For years, environmental, social and governance (ESG) factors have been a priority among institutional investors. COVID-19 has underscored the significance of the 'S' risk, as the public health and safety issues stemming from the global pandemic have produced massive unemployment and a global economic slowdown.
The social element has impacted companies' credit standing, with rating agencies issuing negative outlooks and downgrades across a broad array of industries. Corporate governance, long factored into credit ratings, has also played a role. For example, pressured by activist investors, many companies have minimized inventories and balance-sheet cash, weakening their ability to endure the current crisis.
How COVID-19 will ultimately impact ratings, which seek to provide credit-risk outlooks over the medium to long term, remains to be seen. The pandemic continues, and government intervention to aid companies has muddied the water in terms of gauging credit quality.
“The current disruption has highlighted that ESG risks can manifest themselves rapidly,” said Kristen Sullivan, a partner at Deloitte & Touche who leads its sustainability and KPI services. She added that ESG data and metrics are still being developed and arguably insufficient compared to traditional credit-rating inputs. “The interplay with credit ratings is so critical, and it's top of mind as we talk to corporate finance executives.”
Credit metrics should bounce back as the pandemic recedes, but for some industries it may be to a “new normal” in light of ESG considerations that no longer support pre-pandemic ratings. The data and metrics on which those ESG considerations are based, however, are still being developed, leaving uncertainty about what that new normal will look like.
As far as ESG impact on ratings, the 'E' risk factor has less impact today from a credit perspective than 'S' and 'G,' not because it is less important but because the metrics simply aren't there yet.
“In terms of credit risk, environmental factors will really only start to bite when you have regulations that force costs into entities' credit profiles, and there aren't many sectors like that yet,” said Andrew Steel, managing director, sustainable finance, at Fitch Ratings.
Absence of ESG Standards Poses Challenges
The risk to investors as well as issuers is that, unlike traditional financial ratios used to measure credit-risk, ESG data and metrics often bear little resemblance to each other. A plethora of ESG research and scoring firms have emerged, but initiatives to develop standards enabling more effective analysis and comparison are still in formative stages. That has resulted in uncertainty gauging the financial impact of a pandemic or other crisis - particularly with respect to the ratings of individual companies or entire sectors.
“In the absence of reliable ESG measures, we're increasingly putting value at risk, because these new attributes are being integrated into mechanisms that we have relied on to determine access to and cost of capital,” Sullivan said. “There's no EDGAR for ESG reporting, and there's a lack of consistency in terms of company-provided information.”
Given COVID-19's significant ratings impact and the potential for future outbreaks, the current pandemic appears likely to accelerate the adoption of ESG factors into risk analysis. That adoption had already gained significant momentum before the pandemic began, when ratings agencies jumped on to the ESG bandwagon by acquiring multiple ESG research and scoring firms.
In January, Larry Fink, CEO of Blackrock, highlighted investor concerns when he warned corporate CEOs that climate change would, “sooner than most anticipate,” result in a significant reallocation of capital. A few months earlier he had predicted that the giant asset manager's ESG-focused exchange-traded funds would grow from $20 billion to more than $400 billion by 2028.
ESG's increasing importance is also reflected by growth in the ESG data market. Management consultancy Opimas estimates that $617 million was spent on ESG data $ in 2019 - with annual growth of 20% for ESG data and 35% for ESG indices, potentially reaching $1 billion by 2021. Opimas' research found 60% of spending is driven by firms in Europe responding to regulatory pressure, with those in the U.S. accounting for one-third and Asia the remainder.
Here Come the Rating Agencies
Standard & Poor's and Moody's Investors Service say they have long captured ESG factors in their traditional quantitative analysis, when they become “material.”
“Moody's Investors Service's credit analysis has always sought to incorporate all issues that can materially impact credit quality, and that includes ESG factors,” said a Moody's spokesperson.
The spokesperson noted two “key” recent changes: the firm has developed analytic tools providing a common language for analysts to discuss and analyze ESG risks across sectors and asset classes, and has sought to make its ESG analysis more explicit and transparent in its press releases, credit opinions and research.
Even so, in the last year or so, credit rating agencies have gobbled up numerous ESG research and rating firms. In May, S&P Global launched ESG services aimed at investors and issuers.. Last year, Moody's entered the ESG market, acquiring majority stakes in Vigeo Eiris and Four Twenty Seven Inc. Morningstar, meanwhile, recently completed its acquisition of Sustainalytics, another longstanding ESG research and scoring firm. .
The acquisitions have resulted in consolidation. However, there are still numerous established ESG data and analysis providers - including MSCI, Refinitiv, Bloomberg, RepRisk and Institutional Shareholder Services. Moreover, there are upstarts such as State Street Global Advisors, which launched its ESG scoring system last summer, and Truevalue Labs, which says it “applies AI to uncover [ESG] opportunities and risks hidden in massive volumes of unstructured data.”
Those firms typically look at companies' public documents, news sources or other third parties to glean ESG-related information and data. Some solicit information directly from the companies they rate. Each firm has its secret sauce, using different metrics in their analyses and scoring, rendering it difficult for investors to compare them and for issuers to gauge their ESG standing.
Although 86% of the S&P 500 companies provide some sort of ESG disclosure, investors remain dissatisfied with the quality of the information, Sullivan said.
“Having to cut through a 100-page sustainability report to find information that is truly relevant has really elevated the conversation from a reporting exercise disconnected from the business to how to truly integrate ESG risk into the business model and strategy, and how it impacts stakeholders,” she elaborated.
In addition, in the U.S., companies provide that information voluntarily, largely unaudited.
“We have a huge issue with ESG data - and it's an issue for the credit rating agencies as well - because the data isn't being audited,” said Axel Pierron, managing director and co-founder of Opimas.
He noted that longtime ESG firms such as Sustainalytics analyze and cross check data and information, and send their own questionnaires, but the lack of standards results in “huge interpretation.”
Nurturing Standards
Sullivan said that best way to solve for such inefficiencies is to provide disclosures in accordance with recognized standards. Citing the frameworks established by the Taskforce on Climate-Related Financial Disclosures (TCFD), the Global Reporting Initiative (GRI) and the Sustainability Accounting Standards Board (SASB), she said the market is moving in that direction.
SASB describes its standards as “important market infrastructure to help investors integrate [ESG] factors into their decision making in a rigorous, scalable way.” More than 200 companies globally use SASB standards for sustainability disclosures, some in financial filings and most outside, Sullivan said.
Given that SASB released its standards just two years ago, that number is significant. However, Sullivan noted there is certainly room for growth., “That's not yet critical mass in the capital markets but headed in the right direction.”
A company that has made significant headway is Vornado Realty Trust, which furnishes its ESG report to the Securities and Exchange Commission (SEC) via an 8K filing. Deloitte performed a review of the ESG report in accordance with GRI standards and performed an examination on the SASB disclosure appendix. Sullivan said VRT has also “advanced progress on climate reporting in accordance with TCFD.”
Equity investors looking for growth tend to be less concerned about ESG standards and may welcome wide-ranging and disparate sources of data - which, if chosen correctly, may give them an advantage.
Sullivan said that the credit-rating agencies, “gobbling up ESG- and climate-data firms, are going to start to apply more sophisticated AI and big data,” providing “more meaningful insights.” How that ultimately impacts credit ratings is unclear, however, because the rating agencies are taking different approaches to incorporate ESG, and because the data and metrics, and their relevance from a credit perspective, are still unfolding.
Emerging challenges and issues, including the continuing integration of ESG into credit-rating agencies' ratings and broader product suites, will be explored in a future Risk Intelligence article.
More
