Credit practitioners are making great strides in considering environmental, social and governance (ESG) factors in their risk analysis. While these factors are still not addressed consistently and systematically by all fixed income (FI) market participants, positive developments are emerging.
Firstly, the idea that ESG consideration is part of a holistic approach to assessing credit risk is gaining traction: the basic tenet of assessing whether an issuer can pay back its obligations on time and in full still holds, but the global FI community is increasingly seeking ways to factor in sustainability considerations when allocating capital and managing risks.
Secondly, enablers of ESG factor assessments are increasing, albeit slowly, as data availability and disclosure improve, information becomes more accessible, and data are measured more accurately.
Thirdly, credit rating agencies (CRAs) are being more transparent about how they consider ESG factors in their methodologies, while research on ESG topics has increased and analytical tools are proliferating. CRAs are also appointing dedicated ESG analyst teams, and creating web pages to facilitate the dissemination of related material.
The start of 2019 saw a flurry of activity in this field as Fitch Ratings launched proprietary ESG Relevance Scores to identify sector specific-ESG credit risks and highlight their relevance and materiality to an entity’s credit rating decision. At the same time, following a request for public comment, Moody’s Investors Service published a cross-sector rating methodology explaining its general principles for assessing ESG risks in agency credit analysis globally. And, S&P Global Ratings announced a phased-in incorporation of ESG sections in ratings reports, starting with the oil and gas and utilities sectors.
Importantly, CRAs are providing more examples of how credit quality can be affected by ESG factors. Notably, there was a rapid deterioration in the creditworthiness of California-based Pacific Gas and Electricity Corporation, which filed for bankruptcy last month partly because of increasing liabilities from recurrent wildfires. The municipality of Cape Town also faced a rating downgrade last year after a drought affected its revenues – with indirect economic and societal effects – and increased its debt. There are also examples of rating upgrades, which are rarer: it was the case last year with AMN Healthcare Inc. on prospects that it will benefit from favourable industry trends, including growing demand for health services due to an ageing population.
Meanwhile, investors are increasingly considering ESG factors in a more structured way, as they realise that their impact on bond issuers’ financial performance is becoming more tangible. There are several reasons for this, including extreme weather events, changing consumer preferences and shifts in societal priorities affecting product and brand developments. While many asset owners are not yet clear about what to ask external FI managers about their approach to ESG consideration, several asset managers are beginning to have a framework in place.
Finally, the intensifying regulatory scrutiny of ESG consideration by financial market participants is also catalysing positive change. Notably, in Europe, the work of the High-Level Expert Group on Sustainable Finance and the subsequent EU Commission Action Plan have encouraged credit practitioners to be more focused on ESG factors, triggering preemptive action towards transparency and methodical assessment.
Mapping ESG factors and assessing issuers’ awareness
The Principles for Responsible Investment (PRI) has been working with investors and CRAs since the launch of the ESG in Credit Ratings Initiative in 2016 to promote understanding of practices, identify gaps in the consideration of ESG factors in credit risk analysis, and find ways to address those gaps. The collaborative work achieved so far has helped to highlight that ESG dynamics are more multi-dimensional for FI assets than is the case in equity markets. For example, the potential materiality of ESG factors varies depending on the financial strength of the entity that issues a FI instrument, the type of issuer (sovereign or corporate), and the maturity and structure of a bond.Importantly, it is helping to clarify that when it comes to the materiality of ESG factors, FI investment and credit ratings have different objectives: whereas a credit rating will only include them if material to credit risk (i.e. the risk of default), investors looking for guidance on ESG factors in a potential investment may also use standalone ESG scores (compiled in-house or by service providers) that measure the exposure of a bond issuer to ESG factors – with potential volatility repercussions – but not credit risk.
Even more importantly, time horizons vary and depend on factors including investment objectives and the type of rated entities. So, in recognising credit-relevant time horizons, the issue is more centred on how to balance short-term versus long-term considerations. Here, “what if” analysis – through stress testing, and sensitivity and scenario analysis – can signal long-term risks, incorporate uncertainty and focus on drivers of potential outcomes, as well as help to understand an issuing entity’s level of risk awareness. This is the point at which an ESG factor turns into a credit risk factor: if and ESG factor is not deemed credit-relevant at present, the circumstances under which it could become relevant can be stated.
While many asset owners are not yet clear about what to ask external FI managers about their approach to ESG consideration, several asset managers are beginning to have a framework in place.
To help investors and CRAs frame these issues more systematically, one of the key recommendations of the PRI’s new report, Shifting perceptions: ESG, credit risk and ratings – part 3: from disconnects to action areas, is for both sides to categorise ESG factors depending on type, relevance and urgency. For example, are they event, trend or policy-driven? Are they present, emerging or potential?
It is also helpful to establish how visible the ESG factors are, their likelihood of materialising, and, crucially, their impact on creditworthiness, including the issuer’s balance sheet strength. Once credit-relevant ESG factors and time horizons have been identified, another important step is to rank them in order of importance or urgency by linking an estimate of their severity to the probability of them materialising. Heat maps can be useful to prioritise material ESG factors and provide a relative assessment of their potential impact.
Assessing an issuing entity’s awareness of ESG factors that may affect its credit quality and its ability – and willingness to address them – is also helpful. This could be approached in numerous ways, including looking at how management addressed the credit implications of ESG factors previously, or if they have been mitigated already. At this stage, the analyst’s qualitative assessment has more of a role, focusing on management expertise, corporate culture, labour relations and factors such as reputation and intangible capital. It is also the phase where investors and CRAs (through engagement and outreach) can talk to issuers about ESG topics.
Ultimately, having these conversations more frequently will help issuers to recognise that disregarding material ESG risks can result in suboptimal investments and ratings that could affect their cost of capital. Improved transparency by issuers around what investors and CRAs believe are the most material ESG factors to credit risk could also prompt indirect market benefits in terms of improved issuer disclosure and reporting, as well as fostering a market standard of comparable, meaningful metrics that facilitates analysis.
Carmen Nuzzo is a Senior Consultant for the PRI’s Credit Ratings Initiative.
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