Investors who want to fast-track sustainable fixed-income investments should inundate credit rating agencies with methodology critiques

Bill Harrington, former Moody’s SVP, urges everyone to hound credit rating agencies to embed each credit rating with an ESG upgrade, downgrade or wash.

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Responsible Resolutions: This is the latest article in a series from sustainable finance practitioners about their hopes for the New Year.

“Pension funds are thinking about how to incorporate green thinking into their credit portfolios. In equities, you can vote shares, but how to engage with companies whose debt you buy to make a difference?”

 — Pension Fund Chair [Source: private email]

I am new to the ESG world but have worked to make credit rating methodologies more rigorous for 20 years. As a Moody’s derivative analyst, I applied methodologies in each committee vote to assign a credit rating, developed methodology proposals, solicited and reviewed external feedback, and shepherded new methodologies to final approval and publication.

Credit ratings, climate risk, and the future of sustainable finance

Here’s what I know. A credit rating methodology is emphatically not a mere guideline but rather the critical safe harbor that underpins credit rating agency operations. A credit rating agency preserves immunity to most legal and regulatory penalties simply by ensuring that all committees assign all ratings in a manner consistent with applicable methodologies and processes. A credit rating that deviates from the applicable methodology is supposed to be rare and the rationale for deviation must be well-documented, including in the public rating announcement.

The bond market equivalent of shareholder engagement may be a full-court press (aggressive offense in American basketball) against a handful of credit rating agencies rather than one-on-one engagement with each of the world’s innumerable bond issuers.

To direct debt capital to sustainability projects, the bond world should tell each credit rating agency to overhaul methodologies so that, at the very least, exposures to physical risks such as fire and flooding are core inputs in assessing issuer ability to repay their bondholders. Credit ratings that differentiate issuer likelihood to pay based on a transparent assessment of the issuer’s readiness to manage physical climate risks over a meaningful time horizon will catalyse sustainability projects by lowering financing costs. At present, fixed income investors cannot use credit ratings to adequately assess bond issuers’ climate risk readiness.

Current credit rating methodologies incentivise issuers to avoid investing in sustainable projects and/or pursuing  ESG goals by allowing ratings committees to omit the credit impact of physical risks and other ESG exposures from their credit ratings.

A concerted investor push for more rigorous credit rating methodologies will obligate credit rating committees to downgrade as well as upgrade. In a cohort of otherwise similar issuers, those with significant exposures to physical and other ESG risks will have lower ratings than the remainder that either don’t face the exposures or are mitigating them.

The goal of demanding this information from the credit ratings agencies is to oblige the large oligopoly providers – S&P, Moody’s and Fitch control more than 90% of the market – to specify the same rigorous approach in all credit rating methodologies. This means that climate risk factors would be transparently incorporated into both sector methodologies and overarching ESG methodologies.

Why should investors ask that climate risk be part of all methodologies? Because methodologies are a major bond market pressure point, a bottleneck within a bottleneck. Time-constrained investors who are committed to engagement in fixed income markets should use this to their advantage.

Taking advantages of bottlenecks in the credit ratings system

The first bottleneck is the credit rating agencies themselves. Collectively, Fitch Ratings, Moody’s Investors Service, and S&P Global Ratings assign at least one rating to most publicly-issued bonds. The bottleneck within the bottleneck, i.e., within each credit rating agency, is methodology adherence. Every credit rating agency, from largest to smallest, imposes the same overarching constraint on rating committees: abide by the applicable methodologies! Methodology deviations are expensive and disruptive. They must be documented internally, to regulators, and in public rating announcements.

Shaping credit rating agency approaches to climate risk

The ESG world can shape the internal bottlenecks of each credit rating agency because the companies periodically update methodologies and continually solicit external critiques to inform this process. When few external parties submit critiques on a given methodology, a credit rating agency has considerable leeway in finalising the approach at its discretion. However, when a wide range of issuers, investors, and industry groups submit comments and critiques, a credit agency generally pauses, and often revises, methodology content.

