Prompted by a push by investors to incorporate environmental, social and governance (ESG) issues in their analysis of investment risk, credit-rating agencies are advancing efforts to integrate these sustainability factors into their credit assessments. However, the agencies are taking varied approaches, and the adoption of ESG data and metrics raises several issues and subsequent risks - some stemming from how ESG analysis is unfolding, and at least one as old as the rating agencies themselves.
Perhaps the most pressing issue today is the lack of standards. Axel Pierron, managing director and co-founder of Opimas, said ESG data providers (including specialist firms, stock exchanges and asset managers) are quite varied, and may provide ratings and analytics in addition to data.
These firms, moreover, are expanding their sources of data to make it timelier and more reliable. However, inadequate standardization means investors seeking to reallocate portfolios toward ESG risk will be making potentially ill-informed investment decisions.
“Investors may end up with stocks that are overpriced due to - at best -incomplete or outdated data,” Pierron said. An unforeseen event revealing flawed data supporting a company's high ESG rating, he added, could deleteriously prompt investors to question whether to integrate ESG criteria into investment decisions.
On the credit front, Pierron noted, there is no clear correlation between ESG ratings and credit ratings, and that the former's heterogeneous qualitative and quantitative elements don't always enter the credit-ratings analysis. Most environmental criteria, for example, do not yet impact a company's credit rating significantly, because the metrics simply aren't in place yet.
“This could change if regulators were to step in to increase the cost of carbon emission allocation,” Pierron said.
He noted that the ESG and credit ratings could even conflict. A renewable energy start-up, for example, is likely to have good ESG ratings. But because its business model depends on regulatory incentives favoring renewables, its credit rating may reflect the probability of default if public policy were to change.
In the context of the current pandemic, companies using cash to retain employees despite slowing growth may score highly in terms of ESG, but suffer from a credit standpoint.
Ratings Conflict
Another issue is the perceived conflict of interest that arises when the rating agencies, whose credit ratings are paid for by issuers, provide ESG assessments that investors may use in their investment allocation decisions.
Fitch Ratings has avoided the issue by developing a methodology for applying ESG factors to credit risk, rather than pursuing acquisitions. Steel recalled an influential December 2017, titled “Rating the Raters on ESG,” that emphasized the importance of the agencies' roles in “establishing de facto standards for disclosure by issuers.” The paper called for them to develop and disclose systematic methodologies for assessing material ESG considerations at the industry level and provide transparency on how ESG considerations affect the credit-rating review of each issuer.
“In mid-2018, we [at Fitch] started working on a major project to transform our research, so that we very transparently explained how ESG risk factors as a subcategory were impacting credit ratings,” Steel said.
In early 2019, Fitch launched its template system that provides an individual entity- and transaction-scoring system showing the level of impact from ESG factors on individual credit-rating decisions, as part of the overall Fitch credit rating. The agency now produces 96 templates, ranging from industry sectors such as food retailers and oil and gas producers to covered bonds, RMBS and public finance entities. Each template is based on a set of general-issue risk categories, with five environmental, five social, and four or five governance categories.
The general issue environmental risk categories, for example, are greenhouse gas emissions and air quality, water and wastewater management, energy management, hazardous waste and materials management, and exposure to environmental disasters. For each industry-sector template, Fitch identifies the sector-specific credit risks that relate to the general risk issue categories and then provides a reference column identifying which main aspects of a 'business could be impacted if the sector specific risk materializes.'
In the case of Volkswagen's emissions scandal, Steel said, the main area of credit risk in the automotive manufacturing sector for greenhouse gas emissions and air quality for entities was emissions from the vehicle fleet being manufactured and sold. The reference areas that could be impacted by this risk materializing were brand positioning, financial structure and profitability. VW's overall size and strength resulted in little impact on the first two, although the hit to profitability from fines did prompt a downgrade.
Steel said the research has clearly showed that, even within an industry sector, each of the ESG risks could impact credit differently for sector entities, depending on their unique business and financial profiles. For example, if a smaller luxury automaker with more debt on its books faced the same issue as VW, it would see likely see not only its profitability but also its brand and financial structure impacted - and thus its overall credit rating might be affected much more severely.
“We're being very clear about extracting for investors the risks from our analysis that are related to ESG from a credit perspective and providing commentary around whether they alter the rating we currently have out there in the market,” Steel said.
The Moody's ESG affiliates “inform Moody's Investors Service (MIS) credit analysis on contingent risks” related to ESG, but their employees do not participate in MIS credit-rating committees, an agency spokesperson said. The spokesperson added, “MIS has strong policies and procedures in place to protect the independence and quality of its credit analysis and maintains a strict separation between analytical and commercial operations.”
Issuer-Pay Issue Re-emerges
S&P Global's ESG acquisitions present a fuzzier situation, since it has relaunched products under the S&P Global brand, charging fees to investors and issuers.
The S&P Global Rating ESG Evaluation - one of the new products - is a “forward-looking assessment of an entity's capacity to operate successfully in the future,” according to S&P Global. The S&P Global ESG Score, on the other hand, assesses a company's current and past sustainability practices. