Credit ratings are perhaps the most widely referenced indicator of an issuer’s financial health, despite the industry’s somewhat chequered history.
For the founders of specialist sustainability provider Beyond Ratings, the shortcomings of classical credit analysis also stem from a poor integration of climate and broader sustainability risk factors and addressing this has become something of a calling card for the company.
According to Sylvain Chateau, a co-founder and chief operating officer of the Paris-based outfit, the company turned its attention to climate risks around the time of its 2014 founding, shortly before the formation of the Task Force on Climate-Related Financial Disclosures (TCFD) and France’s landmark Article 173 would bring increased regulatory and investor scrutiny on the topic.
“We first felt that credit ratings are supposed to give investors a good sense of the risks associated with a bond. But once we started investigating, we realised that at the time physical climate and transition risks were poorly integrated into credit analysis methodology, despite these risks becoming increasingly material,” he says.
“We started our research with sovereigns because global carbon emissions are primarily a government issue, and so we found sovereign debt to be the most appropriate asset class for us to apply our methodology. After around four or five years of research and development, the most advanced modeling that we achieved was in the credit risk space.
“So the idea was really to build a model that could demonstrate how climate and broader sustainability factors related to performance factors such as credit default swap prices and yields.”
The company found that weighting a sovereign’s sustainability profile and its macro financial performance equally by 50% resulted in a better correlation with future performance such as credit spreads, compared to other approaches.
Chateau attributes this to a focus on materiality when assessing and selecting sustainability factors, a mindset he argues sets Beyond Ratings apart from other ESG providers. This is why factors like the use of the death penalty isn’t included in the few dozen of ESG indicators that Beyond Ratings considers when assessing sovereigns, he says, as “there is absolutely no link between the death penalty and economic growth or the pricing of the debt”.
“At the end of the day, we want to be financial analysts who incorporate ESG issues rather than the other way around. From the start, we anticipated that ESG would be systematically incorporated into mainstream finance so we really didn't want to start a niche business when the niche was supposed to disappear.”
In addition to credit analysis, Beyond Ratings offers broader ESG research for sovereigns focusing on the economic impact of relative sustainability performance. Chateau says in the course of their research, the company found a strong link between a given country’s economic growth – represented by GDP per capita – and its expected ESG performance. By examining discrepancies between a country’s ESG performance with that of a peer group with similar levels of wealth, Beyond Rating says it can predict future economic performance based on whether a country is a leader or laggard.
The company also provides forward looking temperature scores on carbon emissions for individual sovereign issuers and overall portfolio scoring. According to Chateau, investors can use this data to assess how they are progressing against internal climate objectives or targets. For example, a portfolio scored at 4°C is consistent with a global warming of 4°C by 2050, and will need to be reallocated if it is to be considered ‘Paris-compliant’.
By dedicating our research to sovereign issuers, says Chateau, we have built a reputation for ourselves as experts on the topic.
But this was not always the plan. Instead, since its founding the company had harboured designs to operate as a full-fledged credit ratings agency. In March 2019, Beyond Ratings finally received accreditation from European regulators to begin issuing sovereign credit ratings after what Chateau describes as a “huge process of due diligence”.
However, this was not to be. Soon after, Beyond Ratings was acquired by the London Stock Exchange Group (LSEG) for undisclosed terms and a potential move into credit ratings was vetoed by the new owner. Subsequently, a decision was taken to relinquish the credit ratings license.
Chateau disagrees with suggestions that the move was a loss to the company, pointing to other avenues for growth afforded by the LSEG tie-up.
“Aside from credit ratings and bond pricing there are other ways to provide investors signals to make them allocate their capital toward more sustainable investments, one of which are indexes. Our first-of-a-kind climate risk indices does this by increasing investor exposure to sovereign issuers which demonstrate better resilience to climate risks.
“Now that we are part of the London Stock Exchange Group, we want to replicate what we have achieved for sovereign bonds, in other asset classes but it will be rooted in our tried-and-tested approach of using quantitative data modeling and forward looking indicators to support our clients.”