S&P Global Ratings has published a series of reports analyzing how decarbonization could occur across several high carbon emitting sectors, and how this has affected (or may affect) the credit quality of entities. The sectors include utilities, cement, airlines, chemicals, and metals. The research can be found on RatingsDirect and at S&P Global's Sustainability Insights Climate Change website.

The series highlights our expectation that, while the pathways to decarbonization will vary across industries with hard-to-abate emissions, they are likely to share key characteristics. Those similarities explain why emissions-linked credit rating actions have been generally rare across all sectors (see "Why Climate Risks Are Changing So Few Corporate Ratings," April 12, 2023) and why we don't currently expect climate transition risk to significantly disrupt credit quality.

That benign outlook could change. We expect a shift would be slow, but acknowledge that decarbonization and the transition to a low-carbon economy could disrupt industries, and particularly those considered to have significant and hard-to-abate carbon emissions. Such disruption, if it occurs, could imply an increase in credit risk for the issuers we rate.

Here we set out six key observations from our recent research.

Observation One: Lessons From A Transformative Decade For Utilities

The power and gas utilities sector is the most advanced in terms of energy transition and has been most affected by the decarbonization journey--perhaps not surprisingly given that energy is at the heart of the decarbonization of economies. The sector's investment in low-carbon technologies has been significant over the past decade and notably included greener generating assets and network upgrades. At the same time, utilities in some regions have faced early closure of fossil fuel based assets (due to evolving regulations, less favorable prices, and adverse fiscal conditions), which has added uncertainty to returns and cash flow generation during a period of significant investment. We note that the utilities have had to choose from several decarbonization technology options that were, initially, relatively immature and often costly compared to their legacy assets. The resultant heightened execution risk has often weighed negatively on our assessment of business-risk profiles. This was particularly true in Europe and to a lesser extent the U.S.

In the EU, the material transformation of the power system over the past decade (see chart 1 and chart 2) has reflected notably strict regulations, the rapid development of decarbonization technologies (including renewables), and the sector's ability to raise capital. The result has been a 36% decrease in direct (Scope 1) and indirect (Scope 2) carbon emissions between 2013 and 2023.

Chart 1

Chart 2

Looking more closely at a sample consisting of the top 15 European utilities we rate, we see that total annual investment has gradually increased over the past decade to about €90 billion per year in 2023, from just over €50 billion in 2013. Aggregate debt increased by about €110 billion to over €450 billion over that period, while average debt to EBITDA grew just 0.3X to 4.4X by year-end 2023.

Utilities' decarbonization burden has lowered average ratings one notch, for now   Despite significant capital outlays, political pressures, and companies' efforts to decarbonize, the credit rating implications of decarbonization have been generally limited. On average, our ratings on European utilities have fallen one notch over the past decade, to higher 'BBB' levels, but remain well entrenched in investment grade territory (with the exception of pure-play merchant generators, due to the more volatile nature of their business). We consider that this reflects the businesses' effective management of the transformation (notably in protecting balance sheets while delivering on portfolio rationalization), and regulatory support and subsidies, which have helped mitigate risks.

The rest of this decade is likely to be characterized by continued financial pressures due to ongoing increased investment driven by further decarbonization requirements and, for generators, by increasing volatility in power prices. The majority of our outlooks on rated EU utilities are stable, yet we anticipate that our median rating on European utilities could be lowered a notch, at most, depending on the balance of positive and negative factors that emerge as the transition unfolds (see table 1).

Table 1

While the above factors relate particularly to utilities, we believe that similar elements (including relating to technology adoption, changes in the regulatory landscape, and targeted state support) could materialize in other industries with hard-to-abate emissions. That could equally enable those industries to gradually decarbonize, with manageable challenges for creditworthiness.

