Look Beyond ‘G’; Embrace ‘E’ and ‘S’
Globally, investors are increasingly demanding credit rating agencies (CRAs) to provide transparency on various risk factors beyond credit risk. Some European investors have taken a step forward and are seeking deeper analysis on new-age risks such as Environment, Social and Governance risks (ESG) and pushing CRAs for their inclusion in the overall credit ratings assessment.
In this context, PRI—Principles of Responsible Investing—conducted an extensive 3-part study between 2017 and 2018. The key aim was to understand the opportunities and challenges for effective integration of ESG into credit rating and risk assessments. The study engaged rating agencies, investors and various other capital market participants and made four key recommendations.
Further, TCFA—Task Force for Climate Related Financial Disclosure—initiative has also emphasized the need for strengthening the disclosure and analysis on the environmental factors and its impact on the issuer credit risks and opportunities.
How are CRAs embracing ESG?
So far, nineteen rating agencies have already signed UN PRI doctrine and committed to including ESG factors in the credit ratings statement. <UN PRI CRA signatories>
Last month, ESMA released guidance on how CRAs should consider ESG factors in their overall analysis. However, it did not make it mandatory for CRAs to integrate ESG factors in their credit risk assessment.
It shows that the CRAs are still not yet ready for a robust ESG regime.
What are the practical challenges?
The CRA rating criteria, frameworks, and default recognition policies are well-tested, documented and disseminated to investors. The ESG risks and opportunities are still evolving, and CRAs have not fully established its systemic impact on the credits.
There are four key challenges for effective integration of ESG into credit ratings. These include the materiality of the risk, time horizon for the risk to materialise, data availability, and alignment of frameworks for standardized benchmarks.
a) Materiality: How material is the ESG risk in the industry’s context?
For instance, customer welfare is a material social risk in the pharma sector and not so much in oil & gas. Similarly, hazardous material management is an environmental risk for the utility sector and not so much for the gaming sector.
SASB—Sustainability Accounting Standards—has done seminal work in this area to identify the top ESG risks in each sector. This is the most authentic and publicly available source and serves as a reference to establish materiality. In the credit ratings world, Fitch has developed an ESG relevance heat map. <Heatmap>
b) Timing: Is the ESG clock ticking in tandem with the repayment schedule?
The credit risks manifest over a finite time period; Example: tenure of the bond or term of the loan. But the ESG risks would manifest over a much longer period, and sometimes could be a ‘black-swan’ event, making modeling such risks difficult.
For instance, a cement company identifies high emissions as an environmental risk. Let’s assume that the company has a plan to transition 50% of their energy sourcing to renewables over the next 5 years. Exceeding the capex budget by 25% could heighten the project/credit risk. But delays in commissioning the renewables plants by 3 more years may not impact the credit risk substantially, although it reduces the ESGness of the company.
c) Quality: Who is watching the quality of the data and the models?
Finally, availability of quality data is a big challenge. Most of the ESG reporting undertaken by corporates are self-disclosures and often ends up as box-ticking exercises. TCFD 2019 Status Report shows that only 4% of companies reporting adhere to most of the recommended disclosures.
Even if clean datasets are available, they are not in a standardized format. There are at least a dozen standards including SASB, GRI, PRI, CDP, SDG, TCFD, GHG protocol, CBSB, etc. Each of these is serving a unique purpose. However, the good news is that there are discussions to align some of these standards and reporting guidelines.
Even if CRAs overcome the above hurdles, there is still some ground to cover such as training analysts, regulatory oversight, market awareness, and so on. But one virtue of CRAs is their unparalleled access to the company management. This helps them in asking the right questions, uncovering the relevant insights and shaping the thinking of the capital markets on ESG opportunities and risks.
So, for CRAs, ESG is not a question of if but when!
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