap-and- 26 sectors including power, water supply, 31.7 18.2 4.6 11.9trade; intensity target industrial manufacturing

Quebec 2013 Mandatory cap-and- Electricity (including imports) andtrade; absolute target industry in 2013; ground transportation

and heating fuels in 2015 23.7 15.5 10.3 11.3

Hubei 2014 Mandatory cap-and- Electricity, iron and steel, chemical, N/A 18.2 3.0 3.8trade; intensity target cement, auto manufacturing, and

aluminum

Chongqing 2014 Mandatory cap-and- N/A 11.0 3.8trade; intensity target

Pricing information is in US$/tonne. Table depicts forecast trading range of carbon price by market from 2015 to 2020 based on spot price information and RepuTex forecasts as of May 5, 2014. N/A—Not applicable.

Table 3 | Current Emissions Markets And Prices

emissions data and issues relating to thequality of data. The full obligation is alsodifficult to accurately quantify becauseapplicable carbon prices are not clearlydefined, and there are no widely adoptedguidelines to standardize liability valua-tion across sectors. Also, companies arenot mandated to disclose their indirectexposure and the resulting liabilities.These are among the reasons investorsare starting to focus on indirect carbonprice risk and its impact on corporatecredit quality.

Standard & Poor’s analyzes the effect ofcarbon price risk on a company’s credit-worthiness by considering the direct andindirect financial effects of exposurethrough the profitability, asset and liabilityvaluation, and cash flow (see table 2).

The Full Picture: Carbon Price Risk On CorporateCreditworthinessOverall, the impact of carbon price riskon corporate credit risk is transmittedthrough four major risk areas: regula-tory risk, market risk, business risk, andfinancial risk.

Regulatory risk is becoming inevitablebecause of the trend for governments toimpose more stringent emissions con-trols and the uncertainty of environ-mental policy over the long term.Although different from conventionalcommodity markets, emissions marketscreate carbon price risk because themarket price is fluctuating and govern-ments control the total supply of carbonpermits, which can decrease in thefuture, particularly in free-floating emis-sions markets. Increases in supply costsand changes in customer demand willraise business risk levels, in particular forcorporates that have weak supplier andcustomer bargaining power. Financialrisk results mainly from lower prof-itability and free cash flow, and by thelimited visibility into “shadow liabilities.”

Companies can control carbon pricerisk through risk management, recov-ering costs by passing on the cost ofcarbon to downstream customers viainvestment in emissions abatement, orthrough trading and hedging strategies.For many industries, we believe this may

represent an opportunity to generateincome in cases where cash recoveredfrom customers, or the market, exceedsthat of the initial liability.

A comprehensive risk analysis of reg-ulation, market, business, and financialaspects across the value chain that incor-porates both direct and indirect expo-sure, along with evaluating risk manage-ment strategies, is critical in determiningthe total impact of carbon risk on afirm’s creditworthiness. CW

NOTES:● Corporate Value Chain (Scope 3)

Accounting and Reporting Standard,Greenhouse Gas Protocol, May 2013(http://www.ghgprotocol.org/files/ghgp/public/Corporate-Value-Chain-Accounting-Reporting-Standard_041613.pdf)

● Use of internal carbon price by compa-nies as incentive and strategic planningtool, CDP, December 2013(https://www.cdp.net/CDPResults/com-panies-carbon-pricing-2013.pdf)

● World Bank, “Mapping Carbon PricingInitiatives: Developments andProspects,” December 2013

The authors would like to acknowledge

the contributions of Hugh Grossman and

Bret Harper of RepuTex to this article.










Credit Rating or Rating Outlook.




Steven J. DreyerWashington D.C. (1) 202-383-2487

Ronald M. BaroneNew York (1) 212-438-7662


Carbon

SPECIAL REPORT


FEATURES

While investors and issuers are beginning to recognize

the impact of carbon pricing on corporate

profitability, the same is less true of the effects of

climate events on a company’s business and financial risk

profiles. Unlike exposure to emissions regulation, which trading

carbon credits and investment in emissions abatement can

address, the unpredictable nature of climate events constrains

the planning and implementation of effective risk management

strategies. The increasing frequency of extreme weather events

such as flooding, intense storms, heat waves, and cold snaps is

putting pressure on companies to identify, quantify, and disclose

the material risks related to such events.

Dealing With DisasterHow Companies Are Starting To Assess Their Climate Event Risks


Overview

● Extreme weather events are responsible for 90% of documented natural

catastrophe loss events, causing $124.5 billion of overall losses out of the $135

billion total natural catastrophe losses. ● Worsening financial performance as a result of climate event risk can negatively

impact both short-term liquidity and long-term debt financing positions, leading to

an increase in credit risk. ● Regulators and investors need to focus more closely on climate and carbon risks as

an indicator of company performance and value.

Climate event risk has the potential todamage profitability, impair asset value,and constrain cash flow. This can weakena company’s liquidity position and com-promise its ability to raise funding andservice debt over both the short term andlong term. In Standard & Poor’s RatingsServices’ opinion, corporate credit qualitymay suffer if companies do not imple-ment adequate risk management meas-ures regarding climate events.

Extreme Weather Events Are On The RiseAccording to the IntergovernmentalPanel on Climate Change, “A changingclimate leads to changes in the fre-quency, intensity, spatial extent, dura-tion, and timing of extreme weather andclimate events, and can result inunprecedented extreme weather and cli-mate events.”(1)

Over the past few decades, we’ve wit-nessed an increase in extreme weatherevents. In 2013, reinsurance group MunichRe recorded 888 loss-related natural catas-trophe events worldwide (see chart 1),slightly down from the 936 events recordedin 2012 but above the 10-year average of822. Of the 888 documented loss events,90% were weather-related, encompassingstorms, floods, heat waves, cold snaps,droughts, and wildfires, while earthquakesand volcanic eruptions were responsiblefor the remaining 10%.

According to Munich Re, weather event-related losses have been increasing sincethe 1980s, and the volatility of losses hasbeen much higher during the past decade

(see chart 2). In 2013, overall worldwide nat-ural catastrophe losses from the 888recorded events totaled $135 billion,among which $124.5 billion was weatherrelated. In 2013, at $33 billion, weather-related insured losses represented 94% oftotal insured losses, 4% higher than the 10-year average percentage.

Climate event risk represents both ashort- and long-term exposure for compa-nies. Increased rainfall, f looding, andstorm intensity can interrupt production,while extreme heat and fires can affectoutput and supply/distribution networks,potentially increasing cash flow volatilityand disrupting supply chain links.

As with the impact of carbon pricing (see

“Corporate Carbon Risks Go Well Beyond

Regulated Liabilities,” on p. 21), climate eventrisk carries direct and indirect exposure forindustry. It affects a company’s value chain,covering the upstream supply chain, directoperations, and downstream supply anddemand for goods and services.

Exploring Industry’s SensitivityTo Climate Event RiskPhysical consequences of increasedcarbon in the earth’s atmosphere are notyet fully understood but there is a growingunderstanding of the potential effects ofclimate change on industrial sectors.Consequently, while the actual sensitivityof these sectors to climate event risk is dif-ficult to quantify, there is evidence that therisk is material: Extreme winter weather inNorth America in early January 2014, forexample, had serious consequences foreconomic activities, ranging from indus-

trial output to consumer spending.Significant impact arose from the loadplaced on electricity generators, forexample PJM Interconnection, the largestU.S. grid operator, hit a record winter peakuse of 141,500 megawatts (MW) duringthat time. Furthermore:● Peak energy use occurred at a time

when nearly 20% of the generators inPJM’s territory were out of action dueto the cold weather.

● At one point, nearly 40,000 MW ofPJM’s 190,000-MW installed capacitywas offline.

● Much of the generation losses weredue to natural gas pipeline constraints,which caused gas prices to spike morethan 300%, resulting in the take-up ofsignificant capacity from wind genera-tion.

● Steam-cycle fossil fuel-fired powerplants (primarily coal) made up abouthalf of the outages in PJM’s territory,with diesel generators making up thesecond-largest portion. In some cases,coal stacks were frozen or diesel gen-erators simply couldn’t function insuch low temperatures.Exposure to climate event risk varies

by sector, depending on a company’sbusiness operations. For example, busi-nesses dependent on biosphere services,such as forestry and agriculture, may bemore vulnerable to day-by-day changesin productivity (see table), while firmsreliant on mineral assets and transportservices may be exposed to more inter-mittent events. Energy infrastructure isespecially at risk (see sidebar).



Assessments by the National Research Council and the U.S.

Global Change Research Program indicate that U.S.

energy infrastructure is increasingly vulnerable to a range of

climate change effects, particularly in areas prone to severe

weather and water shortages. Climate change can affect infra-

structure throughout all major stages of the energy supply

chain, thereby increasing the risk of disruptions. For example:● Resource extraction and processing infrastructure,

including oil and natural gas platforms, refineries, and pro-

cessing plants, is often located near the coast, making it

vulnerable to severe weather and rising sea levels.

● Fuel transportation and storage infrastructure, including

pipelines, barges, railways and storage tanks, is susceptible

to damage from severe weather, melting permafrost, and

increased precipitation.● Electricity generation infrastructure such as power plants is

vulnerable to severe weather or water shortages, which can

interrupt operations.● Electricity transmission and distribution infrastructure,

including power lines and substations, is susceptible to

severe weather and may be stressed by rising demand for

electricity as temperatures climb (or fall).

Climate Change Threatens Energy Infrastructure


According to the U.S. GovernmentAccountability Office, the rise in sea levelfrom global warming may double the riskof coastal flood events by 2030. In thelower 48 states, nearly 300 energy facilitiesstand on land this would affect, includingnatural gas infrastructure, electric powerplants, and oil and gas refineries. Oil andgas facilities in California, Florida,Louisiana, New Jersey, New York, andTexas are particularly at risk.

Risk Management AndAdaptation Are Far From StraightforwardBecause of their complex and interrelatednature, climate event risks are difficult topredict. Both short- and long-term risk

management strategies need to take intoaccount not only the gradual effects ofincreasing temperatures, but also thesudden and often profound effects thatextreme weather events can have. What’smore, implementing risk management andadaptation measures for long-life fixedassets may be difficult because of financialand technological restraints and the lim-ited availability of viable alternatives.

Regulators And ShareholdersPush For More DisclosureEnergy-intensive companies have comeunder increasing pressure from regulators inrecent years to inform investors of the risksthat carbon pricing and extreme weatherevents would place on their business. In the

Source: Munich Re Topics Geo, 2013.© Standard & Poor’s 2014.

Climatological events:extreme temperatures, drought, wildfire

Hydrological events:flooding, mass movement

Meteorological events:tropical storms, extratropical storms,convective storms, local storms

Geophysical events:earthquakes, tsunamis, volcanic eruption

1980 1985 1990 1995 2000 2005 20100

100200300400500600700800900

1,000

Chart 1 Number Of Natural Catastrophies 1980–2013

*Values adjusted for inflation using the Consumer Price Index (CPI) of each country.Source: Munich Re Topics Geo, 2013.© Standard & Poor’s 2014.

Overall losses (mil. $ values as of 2013)

1980 1985 1990 1995 2000 2005 20100

50

100

150

200

250

300

350

400

Trend: insured lossesInsured losses (mil. $ values as of 2013)*Trend: overall losses

Chart 2 Overall Weather Related Losses And Insured Losses 1980–2013

U.S., the Securities and Exchange Commissionrequires firms that file annual reports to dis-close material climate change risk. In theU.K., effective from Oct. 1, 2013, theCompanies Act 2006 (Strategic Report andDirectors’ Report) Regulations 2013requires large listed companies to reporttheir greenhouse gas emissions in the direc-tors’ reports for the financial year ended onor after Sept. 30, 2013, so that investors canassess the relevant climate risk. In April2014, the European Parliament voted infavor of a new law that will require largelisted firms to publish environmental andsocial data in their reporting to investors.

Companies are responding. Exxon Mobilrecently became the first oil and gas pro-

ducer to agree to publish details of its cli-mate risk exposure from stranded assets(that is, oil and gas reserves that the com-pany could not exploit if the regulatoryregime tightened), a sign of the growingacceptance among companies andinvestors that climate and carbon risks areincreasingly material to corporate perform-ance and value.

Meanwhile, CDP (formerly the CarbonDisclosure Project), an international, not-for-profit organization, administers a globalsurvey that enables companies to measure,manage, disclose, and share environmentalinformation. It scores companies to reflectspecific business risks and potential oppor-tunities related to climate change and

internal data management practicesregarding greenhouse gas emissions.Companies that make their CDP surveyresponse public and achieve a score withinthe top 10% of the Global 500 survey popu-lation qualify to list in the Climate DisclosureLeadership Index. The top scorers in 2013included BASF SE, BMW AG, BNY MellonN.A. Cisco Systems Inc., Eaton Corp., GasNatural SDG S.A., and Nestlé S.A.