Observation Two: Pressure To Decarbonize Hard-To-Abate Sectors Varies Regionally

Almost all countries have committed to decarbonize their economies over the coming decades and are taking steps to achieve this. Yet global emissions have continued to grow in recent years, diverging from the emission reductions needed to align with warming limits established by the Paris Agreement. Our research found that total absolute Scope 1 and Scope 2 greenhouse gas (GHG) emissions from companies didn't fall in most economic sectors between 2016 and 2021 (see "Climate Transition Risk: Historical Greenhouse Gas Emissions Trends For Global Industries," Nov. 22, 2023).

Among regions, Europe has imposed the greatest regulatory burden for decarbonization of its most carbon intensive industries.  This is notably the case with regards to renewables targets in the energy mix, interim decarbonization targets, and its carbon market (which is the main policy tool). The recent reform of the EU Emissions Trading System (EU ETS), part of the European Green Deal, will lead to a gradual decline of free allowances and a reduced market size, with the aim of increasing carbon costs for industries within its scope and ultimately incentivizing decarbonization efforts.

The effects of that could be stark. Our scenario analysis shows that, absent more material mitigation efforts, carbon costs in the cement industry could grow swiftly from 2027, when the phase-out of free allowances starts, to 75% of EBITDA on average by 2032, when the phase-out ends (see chart 3 and chart 4). That would be an increase from 0%-3% of EBITDA over 2019-2021, (see "Decarbonizing Cement Part Two: Companies Could See Pressure On Ratings As The EU Firms Up Carbon Rules," Oct. 27, 2022).

Chart 3 and Chart 4

European companies decarbonization efforts will expose them to other financial pressures. Our deep dive on German chemical companies highlighted that, although climate transformation plans may be largely in place for the chemical industry, their implementation is hampered by the energy crisis, resulting high energy costs, and complex legislative and regulatory requirements (see "German Chemical Industry's Decarbonization Is A Team Effort," March 20, 2024).

Beyond Europe, carbon-related costs currently often range between negligible and nothing.  For the U.S. chemicals sector, our preliminary view is that the subsidies under the current regulatory frameworks benefit U.S.-based chemical producers relative to their European counterparts (though we expect the regulations will evolve). Specifically, the U.S. framework, including the Inflation Reduction Act, creates investment incentives via tax relief and other measures for investments in decarbonization. These provisions could lower chemical decarbonization capital costs and operating costs, and encourage technology investment and infrastructure projects in the U.S. relative to Europe. (see "Decarbonizing Chemicals Part Two: The Credit Risks And Mitigants," Sept. 5, 2023).

In the metals sector, carbon regulations beyond the EU have also been financially benign. For instance, India's National Mission for Energy Efficiency, launched in 2011, sets unintrusive energy efficiency targets for industrial companies, and has established a mechanism for trading obligations between participants. China has similarly also adopted energy efficiency targets for industrial operators, including steel and aluminum makers, while its ETS only covers power generators (though there are plans to expand to other sectors).

The EU's Carbon Border Adjustment Mechanism, which seeks to limit offshoring of carbon intensive production (carbon leakage) could affect companies that export to the EU. It could also result in some countries responding with similar regulations (see "Decarbonizing Metals Part Two: Financial Strength Mitigates Rising Credit Risk," June 3, 2024).

Beyond contributing to business costs, decarbonization policies and regulations could also spur new opportunities and growth.  For instance, ammonia appears likely to play an important role as a carrier of hydrogen, creating new applications for a chemical that is currently mainly used as fertilizer. We also expect a surge in demand for low-carbon products in the building materials industry over the next decade, boosted by intensifying regulatory and public pressure on builders to transition to green buildings and use materials with reduced negative impacts on human health and the environment. This could change the cement industry's competitive landscape over the medium term by supporting larger and more sophisticated European players that can leverage their advantage in lower-emission products (see "Decarbonizing Cement Part One: How EU Cement Makers Are Reducing Emissions While Building Business Resilience," Oct. 27, 2022)

Observation Three: Most Decarbonization Risks And Targets (Out To 2030) Appear Manageable From A Credit Perspective

We expect companies will target decarbonization's low-hanging fruit, including investment-light solutions that could collectively lower GHG emissions by 20% to 30%. They include efficiency improvements, greater electrification and other forms of green-energy procurement, and increased switching of the grid to renewable electricity from fossil fuels sources.

