BLOG — Jan 09, 2025
Assessing Resilience: The Importance of Climate Stress Testing in the Middle East, Africa, and India
By Nour Taher and Andrey Eliseev
This report is written and published by S&P Global Market Intelligence, a division independent from S&P Global Ratings. Lowercase nomenclature is used to differentiate S&P Global Market Intelligence credit scores from the credit ratings issued by S&P Global Ratings.
Background
Climate change cannot be ignored. Recent and intensifying natural disasters underscore the reality of climate change. Over the past two years, the Middle East and Africa have faced increasing climate-driven disasters, including devastating flash floods and extreme heatwaves. In April 2024, the UAE saw its heaviest rainfall in 75 years, with over a year's worth of rain falling in a single day, flooding cities like Dubai and Abu Dhabi, halting airport operations, and prompting emergency responses, including a $544.6 million recovery fund. Elsewhere, Libya's 2023 floods killed over 11,000 people, and North Africa endured severe heatwaves and wildfires. These events underscore the growing impact of climate change, highlighting the urgent need for resilient infrastructure, climate adaptation, and disaster preparedness across the region.
Model Description
Climate Credit Analytics (CCA), a climate scenario analysis and credit analytics model suite with robust tools that combine S&P Global Market Intelligence’s data resources and credit analytics capabilities with Oliver Wyman’s climate modeling and stress testing expertise. CCA allows users to stress test their corporate loan portfolios or simply their exposures through multiple regulatory and NGFS scenarios up until the year 2050, using different drivers that explain the impact on the different financial line items for the different sectors and eventually scoring the impact on those companies' creditworthiness.
The model helps financial institutions align with the Basel Committee on Banking Supervision’s principles for the effective management and supervision of climate-related financial risks, such as measuring the impact assessment of transition and physical risk on their loan portfolio by identifying, measuring and evaluating the impact of climate credit risk on the bank’s asset quality and capital buffers.
Chosen Scenarios
We have chosen the three most prominent scenarios of NGFS (Phase 3) and ran the sample portfolio results using them, namely current policies, delayed transition, and net-zero 2050. However, for simplification, we focused the discussion of the results below on net-zero 2050 results, focusing on transition and physical risk impact on the future creditworthiness of the companies.
Sample Description
Carbon intensity and climate resilience vary across different sectors. We analyzed 125 large public listed companies with sufficient financials and relevant industry data to run the model across the Middle East, Africa, and India. For the purposes of our research, we focused on the most carbon-intensive industries that make the largest contribution to global greenhouse gas emissions, such as power generation, oil and gas, metals and mining, airlines, transportation, chemicals, steel, real estate, telecommunications, and construction materials.
Company-level impact
Before we discuss portfolio impact, it is helpful to understand a single company's response to a climate scenario. Let us examine how a large cement producer embarks on an energy transition journey, changing its operational profile and adapting to different forecasted market and industry headwinds under the different NGFS scenarios discussed earlier.
To begin with, it is anticipated that most countries would introduce varying levels of carbon taxes that would force cement producers to make substantial investments to reduce their carbon footprint replacing their traditional high carbon-intensive technologies with greener ones. As figure 1 illustrates, this transition would impose increased levels of leverage (26% to 42%), lower EBITDA interest coverage ratio (18x to 5x) and declining return on capital (6.0% to 2.6%), all under net-zero 2050 scenario.
Source: S&P Global Market Intelligence Climate Credit Analytics model outputs, 2024. For illustrative purposes only.
Given that the cement industry like others is a highly competitive industry, producers do not have sufficient price elasticity to pass much of the additional operational expenses on their customers by allocating climate-related additional costs in the final product price, but rather taking these additional costs on their own. While GDP and population growth may support a company's growth, this organic boost is unlikely to offset the rising CAPEX, OPEX, and funding costs associated with climate transition. As a result, the company assessed here, along with many others, will see declines in profitability and debt capacity.