Assessing The FinancialImplicationsClimate event risk can have a significantimpact on an economy. According toAllianz SE, weather and climate directlyor indirectly affected $5.7 trillion of the



Sector Exposure Risk profile Adaptation strategies

Agriculture Potentially longer growing seasons in cooler climates Extreme Adjustment of planting dates and crop varieties

Increased droughts that impair productivity Improved land management, such as erosion control andsoil protection through tree planting

Proliferation of pests and disease Initiation of reforestation and afforestation activitiesimproving irrigation efficiency, and conserving soil moisture

Oil and gas Increased storm activity disrupting asset operations High Modification of assets to allow operation in line with and reducing production climatic changes

Increased costs for cooling Remedial works to ensure fuel storage and transmissionstructures are secure

The effects of rising temperature on assetperformance, efficiency

Power Extreme demand events due to heatwaves and cold High Design modifications such as decentralizing generationsnaps are becoming less predictable

Unseasonal temperature changes may alter Energy efficiency and demand-side management through established demand profiles the use of smart grid technology

Low rainfall and high temperatures impair thermalpower station cooling Diversifying sources of energy

Property Increased frequency and intensity of extreme weather High Improved construction practices and energy efficiency events can affect property, notably low-lying and programs, along with building insulation, window glazing, coastal property. and shading

Increases in bushfire frequency may raise rates ofdamage to buildings and structures Work with planning authorities

Drier conditions may lead to increased groundmovement and changes in groundwater Better identification of at-risk locations

Water Increased rainfall and flooding may overwhelm High Expanded rainwater harvestingexisting infrastructure

Temperature increases may result in a reduction of Diversification of water sources—surface and groundwater, surface water availability by reducing environmental wastewater and recyclingstorage and increasing evaporation

Water use and irrigation efficiency

Transport Increased temperatures may stress transport Moderate Long-term design considerationsinfrastructure such as roads and bridges

Exposure of infrastructure to flooding, water, and Planning for roads, rail, and other infrastructure to cope snow damage with warming, drainage

Metals and mining Extreme weather events such as site impairment due Moderate Long-term design considerations in planning stage of to flooding may affect production and site efficiency new assets

Reduced availability of water may impede Planning for roads, rail, and other infrastructure to water-intensive metals and mining activities cope with warming, drainage

Source: RepuTex Carbon Analytics.

Adaptation Strategies For Industry Sectors Sensitive To Climate Event Risk

U.S. economy in 2012, representing over30% of GDP. Routine weather variancescost $534 billion, equivalent to 3.4% ofU.S. GDP. Comparable exposures for theEU in 2012 were $5.9 trillion, equivalentto 35.8% of GDP, and routine weathervariance costs of $561 billion, equivalentto 3.4% of GDP, respectively.

While weather has always been a crit-ical business risk for many industries, anincrease in the frequency of extremeevents could weigh on company balancesheets. Between 1980 and 1989, theinsurance industry paid out $15 billionper year for weather damage worldwide.By 2010 to 2013, this figure had risen to$70 billion per year. And physicalweather events do not need to beextreme to affect financial performance,merely unseasonal or unexpected.

Variations in weather can impair acompany’s financial risk profile from thesupply or demand side, as well opera-tionally, with potential knock-on effectson creditworthiness arising from fluctu-ating revenues and capital expenses.

In the short term, climate events tendto affect profitability as a result of assetimpairments and production-basedevents. Over the longer term, profitabilityand asset valuations could come understress, leading to higher costs for insur-ance and risk management, asset write-downs, and reduced property values. Atthe same time, companies may need toadapt their business models by modifyingmanagement practices, changing assetdesigns, or in some instances relocatingassets. Consequently, companies that failto take account of these long-term risksmay suffer significant stress and havelittle flexibility to manage their exposure.

The negative effects on profitability,asset values, and cash flow can weakencompanies’ liquidity positions, in partic-ular for the cash conversion cycle thataccounts payable days, accounts receiv-able days, and inventory days can affect.This is because the same climate eventwill impinge on the company, its sup-pliers, and its customers.

A deteriorating asset base couldimpair a company’s ability to raisefunds. In our view, each climate eventwill likely have both an immediate and

prolonged effect on a company’s abilityto service its debt. In some extremecases, this could lead to companiesdefault ing on their obligations tolenders and bondholders. Therefore, acomprehensive cl imate event r iskanalysis should take in the long-termperspective. For example, a flood candestroy a company’s production facility,causing instant financial loss and trig-gering a reassessment by creditors.However, the f lood may also lead toincremental investment for reconstruc-tion and the loss of customers, whichin turn may reduce the free cash flowavailable to service debt.

Managing Climate EventExposure Is Becoming CriticalOverall, we believe that credit qualitymay deteriorate if a company does notimplement adequate risk managementmeasures to cope with climate events.Indeed, an ef fective managementstrategy to mitigate short- and long-termclimate-related exposures is becoming acritical issue for an increasing number ofnonfinancial companies. For capitalmarket participants, greater disclosure ofclimate event risk and a better under-standing of the financial effects of suchrisk should lead to improved creditanalysis, in our view.(1)Managing The Risks Of Extreme Events

and Disasters to Advance Climate Change

Adaptation, 2012 (Intergovernmental Panel

on Climate Change). More details can befound at https://www.ipcc.ch/pdf/spe-cial-reports/srex/SREX_Full_Report.pdf

The authors would like to acknowl-edge the contributions of HughGrossman and Bret Harper of RepuTexto this article. CW

Under Standard & Poor’s policies, only

a Rating Committee can determine a

Credit Rating Action (including a Credit

Rat ing change, af f i r mation or with-

drawal, Rat ing Out look change, or

CreditWatch action). This commentary

and its subject matter have not been the

subject of Rating Committee action and

should not be interpreted as a change to,

or af f irmation of, a Credit Rating or

Rating Outlook.




Laurence P. HazellNew York (1) 212-438-1864

Steven J. DreyerWashington D.C. (1) 202-383-2487


Climate

SPECIAL REPORT | Q&A


FEATURES

The policy risk associated with renewable energy

frameworks across the EU has never been more

prominent. On May 12, 2014, the U.K.’s Department for

Energy and Climate Change announced that it plans to close its

support scheme for solar power projects generating more than 5

megawatts (MW) from April 1, 2015, two years earlier than

originally planned. This followed German Chancellor Angela

Merkel’s announcement on March 17, 2014, of a cut in feed-in-

tariffs (FiTs; pre-set prices for energy produced from different

renewable resources) across all renewable energy sources and a

scaling back of the country’s ambitious clean energy program.

Ms. Merkel plans to cut FiTs to €0.12 per kilowatt hour (kWh),

on average, by 2015 from the current €0.17 per kWh and

proposes to limit the annual expansion of onshore wind and

solar capacity to 2.5 gigawatts (GW) and offshore wind capacity

to 6.5 GW.

Credit FAQ

Assessing The Credit-Supportiveness OfEurope’s RenewableEnergy Frameworks


Both announcements have fueled uncer-tainty among investors about the futureof renewable energy incentives, despiterational explanations underpinningthem. In the U.K., the government saysit’s cutting solar subsidies to ensure thereis sufficient cash to support other typesof renewable technology such as off-shore wind, wave energy, biogas, andgeothermal, and to limit furtherincreases in consumers’ bills. InGermany, the emphasis is on containingrising energy bills, which are the highestin Europe and about 3x the level ofthose in the U.S. However, Standard &Poor’s Ratings Services believes thisuncertainty can deter investors andpotentially limit the growth of renew-able energy investment in the EU sincemarket participants regard some cleanenergy technologies as commerciallyunviable without government support.Moreover, government incentives oftenunderpin the financial viability ofrenewable energy projects: For instance,subsidies to solar power projects inEurope can account for up to 85% oftheir initial revenues. This, in our view,

illustrates the importance of pre-dictable, ongoing financial support forrenewable energy projects, and high-lights the credit risk associated with anychanges to this support.

In this Credit FAQ, we addressinvestors’ questions regarding howpolicy frameworks for renewable energysources (renewables) have developedacross the EU and rank them accordingto our view of their sustainability andeconomics.

Q. Why are EU countries investing in renewables and what have been the consequences?

A. All countries in the EU have set goalsfor a percentage of energy to be producedfrom renewables by 2020. To encourageinvestment in renewables, many countrieshave implemented incentive schemes inthe hope that this will help them achievetheir 2020 targets. In March 2007, theEuropean Council approved a set of objec-tives proposed by the EuropeanCommission (EC) designed to increaserenewable energy production. These


SPECIAL REPORT | Q&AFEATURES

—Effect on creditworthiness—

Factor Positive Negative

Regulatory support Stable and transparent regulatory regime. Low probability Weak regulatory regime. Significant potential for unfavorableand predictability of adverse changes to tariff regimes or contracts changes to tariff regimes or contracts. Significant scope for

the introduction of new costs that are difficult to quantify and that energy producers would likely have to bear

History (results) Visible increase in renewable energy over the period of Little, if any, increase in the amount of renewable energyimplementation of incentive schemes produced followingthe implementation of incentive schemes

Long track record

Sustainability Incentive schemes are sustainable over the medium-to-long term Incentive schemes are unsustainable and/or have already been reduced or modified since their implementation

Easy grid connection Expensive to connect to grid

Long-term profitability Predictable Lack of consistency from issuer of subsidies

Government able to keep promises Unsustainable programs

Cost recovery Schemes allow for full recovery of investors’ costs in the Schemes do not allow for any recovery of costs in the near-to-medium term near to medium term

Priority grid access Access to grid is limited to peak hours

External risks Able to produce power independent of weather conditions Power production that is highly dependent on the weather(via hydroelectric, geothermal, biomass, and natural gas plant) (namely wind and solar)

National economy Growth Declining economy

Investor-friendly environment Investor-unfriendly environment

Political stability Political instability

Note: The more factors in the positive column, the more credit-supportive the policy framework.

Table 1 | Factors Affecting The Creditworthiness Of Renewable Energy Incentive Schemes


objectives, known as the 20-20-20 targets,entail reducing EU greenhouse gas emis-sions by 20% from their 1990 levels,raising the share of EU energy productionfrom renewable resources to 20%, andstriving for a 20% improvement in energyefficiency across the EU. Targets for 2030are currently being drafted, and are to befinalized by October 2014; the initial pro-posal includes a 40% reduction in green-house gas emissions and an increase in theshare of renewable energy to at least 27%.

Various EU member states have triedto improve on previous incentiveschemes such as those introduced inSpain in the early 2000s, which, due tothe design of Spanish utility regulation,caused tariff deficits when the govern-ment did not set electricity tariffs atlevels that fully recovered costs of pro-duction. The discrepancy between theproduction cost and market price of elec-tricity, coupled with a reduction in powerdemand following the 2008 recession,pushed the Spanish system into a tariffdeficit of about €26 billion by mid-2013.

Q. What is Standard & Poor’s view on thecredit supportiveness of policy schemes?

A. We consider certain renewable sup-port mechanisms to be more credit sup-portive than others (see table 1). For eachcountry that we analyze, the more fac-tors that are in the positive column themore credit-supportive we consider thescheme. Table 1 takes into account vari-ables such as cost recovery, pre-dictability, and the proven history ofindividual schemes. Predictability andprice recovery alone are not enough,however. We’ve seen past examples oftarif fs that have been promised torenewable energy producers and thensubsequently reduced or withdrawn,leaving the producers to compete withcheaper and more carbon-intensivefossil-fuel generating plant. This has ledto some market participants facing theprospect of stranded investments, due tothe large amounts of capital that havebeen pumped into the renewables sector.

The sustainability of support schemesis one of the most important factors inour assessment of renewable energy

frameworks. For example, in both theU.K. and The Netherlands we’ve seenlarge projects either reduced or scrappedcompletely due to a lack of clarity fromgovernments and regulators on theamount of guaranteed returns. Earlierthis year in the U.K., SSE PLC, a verti-cally integrated utility, abandoned plansto invest £20 billion in four major off-shore wind projects due to limited subsi-dies and high costs. In The Netherlands,Eneco sold 50% of its Luchterduinenwind project to Mitsubishi Corp. due topolitical uncertainty and a lack of finan-cial support from the state.

Q. How sustainable is the financial sup-port for renewable energy in EU memberstates, in Standard & Poor’s opinion?

A. Incentive schemes require certainconditions to function supportively. Forexample, connection to the high-voltagegrid network must be straightforward andaffordable. Most networks have beendesigned to connect large centralizedpower plants, so they need to be reconfig-ured to accept small power inputs fromintermittent power sources across thecountry. Generally, we view FiTs as sup-portive mechanisms that provide clearand long-term tariffs that enable investorsto recover their costs. However, the sup-portive nature of such schemes can, as inthe case of Spain, be undermined by eco-nomic and political realities. Politicianshave not been willing to endorse the costsof their national energy policy thoughtariff increases; Spain is one of the fewcountries where tariff-setting power hasremained in the hands of the govern-ment. Despite clear guidelines, a drop indemand post-2008 made cost recoveryimpossible, and exacerbated the growingtariff deficit. To reduce this burgeoningdeficit, the Spanish government hasreduced or, in some cases, completely cutthe subsidies to renewable producers.

Q. Who bears the cost of renewableenergy incentive mechanisms, and whatare the benefits of such mechanisms?

A. In the end, either the government orthe consumer pays for renewable energy

incentives. The cost of FiTs and quotasare usually fully passed through to theend consumer by the energy supplier,while the government provides taxincentives to the generator. Andalthough the government takes the hitfor tax incentives, in many cases, it canadd a levy to help (state-owned) distribu-tion networks recover the cost of thesetax benefits.

If costs cannot be passed on to endconsumers, the government will haveto pay the dif ference between themarket price and contracted price,leading to tariff deficits. Also, when weassess renewable support systems, weneed to determine who is responsiblefor establishing and paying for highvoltage grid access. In the U.K., thisresponsibility lies with the power pro-ducer, while in Germany, Sweden, andNorway it lies with the transmissionoperator. This means that U.K. subsi-dies are necessarily higher to coverconnection costs. In Germany, mean-while, there have been considerabledelays in providing grid access torenewables producers due to the costsinvolved for the generators.

