Climate change’s credit implications for structured finance (SF) could be visible in transactions issued within the next 10 years, Fitch Ratings says. Existing SF notes benefit from mitigants that should insulate their ratings from climate-related risks that could increase arrears and defaults and reduce some asset values.

We divide climate change risks into: policy risks from action (and inaction) by policymakers affecting economic growth and employment, asset price differentiation and borrower costs; physical risks, which may cause asset destruction or impairment and increase ancillary costs such as insurance; and transitional risks from economic and social responses, including technological adaptation that results in stranded assets.

We expect policy risk to be the first to become relevant for SF, followed by transitional and physical risks. Diversification, assets’ short average residual life and/or credit enhancement build-up should help shield many existing rated notes.

We believe our rating assumptions are broadly consistent with potential ramifications of climate change risks for borrower performance and asset values, based on current expectations, knowledge and data. We apply specific additional stresses or sensitivities where implications are already more visible.

More frequent and intense physical events and adaptation and policy response roll-outs will make climate change more relevant for new SF transactions over the next 10 years. Of six key rating drivers in our “Global Structured Finance Criteria”, we expect it to primarily affect asset quality.

Climate change’s effects will largely depend on localised impacts and individual portfolio characteristics, so underlying stresses will be uneven across regions and sectors. Predicting their severity is difficult, but we initially expect assets with a longer residual life - chiefly residential and some commercial real estate - to be more vulnerable, making adaptation policies key.

“Climate Change Risks for Structured Finance: A Primer” is available from www.fitchratings.com or via the link above.