Those opportunities mean, for instance, that chemical companies' interim decarbonization targets (typically set for 2030-2035) are technically feasible without material disruption to the sector's cost structures or significant financial effects (see "Decarbonizing Chemicals Part One: Sectorwide Challenges Will Intensify Beyond 2030," Sept. 5, 2023). Airlines, meanwhile, offer an example of the possibility for non-disruptive operational gains, with Airbus suggesting that emissions could fall by as much as 10% if planes fly direct routes and climb and descend at optimal fuel-efficiency speeds (see "Europe's Airlines To Bear Highest Carbon Costs," April 3, 2023).

Near-term decarbonization initiatives' additional costs will likely be borne by customers, enabling companies to protect profit margins.  This may be because the incremental cost remains manageable for consumers or because of lack of substitution products. Sectors like airlines have a solid track record of passing on volatile input costs, as was evident during recent price hikes driven by inflation, notably in fuel and labor. More expensive tickets appear to have been widely accepted, partly due to post-pandemic, pent-up demand and high household savings.

Our sensitivity analysis found that a one-way flight from London to Barcelona creates about 0.2 tons of CO2 per passenger. Assuming that free EU ETS carbon allowances are phased out, and applying an EU ETS price of €90 per metric ton, emissions will add about €18 to the ticket price. Given an estimated price of about €60 for the trip, the regulatory burden appears significant but manageable for travelers with few alternatives. Similarly, substitutions for cement are currently limited, meaning demand should remain structurally steady. Customers willingness to absorb price increases will likely have limits though, and pressure on profitability still looms as costs continue to increase.

More significant investment is being prudently deployed, so far.  While issuers may sometimes invest in new, more structurally important projects, such investments remain marginal overall, not least because the projects are not yet being scaled-up. This is often because the disruptive technologies remain immature, costly, and lack the infrastructure or end-market to support scaling. For instance, cement sector pilot projects employing carbon capture, utilization, and storage (CCUS) technologies are slated to be operational beyond 2025, yet by the end of 2022 only 5% of those projects were under construction, with the rest is still in early development.

In steel, a combination of technologies including direct reduced iron, electric arc furnace, and green or low-carbon hydrogen could cut production emissions to a small fraction of their current levels (see chart 5).

Chart 5

The combination of those technologies remains in development, while deployment could necessitate significant changes to companies' asset bases. We see cost challenges to further development, for instance due to the price of green hydrogen. In the meantime, blue hydrogen (produced by combining natural gas with heated water to create hydrogen) and carbon capture could be used as a steppingstone technology, but they are expensive and will add to overall production costs. Nonetheless, most large European metals companies are testing their use.

Most decarbonization initiatives already launched in hard-to-abate sectors won't materially affect investment plans, cash flow generation, and ultimately balance sheets over the coming years. They could nevertheless deliver some tangible progress toward carbon reduction over the rest of the decade.

Observation Four: Decarbonization Pathways Could Deliver Additional Benefits

Efficiency gains may result in improved profitability, notably for metals and chemicals makers, where energy efficiency has a direct link to lower operating costs, and is a route to emissions reduction. While some energy efficiency measures will be cost effective, later incremental gains might eventually offer only limited payback. Nonetheless, recent spikes in energy prices have galvanized energy-saving efforts, as has the threat of natural gas supply shortages in Europe, making energy efficiency a common sustainability strategy for companies' seeking to control costs and reduce their carbon footprint.

Development of low-carbon premium products may support growth.  As noted earlier, we believe the competitive landscape for building materials will be reshaped by surging demand for low-carbon products over the next decade. European producers, which are leading development of advanced products, aim to reap the rewards of that shift, which could include a gradual diversification away from standard cement. In that environment the higher prices enjoyed by premium products should help some companies to protect their margins from much higher carbon costs. Still, much wider use of recycled materials or low-clinker products will require alterations to the construction industry's value chain and greater end-user acceptance, which could prove a challenge in some countries. Therefore, we generally do not currently reflect this trend in our assessment of companies' business risk profiles.