The three main incentive mechanismsare FiTs, tax incentives, and quota sys-tems. Each has characteristics that affectthe level of credit support that they offer.

Feed-in tarif fs (FiTs). Generally, weview FiTs as a credit-supportive incen-tive for renewable energy production.FiTs provide a pre-negotiated pricethat the network pays for energy pro-duced from dif ferent renewableresources. The reason we view thesetariffs as credit-supportive is that theyare set out in advance, detai l ingexactly how much will be paid, and forhow long. This gives investors a degreeof certainty, enabling them to reach aninvestment decision based on projecteconomics. Until recently, EU memberstates provided generous strike priceson green energy production methodsbecause they wanted to expand theirrenewables production.

The success of a FiT depends onwhether market participants view it assustainable (that is, the full extent of thecost can be passed onto the end con-

sumer by the purchasing uti l it ies).When this is not the case, such as inSpain, network distributors have had toabsorb the unrecovered costs alongsidethe government. This difference in pro-duction costs and electricity prices toend consumers is the cause of poten-tially huge tariff deficits, leading to thereduction and, in some cases, completeelimination of the subsidy.

Tax incentives. Tax incentives areanother method by which governmentsencourage investment in renewableenergy. The cost of this incentive fallsmore on the government than on the endconsumer, although it will have indirecteffects on the latter as well. That said, wedo not consider tax incentives to be ascredit-supportive as FiTs. This is becausetax incentives do not always provide con-tinued support for investors since renew-able energy has to compete with all otherenergy producers in the free market.However, in an efficient incentive struc-ture, the upfront tax relief should coverthe original investment costs. As a result,renewable generators should be able tocompete at a market level with othergenerators owing to the lower capitalcosts that need to be recovered.

A benefit of tax incentives is that thereis no risk of causing a tariff deficit due tolack of government support, providedthat pre-construction calculations werecorrect and the market price is highenough for the renewable sources to beable to compete after covering theirinvestment costs fully or partially by thetax benefit.

Quota systems. Quota systems exist inmany markets and have been put in placeto encourage generators to produce more

green energy. Quota systems require theproduction of a certain amount of energyfrom renewable resources. Unlike otherschemes, generators cannot opt in or outof quotas. Standard & Poor’s does notconsider these systems credit-supportive:Although quotas encourage the produc-tion of renewable energy, generators arepenalized if they do not comply and facea certain amount of price risk.

Quota systems exist in the U.K. andNordic power markets. In the U.K., thesystem is called the RenewablesObligation (RO) scheme and requireslicensed U.K. electricity suppliers tosource a specified proportion of theelectricity they provide to customersfrom eligible renewable sources. Norwayand Sweden operate a combined schemethat works in a similar way. If a gener-ator is short on Renewables ObligationCertificates (ROCs), then it must pur-chase the shortfall at market prices tofulfil its obligated amount of ROCs forthe amount of energy it produces. Thishas created a market for ROCs, whichare traded on the open market, with aconsequent fluctuation in prices.

Q. Which countries have the most credit-suppor tive renewable energy frame-works, in Standard & Poor’s opinion?

A. We consider that the most credit-supportive renewable energy frame-works in Europe are those in Germany,the U.K., Denmark, The Netherlands,Sweden, Norway, and Spain (see table 2).All of these countries have successfullyprovided funding for companies andincentives for investors to producemore renewable energy. As a result,most of these countries have signifi-cantly increased the percentage of elec-tricity production generated fromrenewable sources.

We now present an overview of thecredit-supportiveness of the renew-able energy frameworks for each ofthese countries.

Germany. Until recently, Germany’srenewable energy framework was bothpredictable and stable in terms of regu-lations and incentives. The incentives forrenewables production comprise a FiT, a



Country/Ranking Renewables incentive schemes

1. Germany Feed-in-tariff, tax incentives, and beneficial loans

2. U.K. Renewables Obligation Certificates (quota system), Electricity Market Reform, and feed-in-tariff

3. Denmark Feed-in-tariff funded by public service obligations, and tax incentives

4. The Netherlands Feed-in-tariff (¤ 3 billion limit), tax incentives, and beneficial loans

5. Sweden and Norway Renewable quota system and tax incentives

6. Spain Feed-in-tariffs and tax incentives

Table 2 | Ranking Of Selected EU Renewable Energy Frameworks

In Terms Of Credit Supportiveness

premium tarif f rate, and favorablefinancing for renewable projects throughKfW, the national development bank.

KfW provides one of the few incentiveschemes where the cost of the programhas no impact on the end consumer. Inthis case, the cost is fully borne by KfW,which offers low-interest loans, usuallyover 20 years and with a three-yearrepayment-free start-up period.

The FiT in Germany works in tandemwith a premium tariff, which is the differ-ence between the FiT for the specificrenewable technology as set out in TheRenewable Energy Sources Act(Erneuerbare Energien Gesetz) and theaverage stock market price. Plant opera-tors are free to choose whichever tariff ismore beneficial to them.

The support of the German system isunder threat, however. Federal economyminister Gustav Sigmar Gabriel recentlyproposed a cap on renewable energy,limiting onshore wind and solar powerto 2.5 GW per year and offshore windpower to 6.5 GW per year, and reducingthe average FiT to approximately€105/MWh by 2015 from approxi-mately €125/MWh today. There arealso further planned cutbacks on subsi-dies between now and 2017, and even-tually green energy will have to com-pete on the open market alongsidenonrenewable sources.

U.K. After Germany, we consider theU.K. to be one of the most credit-sup-portive renewable energy regimes inEurope. It offers a range of incentivesand—at least until recently—stable andpredictable government support. Theincentives cover the RO scheme, a small-scale FiT, and a new full-scale FiTknown as Contracts for Dif ferences(CfD), which is soon be implementedunder the Electricity Market Reform.

The RO scheme, introduced in 2002,was the first program in the U.K. toencourage renewable energy produc-tion and has required a steadilyincreasing amount of renewables obli-gation certificates (ROCs) per MWhsupplied. For 2014 to 2015, theamounts are 0.244 ROCs/MWh pro-duced, up from 0.206 ROCs/MWh in2012 to 2013. Between 2013 and 2017,

the scheme sets an average of 1.4ROCs/MWh produced, the actualamount dependent on the complexityand cost of the technology used. Thesmall-scale FiT, for renewable energyprojects of up to 5 MW capacity, hasprompted investment in a number ofsmall renewable projects, mainly solar,wind, and small hydroelectric schemes.

The CfD, which is set to come onlineby the third quarter of 2014, applies toall renewable power projects, regardlessof size. When the CfD program is active,energy producers will be able to choosebetween it and the RO scheme for theirrenewables production until 2017. Afterthat time, new projects will come underthe FiT scheme. The evolution of thesuggested strike price for CfD projectsspans an average of £140/MWh in 2014to 2015 to £134/MWh in 2018 to 2019.

The RO scheme has been active forthe longest and has been relatively suc-cessful in promoting renewables produc-tion in the U.K. However, there is still along way to go to achieve the govern-ment’s target of 15% green energy pro-duction by 2020; it had reached only 4%at the end of 2012. Consequently, webelieve the U.K. will continue to providestable and predictable support forrenewable energy production.

Denmark. Demark has a program similarto a FiT, in which renewable energy pro-ducers receive a bonus payment on top ofthe market price from Energinet.dk, anational agency that maintains security ofelectricity and gas supplies. The sum of thebase tariff and the bonus payment is limitedto a statutory maximum per kWh, which inturn depends on the source of energy usedand the date of connection of a given plant.This program has led to Denmarkbecoming one of the largest producers ofoffshore wind power in the world.

Distributors pass on the cost of theaforementioned bonus payments to con-sumers in the form of a public serviceobligation (PSO). Energinet.dk pays thesubsidy in three ways:● It purchases the generated power at a

guaranteed price and then sells thatpower on the Nord Pool Spot powerexchange, the deficit being included inthe PSO costs.

● It pays a subsidy that corresponds tothe difference between a fixed settle-ment price for the renewable energyand the market price for power on theNord Pool Spot.

● It supplements producers’ income upto a guaranteed level for those compa-nies selling their own power genera-tion on the market. This means thatthey receive a monthly subsidydepending on the price of electricity.Energinet.dk assigns these subsidieson a case-by-case basis, which meansthat renewable energy projects canreceive different terms in both tariffsand the length of support, with thelatter averaging 10 to 12 years.In our view, this FiT is stable and

credit-supportive. What’s more, theDanish government and energy min-istry has publicly stated that they willcontinue to support the installation ofrenewables plant and subsidizeresearch and development costs up toDanish kroner 130 million per year. Anenergy policy agreement of March 22,2012, spanning 2012 to 2020, aims todevelop a 100% renewables energysystem by 2050. (In 2012, renewablesmet 26% of energy consumption.)This ambitious, long-term goal leadsus to believe that Denmark will con-tinue to provide credit-supportiveincentives for renewables over themedium to long term.

The Netherlands. We consider theenergy regime in The Netherlands stableand predictable. However, there is a lim-ited amount of support available toinvestors. The Netherlands’ FiT pro-gram, SDE+, replaced the previous SDEprogram in 2012. It operates in phases,the first of which allocates €3 billioneach year on a first-come, first-servedbasis. Although later phases offer moremoney in terms of higher FiTs/KwH,waiting runs the risk of the annual allo-cation of €3 billion being exhausted. Thesubsidy is only open to new installationsunless specifically noted otherwise. Incontrast with FiTs in other EU memberstates, the cost of this subsidy is coveredby the state budget.

The Netherlands also has tax incen-tives that exempt generators of renew-


able energy from the electricity and nat-ural gas tax. Meanwhile, entrepreneursbased in The Netherlands can write offinvestments in renewable energy plantagainst taxes, and consumers that investor put their savings in a green fund alsogain a tax benefit. In addition, banksoffer loans for renewable energy projectsat lower interest rates.

Sweden and Norway. In our opinion,the renewables market in Sweden andNorway is stable and predictable. Thatsaid, neither Norway nor Sweden pro-vide much financial support for renew-able energy producers. Since May 1,2003, Sweden has had a system of trad-able green certificates promoting renew-able energy through a governmentquota. Norway joined this scheme onJan. 1, 2012. The scheme provides onegreen certificate per MWh of greenenergy produced, and requires all energyproducers to produce a certain amountof green-certified energy. In 2013 and2014, these figures stood at 0.135 and0.142 certificates/MWh respectively.These annual targets are set to increaseeach year until 2020.

Following a recent large increase inthe amount of renewable production inNorway and Sweden, the price of renew-able certificates traded on the openmarket has declined sharply. This has ledto talks about increasing the amount ofcertificates needed per MWh of elec-tricity produced. Since 2012, the quotasystem has delivered 6.2 terawatt hours(TWh) of new renewable energy. Withthe recommended new quota, therewould be an extra 8 TWh coming onlineeach year between 2016 and 2019.

Spain. Spain is an example of a failedsupport scheme. When the FiT schemewas implemented in the early 2000s, thecosts were too great to fully pass on tocustomers. At the time, there was pri-ority dispatch for renewables withoutany cap, leading to renewables growingrapidly to 30% of total annual output.Then, a few years into the program, theglobal recession hit Europe. The combi-nation of these factors saw the tariffdeficit balloon to about €26 billion bymid-2013, forcing the Spanish govern-ment to cut back on renewable energy

incentives. This greatly harmed investorconfidence. As a result, we do not cur-rently view the Spanish renewableframework as credit supportive.

Notwithstanding the tariff deficit, therenewable energy support scheme hasgreatly increased the amount of renew-able energy that Spain produces, and thecountry now generates the fourth-largestamount of wind energy worldwide,meeting roughly 25% of annual elec-tricity demand. If energy prices continueto rise, we believe these projects maybecome competitive on the open marketin the future.

Q. How is policy risk in regard to EUrenewable energy frameworks likely toevolve, in Standard & Poor’s opinion?

A. Overall, the ambitious 2020 renew-able energy targets set by the EC remainin place and we believe that EU memberstates will continue to provide incentivesfor the production of green energy. Aseconomies across Europe start to growafter the global recession—our econo-mists forecast that eurozone GDP willincrease by 1% in 2014 and 1.5% in2015—the demand for power shouldalso follow an upward trajectory. Thisincrease in economic growth and powerdemand should sustain the support forrenewable energy schemes in themedium-to-long term.










Credit Rating or Rating Outlook. CW





Tania Tsoneva, CFALondon (44) 20-7176-3489

Alf StenqvistStockholm (46) 8-440-5925


Carbon Markets

News of the successful issue of the largest-ever green

bond by French power company GDF Suez last week is

shining a spotlight on this emerging area of corporate

finance. At €2.5 billion (US$3.4 billion), GDF Suez’s issue

represents close to a third of the total €7.6 billion ($10.4 billion)

of corporate green issuance since November last year, and

almost doubles the previous record of €1.4 billion ($1.9 billion)

set by another French power company, Electricite de France.

Standard & Poor’s Ratings Services estimates that, based on

year-on-year growth trends, the corporate green bond market in

2014 will be double the size of last year’s total green bond

issuance, at around $20 billion.

The Greening Of The CorporateBond Market


Overview● The corporate green bond market is

gathering convincing impetus, with

a number of large transactions

since November last year scaling

the market up to $10.9 billion.● In our view, corporate green bond

issuance is likely to accelerate not

only because this aids diversification

of investor pools for issuers, but

because of the growing intent of

investors to implement environ-

mental, social, and governance goals.● So far, corporate green bonds have

mostly been issued in Europe, with

investment-grade ratings generally

of 'A+', 'A' or 'A-'.