According to one banker who advises US municipalities on issuing bonds to finance physical risk mitigation, “the best approach for ‘credit rating activism’ may actually be to critique the ratings agencies for not explicitly incorporating physical risk into their methodologies. They need to be explicit about what they are doing and how they are doing it so that investors can discount the ratings in accordance with their own investment thesis”. [Source: private email]

2020: a year to make credit rating agencies walk their big ESG talk

Moody’s says that their “rating methodologies for states, local governments and public utilities do not explicitly address climate change as a credit risk. However, the credit challenges of climate change are captured in our   analysis of economic strength and diversity, capital asset management, fiscal strength and governance, among other credit factors."

Current credit rating methodologies incentivise issuers to avoid investing in sustainable projects and/or pursuing  ESG goals by allowing ratings committees to omit the credit impact of physical risks and other ESG exposures from their credit ratings.

No existing methodology requires a credit rating committee to include physical risks, let alone other ESG exposures in baseline determinations of issuers’ ability to pay. Nor does any methodology specify how physical or other ESG exposures will drive issuer upgrades and downgrades today, let alone sector upgrades and downgrades over time. Instead, credit rating agencies stuff methodologies with ESG prattle that is so superficial as to allow a rating committee to entirely ignore physical and other ESG exposures in assessing issuer ability to pay.

At most, credit ratings address physical exposures after the fact, such as when flooding, drought, fires  or other headline events drive an issuer downgrade. Worse still, the non-committal methodologies — as well as credit rating agencies’ bait-and-switch touting of stand-alone ESG ratings, assessments, and acquisitions — foster the illusion that credit ratings rigorously incorporate the credit impacts of physical exposures.

Credit rating agencies are asking for it (investor comments, that is)

Fitch “invites market participants to provide comments” on current and proposed criteria. The company commits to “publish on its website any written responses it receives, in full, including the names and addresses of such respondents, unless the response is clearly marked as confidential by the respondent.”

S&P Global “reviews in-use Criteria periodically and welcomes written comments from market participants on its in-use Criteria.” The company also “welcomes comments on newly proposed Criteria.”

Before a new or materially updated rating methodology is published, Moody’s “invites market participants to provide written comments on the analytical framework described in a Request for Comment.”

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A credit rating agency will always listen to a methodology critique. The hard work is to then induce the credit rating agency to act by embedding the critique in all sector credit ratings, i.e.,  by embedding the critique in applicable methodologies.

A commenter who submits a public critique has many opportunities to leverage it, e.g., in company publications and research, distributions to allies, industry communications, and in public forums with credit rating analysts.

A commenter who submits a public critique and does not care to maintain a working relationship with the credit rating agency has unlimited opportunities to leverage the critique, as my ten-year activism shows. I have embedded methodology critiques in subsequent methodology critiques, regulatory submissions, a peer-reviewed law journal article, a proposed amicus curiae brief, and social media posts. I also speak on-the-record with all journalists who cover credit ratings and ask pointed questions at conferences and other public forums.

Examples can make a critique hard to rebut. For instance, coastal municipalities that are introducing innovative flood mitigation deserve better ratings and, just as importantly, municipalities that do not do so should be downgraded.

To up the pressure on a credit rating agency, a commenter can copy regulators such as the US Securities and Exchange Commission in a methodology critique. True, the SEC is generally loath to sanction credit rating agencies, but the regulator has done so when embarrassed by an overwhelming weight of publicly available information.

Moreover, one credit rating agency — Moody’s Investors Service — is subject to additional scrutiny of methodology and rating practices through at least 2022.  As a result of Moody’s special situation, a commenter can inform the US DOJ or the attorneys general of the District of Columbia or any of the following 21 states: Arizona; California; Connecticut; Delaware; Idaho; Illinois; Indiana; Iowa; Kansas; Maine; Maryland; Massachusetts; Mississippi; Missouri; New Hampshire; New Jersey; North Carolina; Oregon; Pennsylvania; South Carolina; and Washington.

Bill Harrington is Senior Fellow at Croatan Institute — an independent, nonprofit research institute whose mission is to harness the power of investment for social good and ecological resilience by working at the critical nexus where sustainability, finance, and economic development intersect.