Moody's: Auto sector faces rising credit risks due to carbon transition

Moody's Investors Service says that the automotive manufacturing sector globally faces a rapidly evolving environment and rising credit risk as companies need to make material changes to more effectively reduce the sector's carbon footprint and respond to expected growth in the demand for alternative fuel vehicles (AFVs).

"Given that the auto industry is one of the most significant emitters of greenhouse gases, there is a clear need for the industry to improve emissions-reducing technologies and adapt to the broadening emergence of AFVs," says Brian Cahill, a Moody's Managing Director who is a lead representative for Moody's on environmental, social and governance (ESG) topics.

In its analysis, Moody's uses a baseline emissions scenario consistent with the nationally determined contributions (NDCs) established as part of the Paris Agreement signed by 180 countries as of 7 September 2016.

"Although the NDC scenario is forecast to be insufficient to limit global warming to less than 2 degrees Celsius that was the commitment under the agreement, it represents a plausible central scenario, as it tracks the current policy commitments of national governments," says Cahill.

"While we use the NDC scenario as our baseline, our analysis also qualitatively considers a wider range of potential outcomes, depending upon either more or less rapid carbon transition," adds Cahill.

"We believe that major auto manufacturers face material risks, which are transmitted through four channels: [1] rising policy pressure, with stricter emissions-reducing regulatory targets a likely outcome; [2] increasing pressure on margins and cash flows; [3] changing consumer preferences; and [4] disruptive technological shocks," adds Yanase.

Policy risk is substantial as the transport sector is a major carbon dioxide emitter. In this context, the sector needs to improve emissions-reducing technologies and adapt to the global emergence of AFVs.

Moody's believes that regulators' increased focus on emissions compliance will accelerate the reduction of emissions. Along with the advanced economies, many emerging economies have also introduced regulations that will likely affect the strategies of automotive manufacturers for AFVs.

Financial risks are increasing as the manufacturers' R&D and capital spending may need to increase against the backdrop of the global push to reduce emissions and in view of the likely emergence of new competitors. Financially strong companies are best positioned to manage the added drain on their resources, but increased spending will likely further pressure the sector's already low margins.

Changing consumer preferences -- such as demand for AFVs -- is likely to become an important sales driver. We expect demand to grow amid technological improvements, incentives created under government policies and growing concerns over climate change. Automotive manufacturers with a broad range of AFV models and better consumer reputations for reducing emissions will be best positioned to meet this demand.

Finally, Moody's considers that disruptive technological shocks are possible. For example, the difficulty of predicting the degree and speed of AFV take-up is a significant risk for auto manufacturers because producing such vehicles will require changes to the manufacturing process and heightened coordination with auto-parts suppliers. Auto manufacturers without a well-developed technology strategy and ability to rapidly retool, or those with long product life cycles, will fare the worst as the need for manufacturing flexibility and speed-to-market rises.

In this situation, Moody's has developed a heat map to help assess auto manufacturers' relative exposure and positioning to carbon transition risks, and which will assist in our qualitative consideration of the implications for their credit ratings. We will also have more intensive discussions about these issues with the manufacturers to better understand their ability to deal with them.

"In summary, Moody's is increasing its focus on the risks related to climate change for auto manufacturers globally. While we do not anticipate any immediate rating changes, we are monitoring rising risks in this sector for possible future implications. We have developed a carbon transition risk heat map as an informational tool to better organize and more consistently communicate our assessment of companies' positioning to manage these risks, and our evolving view of these risks for the sector and individual companies will be considered in our scoring of qualitative factors in our global automotive industry rating methodology scorecard," adds Yanase.

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