These mega deals show the rising impor-tance of green bonds as a source of cap-ital, driven by both the needs of corpo-rates, as well as the desire by investors

to allocate capital to socially responsibleand environmentally sustainable invest-ments. The aim for both issuers andinvestors alike is to develop a large and

liquid market to reduce transaction andinvestment costs.

Corporate issuers see green bonds asan alternative financing avenue, offeringaccess to a diversified investor base, plus ameans of implementing and maintainingefficiency measures considered environ-mentally sustainable. A key distinction ofgreen bonds from mainstream corporateissuance is that proceeds are ring-fencedand allotted to finance or refinance proj-ects addressing environmental issues. Sofar, investors have not shown any discrim-ination against corporate green bonds,with oversubscription of many issues todate. Standard & Poor’s believes this trendis likely to continue, as green issuanceshifts away from multilateral developmentbanks toward mainstream corporates. Thefuture development of the green projectbond market could also see the aggrega-tion of environmental projects to formdebt obligation instruments and anincreased focus on the refinancing ofexisting environmental projects.

The Climate Bonds Initiative (CBI), anonprofit organization that promotesinvestments to combat climate change,predicts total green bond issuance fromall sectors will reach $40 billion in 2014.However, based on the amount of greenbond issuance so far this year, we thinkthat half this figure could easily bereached by corporate issuance alone.Entry into this expanding market isenabling corporates to tap an additionalpool of investors who are committed toprinciples of socially responsibleinvesting. In our view, corporateissuance is likely to accelerate not onlybecause this aids diversification ofinvestor pools, but because of investors’growing intention to implement environ-mental, social, and governance (ESG)targets initiated by the United NationsPrinciples for Responsible Investment(PRI). As of April 2013, the 1,188investors who had signed up for the PRIrepresented approximately $34.0 trillionof assets under management (AUM),which was over 2.5x the amount fiveyears previously (see chart 1). In addition,the PRI has encouraged 30 stockexchanges to enhance ESG disclosuresamong their listed companies.



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© Standard & Poor’s 2014.Source: United Nations Principles for Responsible Investment (PRI).

AUM (right scale)No. of signatories (left scale)A

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Chart 1 Growth Of Principals For Responsible Investment Initiative

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Chart 2 Distribution Of Green Bonds By Coupon Range

Automakers Consumerproducts

Real estate Forest andpaper products

Engineeringand

construction

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(Industry group)

012

345

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(Average maturity)


Chart 3 Average Corporate Green Bond Maturity By Industry Group

Green Bonds ExplainedCrucially for investors, the credit risk of acorporate green bond remains on theissuer’s balance sheet. This means that,unlike with multilateral bank issuance,investors do not have to sacrifice yield togain green exposure, nor significantlyincrease their risk profile to invest in assetsthat aid environmental efforts. This can sat-isfy investors’ requirements for yield, whilesafeguarding their reputation for sociallyresponsible investing. Investors are alsolikely to examine an issuer’s environmentaltrack record and reporting standards along-side participation in such initiatives,increasing the need for rigorous disclosurein offerings. Investors in green bonds alsowant assurance that the proceeds are beingused to enable environmentally sustainableoutcomes. In addition to this, according toa recent report by Societe Generale,investors have raised concerns regarding

the lack of verification of how the proceedsof green bonds are used (see Note 1). Wetherefore expect a revision to standardsused for green bond issuance to boostinvestor confidence, including those gov-erning the use of proceeds.

A group of financial institutions hascreated a set of green bond principles toenable issuers to categorize their bondsas “green.” In all cases, the proceedsshould be exclusively applied towardnew or existing projects that promoteclimate and sustainability actions. Thereare currently four types:● Green use of proceeds bond: with

recourse to issuer;● Green use of proceeds revenue bond:

nonrecourse to issuer—credit expo-sure is to the pledged cash flows ofrevenue streams, fees, taxes, etc.;

● Green project bond: investor hasdirect exposure to the risk of the

project with or without recourse toissuer; and

● Green securitized bond: collateralizedby one or more projects, e.g., coveredbonds or asset-backed securities.

The Market Is Growing As Corporates Issue Billion-Dollar DealsCorporate green bonds still make up a rel-atively small percentage of the total greenbond market, at about 30%, and aredwarfed by the size of mainstream corpo-rate bond issuance, which according toS&P Dow Jones Indices stood at $18 tril-lion as of April 2013. Nevertheless,despite facing issues of volume, liquidity,and regulatory monitoring, the corporategreen bond market has gathered con-vincing impetus since late 2013, with anumber of large transactions expandingthe market to $10.4 billion. In November


Standard & Poor’sCompany name Industry group credit rating Amount issued ($) Maturity date Coupon (%) Issue price

Acciona SA Engineering and construction NR 86,596,500.0 29/04/2024 5.6 100.0

Arise AB Utilities NR 167,087,000.0 25/04/2019 3.9 100.0

Electricite de France Utilities A+ 1,899,840,000.0 27/04/2021 2.3 99.6

GDF Suez Utilities A 1,777,160,000.0 19/05/2026 2.4 98.5

GDF Suez Utilities A 1,640,450,000.0 19/05/2020 1.4 99.3

Iberdrola International BV Utilities BBB 1,036,770,000.0 24/10/2022 2.5 N/A

Regency Centers LP Real estate NR 250,000,000.0 15/06/2024 3.8 99.5

Rikshem AB Real estate NR 15,249,200.0 20/05/2016 1.1 100.0

Skanska Financial Services AB Engineering and construction NR 130,886,000.0 08/04/2019 1.9 100.0

Svenska Cellulosa AB SCA Forest and paper products A- 154,240,000.0 02/04/2019 1.6 100.0

Svenska Cellulosa AB SCA Forest and paper products A- 77,120,000.0 02/04/2019 2.5 100.0

Toyota Automakers AAA 560,000,000.0 15/08/2016 0.4 100.0



Toyota Automakers AA+ 43,750,000.0 15/04/2020 0.0 N/A

Unibail-Rodamco SE Real estate A 1,025,360,000.0 26/02/2024 2.5 98.7

Unilever PLC Consumer products A+ 414,200,000.0 19/12/2018 2.0 N/A

Vasakronan AB Real estate NR 152,272,000.0 25/05/2016 1.3 100.0

Vasakronan AB Real estate NR 152,158,000.0 24/10/2016 1.3 N/A



Vasakronan AB Real estate NR 45,681,600.0 25/05/2016 1.8 100.0

N/A—Not applicable. NR—Not rated.Source: Bloomberg Professional.

Credit Fundamentals Of Corporate Green Bonds

2013, the first billion dollar issue arrivedin the form of Electricite de France’s(EDF) $1.9 billion 7.5-year green bond,which was twice oversubscribed. Interms of the mainstream green bondmarket, this was significant, not justbecause of its size—this was the largestto date at that time—but because it wasissued by a corporate entity with a ratingof ‘A’. Up to then, green bonds hadmostly been issued by multilateral devel-opment banks with ‘AAA’ ratings.

Next to break the $1 billion benchmarkwere Unibail-Rodamco SE with a $1 bil-lion 10-year bond and IberdrolaInternational BV with a $1 billion 8.5-yearbond. Unibail’s green bond was 3.4x over-subscribed and illustrated the real estatecompany’s ability to diversify its sourcesof funding. It met investors’ greenrequirements as its proceeds can only beused to finance building in compliancewith the Building Research Establishment

Environmental Assessment Method sus-tainability standard. Iberdrola’s bonds,which will finance wind power and smartmetering environmental projects, faredeven better, as it was 4x oversubscribeddespite only offering a 2.50% coupon, thelowest offered by the Spanish utility todate. Most of these green bonds areissued at par or discounted by less than1.6% (see table). This month has seen thelargest corporate green bond issuance sofar, with GDF Suez’s $3.4 billion dual-tranched green bond. It comprised a six-year 1.375% coupon and a 12-year2.375% coupon. Orders were 3x oversub-scribed, evidence of the continuingstrong demand for corporate greenbonds, with approximately 65% of alloca-tions coming from investors managingsocially responsible investment funds.The proceeds for this deal will be used tofund renewable energy and energy effi-ciency projects.

Alongside these transactions, Unileverbecame the first fast-moving consumergoods company to issue a corporategreen bond, the proceeds of which willbe used for a wide variety of environ-mental projects globally, and intendedto aid diversification. Vasakronan, aSwedish property company, has alsoissued just under $1.3 bi l l ion ofunrated corporate green bonds so farthis year, in f ive smaller deals.Investors were 100% Swedish andalmost all were pension funds.

While the corporate green bondsissued so far have been from well-knownand higher-rated ESG names in themarket, they could pave the way forother corporate entities. Furthermore,the bonds have been issued in Europe,backed by a gradually improving eco-nomic outlook. This may change ifgreen bonds attract U.S. investors, whoenjoy a larger source of liquidity in theirdomestic markets.

The Make-Up Of The MarketCoupons for corporate green bondstend to be about 2%, with fixed rates fornearly all issuance ranging between0.0% and 4%, and virtually none over4% (see chart 2). This typically suggeststhat corporate green bonds are beingmarketed as low-to-moderate returninvestments. Such return characteristicsare commensurate with their maturityprofiles (see chart 3). Maturities are typi-cally between four and eight years forall industry groups, making themmedium-length investments. Auto -makers, consumer products and realestate, and forest and paper productsare at the low end of the spectrum withaverage maturities nearing four years,while engineering and construction andutilities are at the high end, headingtoward maturities of eight years. Longermaturities increase their risk profiles,which is understandable, given thatthese industries have longer researchand development timeframes andinvolve higher capital expenditure(capex) for construction.

Issuance to date has come from anumber of industries, but has been ledby utilities, which represent 62.5% (see



Utilities (63%)


Forest and paperproducts (2%)Consumer

products (4%)

Automakers (12%)

Chart 4 Distribution Of Green Bonds-By Industry Group

Real estate (17%)

Engineering andconstruction (2%)

AAA AA+ A+ A A- BBB NR0.00.51.01.52.02.53.03.54.04.55.0

NR—Not rated.

© Standard & Poor’s 2014.Source: Bloomberg Professional.

Automakers Consumer products Engineering and constructionForest and paper products Real estate Utilities

Chart 5 Distribution Of Green Bonds-By Standard & Poor’s Credit Rating

chart 4). In part, this is because the twolargest offerings to date were from EDFand GDF Suez, totaling $5.3 billion. Inthe future, we expect corporate greenbonds could be issued by a variety ofindustry groups, and will likely be con-centrated in industries that are consid-ered lower-risk, are already experiencinggood growth, and where upfront coststend to be smaller.

Unlike multilateral development banks,which are mostly rated ‘AAA’, ratings forcorporate green bond issuers are spreadover the investment-grade spectrum from‘AAA’ to ‘BBB’, with the majority at ‘A+’or ‘A’ (see chart 5). We think this couldboost confidence among prospective cor-porate issuers who are rated ‘BBB-’ orabove, aiding market volume. In addition,European companies have issued anotable amount of unrated green bonds($1.2 billion), including Vasakronan AB,Skanska Financial Services AB, and AriseAB. These have all achieved couponsunder 4%, with the longest dated maturitybeing five years. In our view, this signalssolid investor confidence, particularly incountries where these corporate entitiesoperate, as demonstrated by 100% ofVasakronan’s green bonds being boughtby local investors.

Future ProspectsIn the current market, a lack of economiesof scale are an obstacle to speculative-grade corporates interested in issuinggreen bonds, or higher-rated compa-nies with smaller funding needs. Asthe market cont inues to develop,smaller environmental projects may beable to attract f inancing by aggre-gating into larger investment offerings.This could make them more suitableto larger investors.

We think it likely that the market willbegin to see structuring of bonds toenhance credit support. We have alreadyseen evidence of this from Toyota; it usedsecuritizations of car loans to collateralizeits corporate green bonds, which werequickly oversubscribed. Notably, theunderlying collateral in these transactionswas not considered “green,” but the pro-ceeds will still be allocated to fund greencar development.

Furthermore, we think the next stageof market evolution will involve a shiftin credit risk away from corporate enti-ties, moving financing for environ-mental projects off their balance sheets.With corporate green bonds, the creditrisk for the investor remains linked tothe issuer’s general corporate credit-worthiness, with bond proceeds typi-cally being earmarked for environ-mental purposes. Environment-relatedprojects tend to have high upfrontcapex, low maintenance costs, and, ifbacked by government subsidies, rela-tively stable revenue streams. However,mainstream investors may not yet bewilling to take on project finance-styleconstruction risk. In the short term, weexpect this type of green bond will berelated to the refinancing of existingprojects or assets, since it tends toinvolve lower risk for investors. Thesecond stage of growth may come inaggregation, where the risk to investorswill depend on factors such as the typeof environmental projects, how manyprojects are in the debt pool or port-folio, and whether construction hasbeen completed. This method has thepotential of increasing the overall creditrating on the portfolio for the combinedprojects, thus enhancing the likelihoodof mainstream investor interest. CW

NOTES(1) Credit Themes: Green Bonds—State of

Play, Societe Generale Cross AssetResearch, May 15, 2014










Credit Rating or Rating Outlook.