Metals companies have also begun marketing green products and have found customers in sectors such as auto manufacturing, where manufacturers require low-impact inputs to support their own decarbonization goals.

Observation Five: Post 2030, Decarbonization Is Heavily Reliant On The Scalability Of Technology, Which Limits Credit Rating Visibility

Technological leaps will be necessary to accelerate decarbonization, yet there is a high degree of uncertainty as to which solutions will emerge, how they will mature, and how to scale them up for meaningful industrial use. For example, we note that CCUS projects currently take eight years or more from planning to completion. This provides time and visibility to foresee if and when the effective technology ramp-up will take place. Transformation timelines for some sectors are even longer. Airlines, for example, will take decades to replace their current fleets, given the long-lived nature of aircraft. We consider technological uncertainty to be a risk and will continue to monitor it, but do not generally factor it into our current credit ratings due to uncertainties about the timing of adoption and the size of funding requirements.

New technologies could be disruptive.  We believe that technological shifts could have a significant effect on credit quality due to resultant changes in operating models and the possibly heavy burden of investment (see chart 6). In the chemicals sector, for instance, decarbonization efforts (on the road to carbon neutrality by 2050) could significantly alter supply chains due to a shift to hydrogen-based manufacturing and the need for significantly greater CCUS capacity. Such changes could disrupt established cost structures and participants' competitiveness, with early movers likely to be better prepared to absorb transition-related impacts.

Chart 6

Similarly, for cement, beyond 2030, a significant drop in direct emissions can only be achieved via reduced usage (stemming from improved product efficiency) and accelerated adoption of CCUS. The required technology for that carbon capture is still at the prototype or development stage and will require significant investment to scale up.

Government support will be a necessary but also difficult balancing act.  Achieving the technological advances required for decarbonization will require support from public bodies and regulators. For instance, the U.S. Inflation Reduction Act (IRA) provides subsidies for a range of low-carbon technologies that could increase the economic viability of deploying renewable energy, CCUS, and other decarbonization technologies. However, private-sector actors remain ultimately responsible for investment decisions, and are transforming markets and businesses in potentially unexpected ways. Governments, for instance, might not have expected subsidies to be so enthusiastically invested in generating assets, and particularly solar photovoltaic (PV) generation. That support was facilitated by a PV market and technology that was primed for private-sector investment. Meanwhile, technologies that support industrial decarbonization, such as green hydrogen, have struggled to attract backing, despite policymakers identifying their development as a major goal (see "Renewable Energy Funding in 2023: "A Capital Transition" Unleashed," Sept. 14, 2023).

Other hurdles will have to be cleared.  Widespread adoption of decarbonization technologies faces multiple challenges including cost hurdles, a lack of infrastructure, often high energy demands, and insufficient standardization. All of those hurdles will have to be cleared before hydrogen, for example, can make a meaningful contribution to decarbonization (see "Hydrogen: New Ambitions and Challenges," Feb. 15, 2024). Similarly, the economic viability of e-fuels remain uncertain due to their high cost, though also due to the pollution they produce (see "E-fuels: A Challenging Journey To A Low-Carbon Future," March 25, 2024).

Observation Six: Strong Creditworthiness Is A Positive When Coping With Accelerating Decarbonization

Financial strength enables businesses to cope with transformation and we believe that decarbonization-related credit risks are more likely to affect companies with weaker credit quality. Such companies typically lack flexibility in their financial structures to deal with disruption, cost increases, or increased capital outlays. That inflexibility, which we generally reflect in our ratings, could also limit access to the resources needed to manage the carbon-transition, including personnel and funding, and a business's attractiveness to would-be partners or collaborators that might help mitigate risks.