Portfolio Impact
- Impact Distribution
Figure 2 below illustrates the distribution of credit score changes, highlighting the impact of climate risk on a sample bank portfolio comprising of 125 companies. Companies facing climate-related challenges may experience credit score downgrades, reflected in the higher percentages of notch downgrades with 24% of the sample experiencing more than three notch downgrades. This suggests that climate risks can lead to significant negative impacts on credit scores, affecting investor confidence and potentially increasing borrowing costs.
Conversely, the presence of notch upgrades indicates that companies may improve their credit scores through effective climate risk management strategies or simply by harvesting opportunities created by climate change. The overall trend suggests that climate risk is a critical factor for lenders and investors alike to consider when assessing the stability and future performance of their portfolios.
Figure 2. Distribution of credit scores changes to the portfolio of companies stressed using Climate Credit Analytics.
Source: S&P Global Market Intelligence Climate Credit Analytics model outputs, 2024. For illustrative purposes only.
- Sectoral Impact
The analysis of the projected credit score changes highlights varying levels of impact on different sectors stemming from climate risk. Industries such as steel and construction materials face the largest potential decreases in credit scores, indicating substantial financial risk due to climate-related factors. This sector's vulnerability may stem from increased regulatory pressures and the need for sustainable practices.
Power generation, metal and mining, and oil and gas also show notable declines, reflecting challenges from transitioning to greener energy sources. In contrast, sectors like telecom are less affected, demonstrating relative stability amidst climate risks.
The distribution of impact reveals that higher-risk sectors may face pressures to attract capital unless their transition plans are underway and potentially include plans to tap the green bond market. Overall, the data suggests that companies in the most affected sectors must adopt robust risk management strategies to mitigate these impacts and enhance their long-term sustainability.
Figure 3. Box and whisker plot illustrating climate impact in credit score changes (in notches) by 2050 by economic sector.
Source: S&P Global Market Intelligence Climate Credit Analytics model outputs, 2024. For illustrative purposes only.
Main Drivers
The drivers of climate change's impact on companies can be categorized into the following key factors:
- Regulatory Pressures: Increasing regulations aimed at reducing carbon emissions compel companies to adapt their operations, often leading to higher costs and necessitating investment in sustainable technologies.
- Market Demand Shifts: There is a growing consumer preference for environmentally friendly products, pushing companies to innovate and diversify their offerings to remain competitive.
- Physical Risks: Companies face risks from extreme weather events and changing climate patterns, which can disrupt supply chains, damage infrastructure, and affect operational continuity.
- Reputational Risks: Businesses that fail to address climate concerns may suffer reputational damage, impacting customer loyalty and investor confidence.
- Financial Implications: Climate risks can lead to increased costs of capital, as investors are more cautious about financing companies with high environmental risks.
Figure 4. Summary of key climate risk factors affecting companies
Source: S&P Global Market Intelligence, 2024. For illustrative purposes only.
Top-Down model[1]
For companies without the data required for bottom-up modeling, a top-down model is developed by S&P Global Market Intelligence to simplify the process. This involves three steps: (1) identifying the banks’ exposures by sector (2) inputting the average probabilities of default for each sector, and (3) running the model that would forecast the average deteriorations of the sample portfolio[2]. We have assessed this model on the eight largest GCC banks by market capitalization, and this revealed a median increase of ninety-five basis points in the probability of default (PD) due to climate risk alone. This rise, unrelated to economic cycles or idiosyncratic issues, could significantly impact these banks’ provisioning and capital levels soon.
Figure 5. Box and whisker plot illustrating climate impact in Probability of Defaults (y-axis) until 2050
[1] Top-down analysis has many limitations, to mention some, is that it may neither capture bank-specific portfolio considerations nor banks’ own assessment of the magnitude and nature of these risks.
[2] Sectoral average deteriorations are derived from extrapolation from the population our bottom-up model was run using, a sample of over 69,000 companies.
Figure 5. Box and whisker plot illustrating climate impact in Probability of Defaults (y-axis) until 2050
Source: S&P Global Market Intelligence, 2024. For illustrative purposes only.
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