Analytical Contact:



Green Bond Market

SPECIAL REPORT


FEATURES

EDITOR’S NOTE: The authors of this article are Anadi Jauhari, CAIA, Senior Managing Director andFounder, Emerging Energy and Environment Group and Infra Credit Alpha (1), and Julia Kochetygova,Senior Director S&P Dow Jones Indices. The thoughts expressed in this article are those of the authorsand do not necessarily reflect the views of Standard & Poor’s Ratings Services.

The green bond market has continued to mature since its

inception in 2007, when the European Investment Bank

first issued its Climate Awareness Bonds series. The first

tranche took the form of a €600 million five-year bond, linked to

the performance of a European corporate environmental index,

designed to identify European companies building

environmentally sustainable businesses.


Green Fixed-Income Indices

A Natural Outgrowth OfThe Green Bond Market

Overview● While the green bond market is still in the early stages of establishing whether it

can provide capital at scale for the low-carbon economy, it has reached an inflection

point and is poised for growth and takeoff.● The threat of climate change is real, and investors will begin to refocus their

portfolios, investment mandates, and mission statements to address its negative

effects. ● Capital needs for the development and creation of low-carbon infrastructure point

to the potential of long-term debt issuance, which can provide a good fit to meet

investor mandates.● Growth of the market is building the foundation for an asset class to emerge, which

is creating the need for green fixed-income indices.

Since then, the market has expanded insize and scope to include diverse issuersand investors, maturities, currencies, andcredit ratings. The early issuers were prin-cipally highly rated multilateral develop-ment banks (MDBs or supranationals),which have a mandate to channel fundsinto climate and environmental projects.Because these projects tended to besmall, with the attendant execution risks,they needed the credit capacity of theMDBs’ strong balance sheets for raisingcost-effective capital. With their high rat-ings, combined with a transparent mecha-nism established under the bond struc-ture to assure that proceeds went solelyto the targeted environmental projects,MDBs succeeded in developing aninvestor base that was seeking safety withsome ability to satisfy its environmentalmission. Our research of the market indi-cates that green bonds will continue theirgrowth trajectory to create the foundationfor green bonds to be treated as an assetclass. This will likely pave the way for theadoption of and demand for green fixed-income indices.

Green bond issuance of about $30 bil-lion (estimated) in 2014, compared with$11 billion in 2013, is still a very smallfraction of the $157 trillion global fixed-income market (McKinsey, 2011). Yet, ithas grown at a 50% plus compoundannual growth rate since inception,albeit from a small base, with significantoversubscriptions, increasing issue sizes,and market liquidity.

We believe that growth in the greenbond market is the result of a number ofconverging trends:● The growing awareness of climate

change by investors and the public,and of its potential impact on busi-nesses, human life, and asset values;

● The recognition that a low-carbonpathway for the global economy tokeep global temperatures withinacceptable limits requires vastamounts of long-term cost-effectivecapital, which only institutionalinvestors can provide at scale viafixed-income instruments that arerated at least investment grade; and

● The development of voluntary criteriaand standards for green bonds.

Green Standards Are Crucial For Market ConfidenceAt its core, the “green” bond concept is amarket innovation that provides for effi-cient capital intermediation betweeninvestors and environmental and climateprojects. What’s innovative is the identi-fication and labeling of a specific bondissue as “green” based on transparent,independently verifiable qualifying cri-teria. The green labeling helps the issuerachieve a desired rating or credit qualityand pricing level that is sufficient to clearinvestor demand for a bundled productof fixed-income and green attributes.Such criteria were fundamental to theestablishment of Green Bond Principles(GBP) by industry participants, includingmajor banks and nonprofits, committedto the growth of the green bond market.

Green bonds, considered a subset ofthe universe of climate bonds and of theeven broader set of thematic bonds, arenot new instruments. The Climate BondInitiative, a nonprofit, estimates that morethan $346 billion in climate bonds are cur-rently outstanding. But we believe that’s aconservative estimate. The amount ofgreen bonds outstanding would be higherif the GBP labeling criteria and guidelinesfor green bonds, adopted in 2013 to 2014,were to be retroactively applied to bondsissued before then by projects and compa-nies that produce carbon-free energy orhave other climate benefits.

A bond issue is green, according to cur-rent GBP guidelines, if the issuer uses theproceeds solely for capital expendituresassociated with green or climate environ-mental benefits, according to certain disclo-sure and transparent “policing” standards.This use of proceeds neither specifies thetype or the nature of the project, nor man-dates a certain level of climate or environ-mental benefits. Moreover, under currentGPB criteria, a third-party provider is toensure compliance with the use of proceeds.

Will Green Bonds Evolve As An Asset Class?For an asset class to develop, it shouldachieve not only a certain critical mass interms of size and liquidity, but also attracta wide range of investors, issuers, andintermediaries that constitute all of the



links in the market, that is, the entiregreen bond “ecosystem.” These buildingblocks provide the necessary trans-parency, and are important in creatinginvestment opportunities of varying risk-returns that issuers and investors canaccess efficiently. As a subset of thebroader global fixed-income market, weexpect the green bond market to developover time to price in not only credit,interest rate, and liquidity risks, but also“green” attributes, depending on thespecifics of the bond structure, to meetspecific environmental mandates, or as asource of additional return or alpha.

Our analysis suggests that the greenbond market will emerge as a distinctasset class, given its potential size, scale interms of breadth and depth, and expectedinvestor interest and demand for its fixed-

income and green characteristics. By thecurrent year-end, we estimate that themarket may grow to about $40 billion to$50 billion in labeled green bonds out-standing. “Non-labeled” or “perceivedgreen” bonds, comprising renewableenergy project bonds, may amount to anadditional $10 billion to $15 billion. Theimproved integrity of the green bond cer-tification and verification process andstandards, as well as the emergence ofindependent service providers, will likelyfurther enhance information efficiency asthe market matures.

Demand For Issuance MayExceed $200 Billion A YearWhile estimates vary depending on thesource, investments in low-carbon infra-structure could range from 1% to 3% of

global GDP, or in excess of $1 trillion ayear through 2050. Green investments, bydefinition, are intended to reduce carbonfootprints or reduce the impact of climatechange, and may potentially involve cap-ital-intensive sectors such as transport,energy, and water. Even if assuming amodest fraction of total investment needsor available investor capital, the potentialissuance can range easily from $50 billionto $200 billion a year.

The demand for low-carbon infra-structure capital will not come just fromthe developed world, which needs toreplace and upgrade its aging infrastruc-ture, but also from the developing world,which faces the daunting challenge ofbuilding new infrastructure. Institutionaland retail capital, intermediated throughpooled investment vehicles, banks, and


Issuer type Illustrative type of green indices Illustrative issue/index constituent

Global issuers

GBP-labeled green Global labeled green bond index Labeled issuers include International Finance Corp., EuropeanInvestment Bank, International Bank for Reconstruction andDevelopment, Financierings-Maatschappij voorOntwikkelingslanden (FMO), African Development Bank, aswell as corporate, municipal, subsovereigns (see below)

Global issuers

GBP-labeled green Global labeled green bond index As aboveNonlabeled green but applies GBP Global universal green bond index OFTO, Topaz, St. Clair

Corporate issuers

Corporate green bond index Bank of America, EdF, Iberdrola, Arise, Skanska, EdP, Unilever,GDF Suez

U.S. municipal

U.S. municipal green bond index Hawaii, Massachusetts● General obligation● Revenue bonds

Subsovereign

Subsovereign green bond index Île-de-France, City of Gothenburg (Sweden)● OECD● Non-OECD

Project bonds (single asset and portfolios)

Green project bond index Topaz, Breeze, Alta Wind Holdings● Investment grade● Speculative grade

Bank loans

Green bank loan index Multiple● Rated and nonrate● Investment grade and speculative grade

Asset-backed securities

Green ABS SolarCity, Hero Funding, Hannon Armstrong, Toyota● Solar● Energy efficiency

GBP—Green Bond Principles.

Potential Evolution Of Green Indices

foreign or local capital markets, willlikely fund the build-out, resulting inlong-term asset creation. A large part of“green capital” will be in the form ofdebt, supported by long-lived assets.

The challenge in capital formation isthe efficient aggregation of green assetsto achieve a target credit quality.Alternatively, these assets could becomepart of larger and stronger balancesheets that could attract capital at adesired risk-return level. Green projectsby their very nature not only lack scale,size, and homogeneity, but also are likelyto exhibit risk and complexity profilesthat might deter investors from investingin the green bond asset class, necessi-tating aggregation via specialized inter-mediaries and “derisked” vehicles.

Green Investor Mandates Are GrowingThe green bond product appeals to arange of investors. Recent green bondissuances have attracted not only SRIand ESG investors (sustainable andresponsible investing, and environ-mental, social, and governance), but alsotraditional institutional investors, such aspension funds, corporate pension plans,endowments, and insurance companies.This is a positive market developmentthat has widened the traditional investorbase for many issuers. While the recentgreen-labeled issuances have been sig-nificantly oversubscribed, investors havegenerally not compromised their risk-return and yield requirements whilegaining exposure on the green or sus-tainable aspects of the issues. Asissuance expands across the credit andmaturity curves, with assets in varying“shades of green,” investors may take amore nuanced and a differentiated viewin pricing credit, liquidity, and greenrisks. It is unclear at this stage whethergreen bond issuances will price moretightly than equivalent nongreen issuesat the same ratings and liquidity levels.

Given the vast potential for issuer andratings diversity as the market grows, itis reasonable to expect that not only willgreen bonds likely provide an outlet tomeet the growing investor environ-mental and sustainable mandates, but

also, potentially, satisfy additional invest-ment considerations. These mightinclude liability and duration matching,stable and inf lation-linked returns insome cases, and diversification fromother asset classes such as public equi-ties. The trend toward incorporating cli-mate change as a long-term risk consid-eration into strategic asset allocationdecision-making by institutionalinvestors may also prompt a shift (or agreater allocation) to green fixed-incomeand other climate-sensitive asset classessuch as infrastructure, farmland, and realassets, which require a longer-term per-spective. Over time, green bondfinancing structures may begin to pricein climate change-related risks, thus pro-viding an avenue for diversificationamong investors.

According to TD Research, institu-tional investors hold 72% of long-terminvestments in the global fixed-incomemarket and are therefore likely to be avital source of long-term funding forlow-carbon infrastructure. Denmark’sATP pension fund, for example, has ded-icated US$1 billion toward climatechange investment. Many large institu-tional investors, such as California StateTeachers’ Retirement System (CalSTRS),have integrated consideration of climatechange into their asset allocation deci-sions and invest in investment-gradeassets that provide some protectionagainst the volatility of climate change.The development of local capital mar-kets in larger emerging markets in LatinAmerica and Asia, especially, as localpension funds and other institutionalinvestors move away from governmentbond investing in these markets, will alsolikely be a source of green debt funding.

Meeting Risk-Return DemandsOver time, green projects will be aggre-gated in portfolios, pooled, or moved tolarger corporate balance sheets and securi-tized, to achieve risk profiles that enablecapital to be raised most efficiently. Newintermediaries are entering the ecosystem.We are already seeing the emergence of“green” monolines (such as AscendingMarkets Financial Guarantee Corp.), multi-laterals (like the Inter-American



Development Bank), and mission-drivennon-profit capital (Clean Technology Fundfunded by major sovereigns) to providecredit enhancement—despite the demiseof the monoline model in the aftermath ofthe global financial crisis.

Over time, similar to credit ratings,some form of green ratings, aimed atquantifying the environmental benefits,could come into existence to allowinvestors and issuers to differentiatebetween the shades of green and the cli-mate change impact.

Government regulation and politicalsupport for the development of low-carbon infrastructure, as well as fiscaland tax incentives, will drive institutionaland retail investor interest in the sector.The conventional wisdom is that infra-structure investment creates jobs andstimulates economic growth, and willlikely create a conducive environmentfor long-term capital formation.

Green Indices Are The Next PhaseIndices have been an integral part ofmarket development and maturation.They provide transparency into the char-acteristics of markets and the inde-pendent tracking and reporting of per-formance. Independent and transparentindices create the basis for a wide rangeof investment strategies, which can fur-ther foster liquidity in those markets.

As investors begin to allocate a shareof their fixed income to green investing,it is reasonable to expect that greenbonds will mainstream into the fixed-income universe, creating a strong needfor green indices. Even in its currentphase of growth, and despite themarket’s current early formative stage,our research, based on investor feed-back, suggests that as investor interestand concerns over climate change con-tinue to grow, green indices are neededto achieve transparency and simplicity,as well as the commoditization of theasset class. Over time, this will result inmore debt capital committed to greenassets, lowering the cost of capital. Suchincreased capital efficiency is key to thedeployment of capital at scale in low-carbon infrastructure.

In general, we expect the develop-ment of green fixed-income indices tomirror that of the green bond market,and the indices to pattern themselvesafter their general fixed-income counter-parts. For example, such indices mayinclude global and regional subfamilies,as well as different types of issuers andrating levels. As the green label stillremains a voluntary standard at theoption of the issuer or investor, themarket may continue to see labeled andnonlabeled green issuances, unless thestandard allows issuers to raise debtmore efficiently, while meeting investorrisk-return and environmental mandateexpectations. One decision for indexproviders, then, is whether to includeonly labeled green bonds in their prod-ucts, or offer two different kinds of prod-ucts, or include both in one product.

What follows is an indicative sketch ofthe likely development of green indicesover time based on our reasonableexpectation of market growth (see table,

where the top rows of the first column repre-

sent where issuance stands today). The ini-tial indices will likely be based on greenbonds that follow the current greenlabeling guidelines, and may expand toinclude other types of green assets notlabeled green but that satisfy the criteriaunder GBP. Additionally, we believe themarket will evolve to provide more gran-ular indices as interest in the asset classgrows. Depending upon growth of thesegments in the green bond market,each index may be made more granularby the green asset’s subsector (solar,wind, energy efficiency); asset type (mit-igation versus adaptation); country ofdomicile for the assets; ratings; andissuer type.