Size and diversification will help companies absorb costs and support investment.  For example, larger cement companies (and particularly those that have already invested to reduce emissions and diversify into lower carbon products) will find themselves in a position of comparative strength. Meanwhile, smaller producers' often narrow focus heightens the risk of a slump in cash flows and decreased profitability, and could lead to market exits.

Most EU cement producers that we rate are regional or global, with lower-than-market-average carbon intensity. That suggests their competitiveness could benefit from market disruption caused by decarbonization. We also note, that larger European issuers generally benefit from geographic diversification outside the EU, affording them a meaningful share of revenues that won't be subject to EU ETS rules and the accompanying increased costs.

The strongest companies could benefit from sector consolidation.  Europe's highly competitive, highly cyclical, capital-intensive airline market is broadly vulnerable to additional regulatory costs from the EU's accelerated reduction of greenhouse gas emissions. Yet we consider that the strongest rated airlines are better positioned to cope with rising costs without a material weakening of their credit quality. Airlines with already weaker margins will find rising costs a greater burden, particularly if they struggle to pass increased costs to customers. That could contribute to a widening of the performance gap between Europe's strongest few airlines and the weaker majority, with the latter potentially finding themselves under pressure to consolidate or facing default. If that removes competition and capacity from the European market, it could provide a further boost to the region's strongest airlines.

Climate Change: A Fundamental But Slow-Moving Credit Quality Driver

Climate change is a megatrend that is gradually reshaping our world, and often in unpredictable ways. The effect of those shifts may take several years to become apparent, yet it seems inevitable that they will be multi-regional and cross-sector, and have the power to transform societies and economies.

The changes will bring with them financial, economic, and environmental risks, along with the potential for social unrest and supply chain disruptions. Yet the changes may also offer opportunities to businesses with the strength, management talent, and foresight to adapt to the disruption, including from technological and regulatory changes linked to decarbonization.

Climate transition has so far led to only limited credit rating changes, but we believe that its effect on credit quality could increase in the future. As we have done throughout our in-depth reports on decarbonization and climate change, we will continue to explain how we view these trends in terms of both their materiality to credit quality and their likely credit risk transmission channels.

Related research:

• Decarbonizing Metals Part One: A Pressing Issue With Uncertain Fixes, June 3, 2024
• Decarbonizing Metals Part Two: Financial Strength Mitigates Rising Credit Risk, June 3, 2024
• European Utilities' Net-Zero Ambitions Face Myriad Hurdles, May 2, 2024
• European Utilities: The Rating Relevance Of Net-Zero Commitments, May 2, 2024
• Global Airlines Outlook: Clear Skies, For Now, April 30, 2024
• Assessing How Megatrends May Influence Credit Ratings, April 18, 2024
• E-fuels: A Challenging Journey To A Low-Carbon Future, March 25, 2024
• German Chemical Industry's Decarbonization Is A Team Effort," March 20, 2024
• Hydrogen: New Ambitions and Challenges, Feb. 15, 2024
• Climate Transition Risk: Historical Greenhouse Gas Emissions Trends For Global Industries, Nov. 22, 2023).
• Renewable Energy Funding in 2023: "A Capital Transition" Unleashed, Sept. 14, 2023
• Germany's Green Energy Ambitions Spark A Transformative Decade For Utilities, Sept. 14, 2023
• Decarbonizing Chemicals Part One: Sectorwide Challenges Will Intensify Beyond 2030, Sept. 5, 2023
• Decarbonizing Chemicals Part Two: The Credit Risks And Mitigants, Sept. 05, 2023
• Why Climate Risks Are Changing So Few Corporate Ratings," April 12, 2023
• Europe's Airlines To Bear Highest Carbon Costs, April 3, 2023
• Decarbonizing Cement Part One: How EU Cement Makers Are Reducing Emissions While Building Business Resilience, Oct. 27, 2022
• Decarbonizing Cement Part Two: Companies Could See Pressure On Ratings As The EU Firms Up Carbon Rules, Oct. 27, 2022