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Sustainability and credit ratings have remained a feature of the much-awaited EU Commission’s action plan on financing sustainable growth. This is testament to the role that these instruments play in improving sustainability-risk-adjusted capital allocation. However, the Commission is calling for more time to conduct research, monitor developments and gather evidence. This is a move probably down to prudence – rather than an attempt to kick the can down the road – as it will facilitate a broader engagement with stakeholders and give greater recognition to important ongoing developments.
The Commission’s report has retained the High-Level Expert Group on Sustainable Finance’s (HLEG) distinction between the two main categories of rating providers: credit rating agencies (CRAs) and sustainability rating agencies (SRAs). Its recent Action Plan also mentions market research, which both CRAs and SRAs can provide.
The distinction is important: CRAs measure the relative probability of default of a bond issuer or of its issuer. When it comes to environmental, social and governance (ESG) issues, they are concerned about the impact of these factors on a bond issuer’s balance sheet and its creditworthiness. SRAs assess how well an issuer (either of equities or bonds) performs against ESG metrics. We would argue that labelling their products as ratings may be misleading, and that ESG scores or assessments are much more suitable. This is because they do not contain the element of judgement which features in credit ratings, and are unregulated. With that said, CRA and SRA products are not mutually exclusive, but complementary in investor decision making.
The Commission’s overall assessment of these market agents, on which the Action Plan is based, gives equal consideration to CRAs and SRAs. However, the Commission did not adopt ‘tout court’ HLEG’s recommendations – rather, it is taking time to assess current practices.
The exploratory period it has set itself before introducing concrete steps will hopefully more prominently highlight the changes that stakeholders in this sector are embracing to enhance the consideration of ESG factors in lending and investment decision making. This is a fast-evolving area in an increasingly competitive market.
CRAs are making significant progress, prompted by client demand as well as through partnering with organisations that promote sustainability – such as the Principles for Responsible Investment (PRI), the Task Force on Climate-Related Financial Disclosure and the Climate Bonds Initiative – and attempt to pre-empt regulatory changes. Meanwhile, ESG-score providers are consolidating, broadening their product offering and refining methodologies to serve fixed income market players as well as equity investors.
Two of the largest global CRAs are leading the pack. As noted in the PRI’s recent report, Shifting Perceptions: ESG, Credit Risk and Ratings – Part 1: the State of Play, they are complementing rating analysis with additional research publications, and have published articles on how ESG factors feature in their methodologies. By engaging with investors on ESG topics – partly through regional roundtables the PRI is organising as part of the ESG in Credit Ratings Initiative – they are helping to effect positive changes in transparency. This includes making explicit ESG factors which are already embedded in credit rating opinions but are not labelled as such. Furthermore, they are discussing with investors how to provide long-term risk guidance, beyond the typical credit rating time horizon.Perhaps the most striking recent development has been rapid organisational changes. Indeed, the responsibility and the co-ordination of efforts to disclose and better reflect ESG consideration in research, rating and analysis no longer rests only with a few people globally. Rather, it is firmly on the agenda of steering committees, working groups and dedicated analyst teams. Competence to assess ESG factors is increasing; it probably will not be long before we start seeing more changes in ratings because of more systematic and insightful consideration of ESG factors. In fact, there is evidence of this happening already, especially regarding environmental factors.
All planned deliverables are due by Q2 2019 at the earliest. This effectively defers action to the new Commission
Importantly, progress is not confined to large CRAs but is being seen among smaller or specialised players that are supporting the PRI. For example, last November a Japanese CRA introduced formal training for its analysts – with others likely to follow suit – and many CRAs have set up dedicated ESG webpages. The CRA landscape is evolving, with the emergence of new actors that are beginning to provide separate ESG risk assessment or an augmented analysis of creditworthiness, including, for example, an in-depth natural capital investigation.
The extent to which the Commission’s work will translate into action remains to be seen. All planned deliverables – including the results of the Commission’s engagement with all relevant stakeholders; the tasks assigned to the European Securities and Markets Authority (ESMA); and a comprehensive study on sustainability ratings and research – are due by Q2 2019 at the earliest. This effectively defers action to the new Commission, to be appointed after the 2019 spring EU parliamentary election.
In the meantime, progress by CRAs and SRAs is likely to continue in the coming months, driven by market interest, as fixed-income, and not just equity, investors are waking up to incorporating ESG considerations in portfolio allocation and becoming more demanding. The challenge is overcoming existing inertia and adopting a more forward-looking approach. It is the PRI’s intention to continue to nurture a dialogue between investors, CRAs and SRAs on this topic in coming months. They all have an important role to play in enhancing issuer disclosure.
In the end, regulatory changes might manifest as tweaks to existing legislation rather than a complete overhaul of existing regulation, which already requires that methodologies, models and key rating assumptions are publicly disclosed, and that staff have sufficient expertise in appropriate areas of financial services. In fact, Regulation (EC) No 1060/2009 on CRAs already states that “Where appropriate, rating methodologies should take into account financial risks deriving from environmental hazards”, and provides a clear basis for advancing credit rating practices.
Carmen Nuzzo is a Senior Consultant for the PRI’s Credit Ratings Initiative and Kris Douma is PRI’s Director of Investment Practices and Engagement