(1) Based in Stamford, Connecticut,Emerging Energy and EnvironmentGroup (EEE) is an alternative investmentfirm focused on clean energy invest-ments, with offices in Mexico City andRio de Janeiro. Infrastructure CreditAlpha Group is EEE’s credit research affil-iate focused on innovative finance. CW



Green Fixed-Income Indicies

SPECIAL REPORT


FEATURES

Limited Visibility For Climate Change’sEffects On U.S. State And LocalGovernment Credit Quality


Weather-related events place local governments, which are

generally the first responders to disaster, on the front lines of

caring for their citizens. They must also manage budget

volatility following such events, as well as repair and adapt their

infrastructure to prepare for changing risks. In Standard & Poor’s Ratings

Services’ experience, U.S. municipal and state governments have

historically been able to manage the risk of natural disasters without

diminishing their credit quality. The credit impact of most natural

disasters has been limited. There are some exceptions, however:

Hurricane Katrina, which hit an underprepared Gulf Coast at a time when

the federal government was ill-equipped to respond, led to a number of

negative credit actions on local communities and Louisiana, and

Hurricane Ike led to a downgrade of Galveston, Texas’ general obligation

and water and sewer ratings. To some extent, our ratings on local

governments and states incorporate the potential for disasters in high-risk

areas, such as the Gulf Coast and the earthquake-prone West, by

considering financial flexibility and liquidity in the context of potential

losses from a major storm or quake. However, the potential for

increasingly frequent climate-related disasters makes the issue more

relevant for local governments all across the U.S.

Overview

● Climate-related disasters have the

potential to pressure some U.S.

local governments' credit quality if

severity increases and the federal

government isn't responsive.● However, thus far, the impact of

such disasters on affected state or

local governments' credit quality

has been limited to a very few

severe cases.● The major threats to credit quality

are depressed economic growth,

increased costs for recovery and

infrastructure at a time of lower

revenues, and reduced federal

government support.

While the timing and severity of weatherevents remain unpredictable, theincreasing uncertainty arising fromchanging climate patterns represents adifficult-to-quantify risk for local govern-ments. This risk could result in morecredit pressure for local governments ifthe federal government were to not pro-vide timely and sufficient financial sup-port for relief, or if the local govern-ment’s ability to prepare fordisasters—for example through improve-ments that reduce the impact on infra-structure of extreme weather, trans-portation adaptation, or flood controlmeasures—comes at the cost of finan-cial flexibility and increased leverage.

In our 2011 article on natural disastersand credit quality (see “Ready for the Big

One? How Natural Disasters Can Affect U.S.

Local Governments’ Credit Quality,” pub-

lished Oct. 27, 2011, on RatingsDirect), wenoted that Standard & Poor’s evaluatesthe impact of natural disasters in light ofkey credit factors—both quantitative(such as the government’s financial posi-tion and the tax base’s relative strengthand diversity) and qualitative (includingmanagement’s emergency preparednessand the adequacy of its response).

The Effects Of Weather EventsOn U.S. Municipal GovernmentsThe immediate effects of extreme weatheron local governments may include volatilefiscal performance, strained liquidity,increasing debt burdens, and economic lossduring periods of extended extremeweather or disaster recovery. While federaldisaster relief is available, increasedrecovery costs for local governments couldresult if future federal government austerityaffects reimbursement levels. Even whenfederal relief is available, it might not com-pletely cover the loss of taxing and revenuecapacity for entities that rely on propertytaxes and retail sales, and distribution of fed-eral funds can take several years.Municipalities, therefore, may be tasked withmanaging the immediate disaster costs—foremergency response costs, debris removal,and restoration of services—using immedi-ately available liquid resources at a timewhen revenue streams, such as sales taxesand development-related fees, may tem-

porarily decline. If future federal budgetswere to limit disaster relief (from the FederalEmergency Management Agency, forinstance), an increase in the magnitude andfrequency of weather-related events couldexacerbate this dynamic over time, forcinglocal governments to assume more of therecovery costs.

Perhaps most difficult to measure are thelong-run economic consequences of afailure to prepare for climate change. In thepast two years alone, major weather eventshave been severe enough to put a dent innational GDP growth for a short time. Bysome estimates, the deep freeze that grippedthe eastern U.S. in early 2014 crimpednational first quarter 2014 GDP growth byone- to two-tenths of a percentage point,and Superstorm Sandy lowered growthduring the fourth quarter of 2012 althoughthe recovery effort quickly boosted outputonce again. At the local and regional level,short-run economic effects may be morepronounced and are sometimes accompa-nied by lost taxing capacity when a portionof the property tax base is damaged. Theinterdependence of urban infrastructure,such as water and wastewater, power, trans-portation, and communications systems canmagnify the downside risk, as we saw fromthe damage to the entire New York metro-politan region and the New Jersey coast fol-lowing Superstorm Sandy.

These short-term losses may be fol-lowed by a rebound in GDP as construc-tion and rebuilding activity ramp up fol-lowing a disaster. Over the long run,however, taxing capacity at the local levelmay suffer if, for example, there are signifi-cant out-migrations as occurred followingHurricane Katrina, or if reconstruction anddevelopment are prohibited in high-riskareas following a disaster, as has occurredin many communities in the Gulf Coast. Inother cases, such as in California’sSacramento Valley, we have observed thedampening effect of weather-related riskon private development activity in high-risk areas as insurers tighten their under-writing standards for disaster coverage,and governments place constraints onnew development. This limits the tax basegrowth that many municipal issuers relyon to fund their recurring and disaster-related expenditures.




Responding To Climage ChangeRisk: Local Strategies And TheirCredit EffectsState and local governments are key stake-holders in national climate change-relatedefforts. States create policies and programsthat encourage or discourage adaptationand mitigation at all levels of governmentthrough regulation, funding, and publicadoption of “clean” technologies.Currently, many state and local govern-ments’ efforts to address climate changehave focused on land-use planning andincremental improvements to public facili-ties and infrastructure. Some state andlocal efforts to reduce carbon emissionshave also been undertaken: most notably,in 2012, California became the first state toimplement a cap-and-trade program toreduce greenhouse gas emissions, whichgenerates a relatively small amount of rev-enue for the state, but which we believe hashad little effect on the state’s credit quality.

A growing number of state and localgovernments are also making adaptiveimprovements to reduce the effects ofweather events on critical infrastructure.These include flood control improve-ments and water storage and deliverysystem upgrades, as well as storm pre-paredness improvements by utility andtransit providers to increase infrastruc-ture resistance to severe storms.

In California’s Sacramento Valley, forinstance, joint federal and local efforts arecurrently underway to finance leveeimprovements designed to achieve 200-yearflood protection, according to FEMA’s mostrecent standards, which have becomestricter in the wake of Hurricane Katrina andsubsequent storms. These types of financingprojects increase debt burdens and cost-sharing with federal and state agencies. Ifshared revenues and tax-supported debttogether are not sufficient to cover costs,these projects may have the potential toerode credit quality by placing strain onresources available for capital spending.

New York State’s Sea Level Rise TaskForce is one example of a nonfederaleffort to identify and address climatechange. The 2010 task force report iden-tifies the risks associated with climatechange—particularly rising sea levels—to communities and infrastructure. It

also recommends actions for state andlocal governments to undertake toaddress these risks, including studyingthe impact of sea-level change on com-munities, making regulatory changes toaddress sea level change, implementingfunding mechanisms, and seeking fed-eral aid for adaptation and disaster-pre-vention measures. However, the recom-mendations are short on cost details.

In our view, New York’s task force andthe California investment highlight someof the efforts underway to understandand mitigate weather-related vulnera-bility. We expect continued focus on thisarea given the pattern of natural disasteractivity over the past decade. The paceand progress of actual investments willlikely be slow due to funding constraintsat all levels of government.

What’s Costlier, Preparing Or Doing Nothing?Ultimately, the risk for U.S. public financeissuers of a changing climate emanatefrom the impact of unpredictableweather patterns on infrastructure andeconomic growth. While we continue tobelieve that local governments—in col-laboration with regional, state, and fed-eral entities—can withstand the effects ofextreme weather with limited impact oncredit quality, only time will tell whetheran increase in the unpredictability of cli-mate-related events will make ratingsmore volatile. But as evidence of climatechange and related risks mounts, thecosts associated with not preparing forthem may continue to grow. CW


Sarah SullivantSan Francisco (1) 415-371-5051

Robin L. PruntyNew York (1) 212-438-2081

Lindsay WilhelmNew York (1) 212-438-2301

Victor M. MedeirosBoston (1) 617-530-8305

Horacio G. Aldrete-SanchezDallas (1) 214-871-1426

Jeffrey J. PrevidiNew York (1) 212-438-1796


Climate Change

SPECIAL REPORT


FEATURES

In October 2012, Superstorm Sandy knocked out electric

service to 1.4 million of New York’s Consolidated Edison

Inc.’s approximately 3.3 million electric customers and about

920,000 of Long Island Power Authority’s (LIPA) approximately

1.1. million customers. The lights also went out for about 1.7

million of New Jersey’s Public Service Electric & Gas Co.’s

(PSE&G) 2.2 million electric customers. For many, the outages

lasted weeks, resulting in strong economic impacts that

reverberated through the region as businesses closed and

gasoline sales ground to a halt. Because the repercussions of the

storm-related power outages were so wide, utility and

government of ficials realized they needed strong utility

responses to prevent this from happening again. Specifically, the

utilities clearly needed to pursue investments in what the

industry calls “storm hardening.”

Although these utilities’ solutions andtheir costs share common elements, thefunding sources available reflect varyingviews among government officials as towhere the financial responsibility forfunding these investments lies. The avail-ability of federal aid is also an importantelement of the funding solutions.Standard & Poor’s Ratings Servicesbelieves that the means for funding andcost recovery can be important factorsin determining credit quality.

The Storm-Hardening Programs’Common AttributesGiven the breadth of these utilities’service areas and their extensive coastalexposures, storm hardening costs will be

substantial—about $1 billion per utility.Common elements of their storm hard-ening programs include raising keystructures, such as substations, toheights that are better able to withstandstorm surges. The utilities will alsoreplace existing poles with strongerpoles in those areas at risk for stormsurges and they will step up activities toreduce the potential for trees andbranches knocking down power lines.

FEMA Comes To LIPA’s AidThe long outages that LIPA’s customersexperienced triggered considerable ireamong customers and politicians,leading to state legislation that imposedgreater regulatory oversight. It whittled

How Utilities Pay For Post-Sandy“Storm-Hardening” InfrastructureInvestments Could Factor IntoCredit Quality


Overview

● After incurring substantial power

restoration costs, utilities affected by

Superstorm Sandy are pursuing siz-

able storm-hardening investments.● The extent to which government

funds are available to defray

these investments or, alterna-

tively, the presence of regulatory

approvals providing for cost

recovery from customers could

have credit implications.

LIPA’s capacity to set rates on its own,subjecting rate adjustments to hearings ifrate increase proposals exceed pre-scribed thresholds. In addition, the legis-lation transformed the utility’s opera-tions by transferring day-to-dayoperations to an affiliate of one of theregion’s investor-owned utilities and setsthree days as the baseline for restoringservice following a major power failure.If LIPA does not meet this target, thesystem operator must provide NewYork’s Department of Public Servicewith an assessment of the utility’s pre-event preparedness and post-eventrestoration efforts. The state also askedLIPA to freeze its base rates for at leastone year, which it did, and the state isseeking a second year on that freeze. Webelieve these actions could reduce theutility’s financial flexibility. We considerfinancial f lexibility to be critical toresponding to potentially volatile costsand preserving credit quality. Our nega-tive outlook on LIPA reflects the con-straints these conditions could imposeon financial performance.

Against the backdrop of the state’sresponse to the storm outages, the utilityfound a financing lifeline in the FederalEmergency Management Agency(FEMA). FEMA reimbursed LIPA forabout 90% of its storm restoration costs.The agency reimburses these types ofcosts for not-for-profit utilities becausethey cannot take advantage of the fed-eral tax benefits that investor-owned util-ities can. Moreover, in an unusual move,the agency also agreed to finance muchof LIPA’s prospective storm hardeningactivities. This decision provides theutility with the capacity to buttress itssystem without incurring substantialinfrastructure investment financingneeds while its base rates remain frozen.The FEMA reimbursement plan helpsshore up credit quality while enablingLIPA to invest in reliability as it facesratemaking constraints.

Limits On Consolidated Edison’s OptionsUnlike LIPA, New York’s ConsolidatedEdison, an investor-owned utility, willnot have the benefit of FEMA resources

to strengthen its system’s stormresiliency. It also funded its stormrecovery and restoration costs differ-ently from LIPA, by capitalizing portionsof its $363 million of spending. Itrecorded the uncapitalized balance as aregulatory asset for deferred recovery. In2012, the company had no current fed-eral income tax liability as a result of,among other things, deduction of costsincurred in connection with Sandy.

Consolidated Edison asked the state’srate regulator for cost recovery for about$1 billion of prospective after stormhardening projects. The regulatorapproved the projects, albeit within aframework of stable rates. We believethat the company will need to effectivelycontrol costs and avoid cost overruns inits sizable capital program to mitigatethe rate freeze’s impact. The costs ofstorm hardening also need to be consid-ered within the context of the recentEast Harlem natural gas explosion.Although the explosion’s cause has yetto be determined, and we believeConsolidated Edison carries insurancethat should cover a portion of potentialcosts if it is found liable, it is our viewthat such a finding could lead to penal-ties and higher compliance costs for theutility’s aging gas distribution system.Our outlook on the company is stable,but possible penalties and additionalcapital investment needs could harm itsfinancial condition and might lead tomodestly lower ratings.

PSE&G Benefits From Supportive State RegulationBy comparison, neighboring PSE&Gappears to operate under more benefi-cial state regulation. On May 1, the NewJersey Board of Public Utilities’ staffrecommended that the regulator allowthe utility to recover from customers

$1.2 billion of the $2.6 billion of the mul-tiyear storm-hardening investments ithad proposed. PSE&G ultimately plansto align its after storm hardeningspending with the amounts the regulatorapproves. Staf f ’s recommendationincludes a 9.75% return on equity on thefirst $1 billion of investment and a rateof return on the balance that this utility’snext rate case will determine.

Vehicles For RecoveringInvestments Can Influence Credit QualityAlthough very dif ferent avenues forfunding storm hardening investmentsare available to these utilities, and someof the investments might weigh nega-tively on credit quality, the utilities andtheir regulators nevertheless are consis-tent in recognizing that investments thatwill help these systems better withstandstorms are critical to enhancing opera-tional predictability and improving cus-tomer satisfaction. Although we believethat these investments can contribute togreater operating stability and benefitutilities’ enterprise and financial risk pro-files, cost recovery—whether from cus-tomers or government reimburse-ments—remains an overarchingconsideration for credit quality. CW



We consider financial flexibility to be critical to

responding to potentially volatile costs and

preserving credit quality.


David N. BodekNew York (1) 212-438-7969

Geoffrey E. BuswickBoston (1) 617-530-8311

Kyle M. LoughlinNew York (1) 212-438-7804

Barbara A. EisemanNew York (1) 212-438-7666

Gabe GrosbergNew York (1) 212-438-6043


Post-Sandy

The storm surge and high winds fromSuperstorm Sandy in October 2012wreaked havoc on New York

Metropolitan Transportation Authority(MTA) and Port Authority of New Yorkand New Jersey (PANYNJ) transportationfacilities. However, despite the significantdisruptions, most MTA services resumedrelatively quickly. Similarly, all of thePANYNJ-operated facilities—includingairports, bridges and tunnels, marine ter-minals, the World Trade Center site, andthe PATH system—returned to full opera-tion within less than a week in most cases.

As a result, the credit quality of both ofthese essential transportation infrastructureproviders did not suffer. Standard & Poor’s

Ratings Services believes these operators’strong contingency plans, which allowed forquick resumption of most services, alongwith their good liquidity positions, ability toobtain additional interim borrowingcapacity, and actions to reinforce steadyfinancial performance, and our expectationof insurance proceeds and federal aiddefraying much of the storm-related costsdemonstrated effective management andmitigated our concerns about the financialfallout from the massive storm.

What We Look For In OurRatings AnalysisDemand, leverage, and capital investmentsare key factors we consider when analyzing

New York-Area TransportationInfrastructure Providers PassedThe Superstorm Sandy Credit Test


Overview

● Superstorm Sandy's impact on trans-

portation infrastructure providers in

the New York City area was signifi-

cant, but quick actions and contin-

gency plans meant that services

resumed relatively quickly.● Management’s strong contingency

plans and quick response were

keys to credit stability.● As a result, despite having to absorb

many of the costs associated with

Sandy-related repairs, these providers

maintained their credit quality.

the creditworthiness of transportation infra-structure providers. The relative impor-tance of each depends on other factors,such as the condition of the local economy,regulations, competition, and management.Overall, Standard & Poor’s expects regionaleconomic activity in 2014 to supportmodest growth in demand for most trans-portation infrastructure providers in the U.S.Credit stress, however, could surface forsome if addressing unexpected shocks(such as natural disasters or security con-cerns) compromises their financial flexi-bility. In these cases, a quick and effectivemanagement response will be critical forthem to maintain the current ratings.

Sandy Didn’t Hurt The MTA’sCredit Standing—In Fact, ItEventually ImprovedWe expect the MTA to recoup most of thecosts of repairing or replacing storm-damaged assets in the next several yearsfrom a combination of insurance and fed-eral government assistance programs.

The MTA’s 2010 to 2014 capital pro-gram (including bridges and tunnels)increased about $10.5 billion (to $34.8 bil-lion) to include Sandy repair, restoration,and resiliency projects. About $4.8 billionof this is for repairing and restoring MTAassets damaged during Sandy, while theremaining $5.8 billion will go toward hard-ening the system against future storms orother catastrophes.

To date, the Federal Transit Administration(FTA) has given the MTA $3.79 billion inappropriated emergency relief funding.We expect the authority to submit addi-tional requests to the FTA for funding ofboth repair and restoration costs andhardening costs from FTA emergencyrelief funds and to adjust its capitalspending accordingly if it receives lessfederal aid or insurance proceeds than itcurrently assumes.

Since Sandy, MTA management has putin place three liquidity facilities that pro-vide the authority with $950 million ofinterim financing capacity. To date, it hasused $300 million. In response to sharpincreases in insurance coverage followingSandy, the authority also decided to sup-plement its property insurance coveragewith a capital markets-based alternative:

$200 million in fully collateralized stormsurge coverage for losses from stormsurges that occur until July 30, 2016.

We believe the added costs did not impairthe MTA’s credit standing because of theauthority’s actions and plans to mitigate thehigher expenditures. In fact, we raised ourrating on the MTA one notch this year afterapplying our revised mass transit criteria.Although we viewed the relatively quickresumption of most MTA services positivelyin terms of our assessment of MTA’s man-agement other factors assessed under ourrevised criteria contributed to the upgrade.One of these included the MTA establishinga $350 million line of credit in January thisyear to bolster its liquidity position.Nevertheless, the rating could face long-termrisk if the MTA’s financial risk profile deterio-rates or its economic fundamentals weakensignificantly. Possible causes for credit stressinclude higher than expected increases inoperating expenses and leverage, less fareand toll revenues due to lower-than-expected demand, fewer state and local sub-sidies, and a material erosion in liquidity.

The PANYNJ’s Credit StandingAlso Remains IntactAs with the MTA, we expect availableinsurance coverage and federal disasterrelief funds will cover much of thePANYNJ’s Sandy-related losses. Theauthority estimates that it lost $2.4 bil-lion, although this figure could rise ifofficials find any latent damage fromsalt-water intrusion at PANYNJ facilities.

The authority’s $2.9 billion 2014 oper-ating budget includes higher insurance pre-mium costs, which rose $18 million fol-lowing Sandy. Its $4.4 billion 2014 capitalbudget includes a $180 million investmentin the PATH’s modernization and Sandyrecovery programs, which includes signalreplacement, station rehabilitation, andpower station upgrade projects. ThePANYNJ plans to invest nearly $16 billionin the first five years of its recently

approved 10-year (2014 to 2023) $27.6 bil-lion capital plan. The plan includes $1 bil-lion of capital investment to pay for repair,mitigation, and resiliency projects, of whichmore than $700 million will go toward per-manent repairs to the PATH system—thePANYNJ facility Sandy affected the most.

Like the MTA, the PANYNJ’s creditstanding did not take a hit from Sandy. Weexpect the authority to retain its creditstanding, assuming its management con-tinues to adjust revenues, expenses, andcapital spending to sustain sound financialoperations, while ensuring that thePANYNJ maintains key revenue-gener-ating assets sufficiently. The authority’scredit quality could face stress if liquidityand financial margins erode considerablyfrom lower-than-expected demand, ifleverage increases, or from addedexpenses from addressing unexpectedshocks such as natural disasters or secu-rity concerns. In these cases, manage-ment’s ability to react quickly is critical forthem to maintain the ratings we have onthem. In light of the PANYNJ’s significantadditional debt needs, we don’t expect theauthority’s credit standing to improve.

Proactive Management Will BeKey For Credit StabilityBoth the MTA and PANYNJ were able tomaintain their credit quality despite thewidespread Sandy-related damage.However, credit risks could loom if theirmanagement teams are unable orunwilling to implement timely adjust-ments to revenues, expenses, and capitalspending to maintain financial profilesconsistent with the ratings. CW



We expect the MTA to recoup most of the costs…

in the next several years...


Joseph J. PezzimentiNew York (1) 212-438-2038

Geoffrey E. BuswickBoston (1) 617-530-8311


Superstorm Sandy

California is suffering a third consecutive year of drought.

The state typically experiences wet, cool weather during the

fall and winter, and dry, hot weather during the spring and

summer. Those winter rains and snow are important buffers during

the dry summers in this agriculture- and population-rich state.

California’s water agencies have been examining ways to meet

current and future water needs. However, the severity of the

current drought has highlighted operational weaknesses leading

some municipalities to curtail their water consumption and

requiring farmers to fallow as much as 800,000 acres of productive

agricultural land with crop losses estimated at $3.65 billion.

California’s Water SystemIllustrates The Near-Term ImpactsOf Long-Term Climate Change


Overview● Given the length and severity of

California's current drought and the

possible long-term effects of cli-

mate change, the state's water

agencies are exploring their options

to mitigate supply risks from water

sources with irregular performance.● To meet their current and future

water needs, water agencies are

developing long-term capital plans

whose costs they're assuming now. ● We expect that funding for these

projects will largely come from

revenue-secured debt and con-

sumer rates.

As a result, concerns about the reliabilityof the state’s water supply have spiked,as have worries about the possibleeffects of climate change. In Standard &Poor’s Ratings Services’ opinion, man-aging operational risks through demandmanagement; increasing water storagecapacity; developing new, stable watersources; and implementing water ratestructures that promote stable net rev-enue performance are key to the futurestability of the water sector in California.

California’s Response To The DroughtTwo major sources of surface water supplyfor the state are the State Water Project(SWP) operated by the CaliforniaDepartment of Water Resources (DWR)and the Central Valley Project (CVP) oper-ated by the U.S. Bureau of Reclamation(USBR). In response to the drought, DWRhas taken the unprecedented move of low-ering the water allocation percentage forSWP contractors to 0%, although subse-quent modest precipitation has allowedDWR to increase those allocations to 5%,while USBR maintained a 0% allocation toCVP agricultural contractors and a 50%allocation to CVP municipal & industrialcontractors. On Feb. 14, 2014, PresidentBarack Obama visited the San JoaquinValley and identified intensifying droughtsand other weather-related disasters asexamples of how climate change couldaffect the nation (for Standard & Poor’s view

on the California Drought, see “Drought

Declaration Provides Limited Relief To

California Water Bond Obligors,” published

Jan. 21, 2014, on RatingsDirect).Regardless of whether the current

drought is an example of climate change atwork or simply another multiyear droughtsimilar to those that struck Californiaduring the late 1970s and early 1990s, theseverity of the current drought has led to aresurgence of public interest in the state’swater supply reliability. For calendar year2013, statewide average precipitation wasjust seven inches, the driest year on recorddating back to 1895(1).

Led by DWR, the state is preparing forclimate change and anticipates that it willrequire significant infrastructure improve-ments to ensure water supply reliability.

Recently updated assessments from theUnited Nations’ Intergovernmental Panelon Climate Change and the U.S. GlobalChange Research Program include climatechange projections for the world andnation, respectively, that are largely consis-tent with the expectations expressed in thestate’s planning documents, such as DWR’sClimate Change Adaptation Strategies andthe California Water Plan.

Although significant uncertainty cloudsthe estimated range of impacts resultingfrom climate change and the time horizonover which they’ll be felt, it is clear thatDWR, USBR, and water agencies acrossthe state are planning ahead to adapt tothese forecast conditions. As a result, weanticipate that these agencies will incursignificant capital costs over the near- to

medium-term horizon to develop thecapacity to provide reliable service under arange of scenarios. And we expect thatthese capital costs will affect financial per-formance far sooner than what might oth-erwise be implied by the likely timehorizon for climate change.

Climate Change In CaliforniaCalifornia’s climate is classified asMediterranean, meaning that the state typ-ically experiences wet, cool weatherduring the fall and winter, and dry, hotweather during the spring and summer.Precipitation occurs when moisture-ladenweather systems pass across the state andover mountain ranges. Of critical impor-tance to the state’s water system is precipi-tation that contributes to the snowpack in



1963

1968

1973

1978

1983

1988

1993

1998

2003

2008

2013

*

(Year)

05

101520253035404550

(Inches)

*Driest year on record, dating to 1895.

© Standard & Poor’s 2014.Source: Western Regional Climate Center.

Precipitation (inches) Average (22.6 inches)

Chart 1 California Statewide Average Precipitation

EstimatedProject name Type cost (mil. $) Capacity (AF) Cost ($)/Capacity (AF)

Completed/in-progress projects

Diamond Valley Lake New facility 1,900 800,000 2,375

Los Vaqueros Reservoir Expansion 120 60,000 2,000

San Vicente Reservoir Expansion 568 152,000 3,737

Projects under consideration

Sites Reservoir New facility 3,600–4,100 1,900,000 1,895–2,158

Shasta Lake Expansion 1,100 133,000 8,271

Temperance Flat Reservoir New facility 2,500–3,400 1,200,000 2,083–2,833

San Luis Reservoir Expansion 360 130,000 2,769

Los Vaqueros Reservoir Expansion 850 115,000 7,391

California Projects

the Sierra Nevada Mountains, typically atelevations of 5,000 feet or higher, whichacts as a natural water storage mechanism.Snowpack develops during the winter andthen is slowly released as watershed runoffduring the spring and summer when theweather is typically dry and precipitation israre. Notably, rain doesn’t come uniformlythroughout the winter, but rather througha few high-intensity weather patterns thatdeliver the bulk of the state’s watersupply. One example of this phenomenonis the well-documented “PineappleExpress,” which is an atmospheric riverthat transports water vapor from thetropics to the Western U.S.

As reported in the U.S. NationalClimate Assessment, annual average tem-peratures in California are projected torise by 2.5°F to 4.5°F between 2041 and2070 and by 3.5°F to 8.5°F between 2070and 2099 depending on which emissionscenario is assumed. The expectedimpact of this temperature rise onCalifornia’s hydrological cycle is twofold:1) winter precipitation will more fre-quently take the form of rainfall and con-tribute less to snowpack accumulation,and 2) snowmelt will occur earlier in thespring than currently experienced.Assuming fixed reservoir capacity andthat a portion of this capacity must bereserved for flood protection, a greateramount of this faster runoff is spilled inthe winter during periods of lowerdemand, leaving less water availableduring hotter summer months and poten-tially resulting in more severe shortages.

Specifically, snow water equivalents, ameasurement of the amount of waterheld within the snowpack, for theSouthwestern states are projected todecline significantly during the comingdecades, according to the assessment.For example, when using data from 1971to 2000 as a benchmark, snow waterequivalent for California is projected todecline to 84% of this level for 2006 to2035, 66% for 2041 to 2070, and 43% for2070 to 2099.

Climate change is also expected to con-tribute to a rise in sea levels, which couldthreaten the state’s coastal regions andareas connected through the San FranciscoBay, including the Sacramento-San Joaquin

River Delta. The impact in the delta istwofold: 1) The risk of levee failure wouldincrease given that these levees were notdesigned to withstand significant seismicevents or resist the expected rise in hydro-static pressures, and 2) the hydrology withinthe delta would change as seawater andbrackish water penetrate further inland.Both of these impacts reduce the reliabilityof water supplies that pass through thedelta as a conveyance mechanism.

Plans To Address Climate Change IssuesWater agencies across the state are takinga multipronged approach to address cli-mate change. One example that does notrequire new capital is implementing waterconservation measures in compliancewith the Water Conservation Act of 2009(SB X7-7), which targets 20% water con-servation by 2020. The state is also plan-ning or has underway several significantwater infrastructure projects to provideenhanced supply reliability in the face ofclimate change, such as new or expandedconveyance facilities, water storage proj-ects, and local resource development.The largest and most expensive project isthe Bay Delta Conservation Plan’s(BDCP) twin tunnel conveyance facility atan estimated cost of $14.6 billion in 2012dollars (for our view on the BDCP, see “The

High Price Of Water Supply Reliability:

California’s Bay Delta Conservation Plan

Would Require Significant Investment,” pub-

lished Feb. 13, 2014).California currently has more than

1,300 dams and surface water reservoirswith over 43 million acre-feet(2) ofstorage capacity. Along with otherapproaches, the state is enhancing thiscapacity to address the shifting hydrolog-ical patterns driven by climate change.Expansions of reservoir capacity sincethe era of major federal dam building inthe mid-20th century include the con-struction of Diamond Valley Lake by theMetropolitan Water District of SouthernCalifornia (MWD), the expansion of LosVaqueros Reservoir by Contra CostaWater District, and the expansion of SanVicente Reservoir by San Diego CountyWater Authority (SDCWA). DiamondValley Lake is an off-stream reservoir(3)

with a capacity of 800,000 acre-feet.MWD commenced construction of thefacility in 1995, and it was completed in1999 at a cost of about $1.9 billion. LosVaqueros Reservoir is also an off-streamreservoir, and its capacity was expandedin 2012 to 160,000 acre-feet from 100,000acre-feet at a cost of about $120 million.San Vicente Reservoir is an on-streamreservoir, and SDCWA is expanding itscapacity to 242,000 acre-feet from 90,000acre-feet by raising the dam 117 feet at acost of about $568 million.

Several proposed reservoir projectshave been studied and planned for wellover a decade and are still awaitingfunding before moving forward. One sig-nificant new storage facility under consid-eration is the Sites Reservoir project inColusa County north of Sacramento. Theproject consists of an off-stream reservoirthat would provide 1.9 million acre-feet ofwater storage capacity at an estimatedcost of between $3.6 billion and $4.1 bil-lion. Four other projects being studied byUSBR are expansions of existing reser-voirs. Furthest along is a project to raisethe dam at Shasta Lake, a key waterstorage facility that was originallydesigned to accommodate a dam about100 feet taller than the existing one. Thecurrent proposal is to raise that dam by18.5 feet to enhance capacity by 133,000acre-feet at a cost of $1.1 billion. Weanticipate that USBR will release a finalenvironmental impact statement for thisproject in December 2014. TheTemperance Flats Reservoir Project con-sists of a 665-foot dam on the SanJoaquin River above Millerton Lake.Management estimates the project willprovide 1.2 million acre-feet of additionalstorage at a projected cost of between$2.5 billion and $3.4 billion. Anotherexpansion project under considerationwould raise the dam at San Luis Reservoirby 20 feet at an estimated cost of $360million. This project would serve a dualpurpose of increasing capacity by130,000 acre-feet, while also providingfunding for seismic strengthening that isnecessary because a fault line crossesbeneath the reservoir. A fourth projectwould further expand storage at LosVaqueros Reservoir. A first phase would


boost capacity by 115,000 acre-feet at anestimated cost of $850 million, and a sub-sequent phase would increase capacity by225,000 acre-feet, giving the reservoir atotal capacity of 500,000 acre-feet.

Further development of groundwaterstorage capacity is also being explored.However, the lack of groundwater regula-tion constrains the potential uses for thisresource. According to reports preparedby DWR, only 22 of the state’s 515groundwater basins and subbasins havebeen adjudicated. Estimates of totalgroundwater storage capacity range from850 million acre-feet to 1.3 billion acre-feet, although usable storage capacity isestimated at a lower, but still significant,143 million acre-feet to 450 million acre-feet. Although some groundwater basinsare managed or adjudicated, thereby lim-iting groundwater pumping by basin users,the majority of California’s groundwaterstorage capacity falls within basins that areunrestricted and allow entities with over-lying groundwater rights to pump waterwithout reporting usage. We anticipatethat groundwater storage could be furtherdeveloped in certain areas where access isregulated, which could enhance overallsupply reliability, but significant expansionto take advantage of this capacity will belimited without more clear regulation.

However, additional water storagecapacity is beneficial only to the extent thatthe total volume of annual precipitationremains about the same or increases,which may not necessarily be the case. Arecent analysis that examined tree rings asan indicator of past climate patterns deter-mined that this region has experiencedvery severe and prolonged droughts in itspast that are well outside the range ofhydrological patterns of the past cen-tury(4). In these circumstances, the devel-opment of drought-proof local waterresources provides a more robust solutionthan an expansion of storage capacity. Themost recent of these projects is theCarlsbad Desalination Project in San DiegoCounty, which will be the largest seawaterdesalination plant in the WesternHemisphere when it begins deliveringwater in 2016 to SDCWA. Managementexpects the $1 billion project to produce 50million gallons per day of drinking water.

Funding Climate Change Water ProjectsWe expect that funding for climatechange related water projects will likelyfollow conventional patterns in that proj-ects will largely be funded on a “benefi-ciary pays” basis with some potentialgaps filled with proceeds from state gen-eral obligation (GO) bonds. The chal-lenge with funding some of the proposedprojects, in our view, is determining theproject’s benefits and the correspondingassignment of costs, and then having theparties involved come to an agreementon a financing plan. Once a cost alloca-tion has been formulated and agreedupon, we expect that a significant portionof these projects will be funded throughrevenue-secured debt.

With respect to state GO bonds forwater projects, voters last approved GObonds in 2006, and those funds havebeen spent or committed. An $11.1 bil-lion state water bond is scheduled for theNovember 2014 ballot, although thestate legislature is currently consideringnine alternative proposals to change thebond amount and the scope of projectsprior to the election. As it is currentlywritten, the ballot measure includesfunding for the following:● $3 billion for water storage projects,● $2.3 billion for delta sustainability projects,● $1.8 billion for ecosystem and water-

shed protection and restoration projects,● $1.4 billion for integrated regional

water management plans,● $1.3 billion for water recycling projects,



F/W water sources F/W water uses S/S water sources S/S water uses0

102030405060708090

100

*Warmer temperatures drive lower snowpack development and increased reservoir spill during the fall and winter,leading to lower water availability in the spring and summer. F/W—Fall/winter. S/S—Spring/summer.© Standard & Poor’s 2014.

(%)

Precipitation Demand Snowpack & storage Spill Shortage

Chart 2a How Climate Change Affects Water Supply Availability—Current Conditions*

F/W water sources F/W water uses S/S water sources S/S water uses0

102030405060708090

100

*Warmer temperatures drive lower snowpack development and increased reservoir spill during the fall and winter,leading to lower water availability in the spring and summer. F/W—Fall/winter. S/S—Spring/summer.© Standard & Poor’s 2014.

(%)

Precipitation Demand Snowpack & storage Spill Shortage

Chart 2b How Climate Change Affects Water Supply Availability—Projected Conditions*

● $1 billion for groundwater protectionand water quality projects, and

● $0.5 billion for drought relief projects.Polling conducted in March 2014 by

the Public Policy Institute of Californiaindicates that 60% of respondents and50% of likely voters would approve thebond measure(5). Notably, the topic ofwater bonds has twice been delayed(from 2010 to 2012 and from 2012 to2014), but conditions appear ripe for themeasure to pass given the continueddrought across the state and heightenedpublic awareness of water issues. In ourview, there does not appear to be thepolitical will within the federal govern-ment to make direct investments in waterinfrastructure projects, and we anticipatethat federal support of water infrastruc-ture projects will instead take the form ofgrants and low-interest loan programs.

Credit Impacts From Climate ChangeGiven the long time horizon over whichclimate change occurs—largely farbeyond the final maturity of debt obli-gations currently in the market—andthe uncertainty of climate change fore-casts, it may be tempting to set asidethe long-term effects of climate changewhen evaluating today’s credit funda-mentals. However, water agencies,either directly or indirectly throughcoordination with their wholesale sup-pliers, are developing capital plans tomeet needs far into the future when cli-mate change may affect system opera-

tions. But those capital plans and asso-ciated costs can affect investors now.

Although the BDCP is the most visible ofCalifornia’s upcoming water infrastructureprojects, billions of dollars of other projectsare also poised to move forward. Ourexpectation is that because of the requiredinteragency planning and economies ofscale, the majority of these projects will bemanaged at the wholesale level and theoperating and capital costs will be passedthrough to retail systems, thereby raisingretail system operating costs and thinningmargins absent offsetting revenue-raisingmeasures. For example, we expect thatwholesale water agencies, such as MWDand its member agencies, will continue topass through these costs to the retail sys-tems that they supply. Partial fundingthrough state GO bonds would provide analternative to revenue-supported debt andwould alleviate some of the burden onwater agencies to otherwise raise rates topay for these capital costs. We anticipatethat retail systems will also borrow for localresource development in addition tofunding typical capital needs.

Features that we identify as creditstrengths in the context of climatechange include:● Water supply diversity with ample

capacity to meet forecasted demandunder conservative hydrology assump-tions;

● Drought-proof, independent watersources;

● Significant water storage capacity,either in the form of surface reservoirs

or in groundwater storage that isaccessible despite drought conditions;

● Rate structures that include preap-proved drought rates, which can beimplemented simply through an actionof the governing board; and

● Rate structures that promote conser-vation, such as through inclining blockrates, which commensurately offsetthe system’s need to develop expen-sive new sources of supply.We also note that financial impacts

could vary across sectors, particularlywhen evaluating agricultural wateragencies as compared to municipalagencies. We are forward-looking whenassessing these potential impacts, andwe continually refine our analyses toincorporate specific projects as theyprogress and as financing mechanismsare determined. CW

NOTES(1) Western Regional Climate Center.

http://www.wrcc.dri.edu/monitor/cal-mon/frames_version.html

(2) One acre-foot is the volume of waterrequired to cover one acre of land onefoot deep in water. Generally, this volumeof water is considered adequate to supplytwo families of four for one year.

(3) Reservoirs may be built either “on-stream” or “off-stream.” On-stream reser-voirs replenish naturally by capturingrunoff from a watershed. Off-streamreservoirs have no natural source ofreplenishment aside from direct rainfall,and instead require active pumping tostore water in the reservoir.

(4) David M. Meko, Connie A. Woodhouse,and Ramzi Touchan. Klamath/SanJoaquin/Sacramento HydroclimaticReconstructions from Tree Rings.

(5) http://www.ppic.org/main/pressre-lease.asp?i=1483


Arizona California Colorado Nevada New Mexico Utah0

102030405060708090

100

*This period represents 100% levels for each state.

© Standard & Poor’s 2014.Source: Scripps Institution of Oceanography.

(Inches)

1971–2000* 2006–2035 2041–2070 2070–2099

Chart 3 Projected Snow Water Equivalent


Tim TungSan Francisco (1) 415-371-5041

Robert L. Hannay, CFASan Francisco (1) 415-371-5038

Paul J. DysonSan Francisco (1) 415-371-5079


California

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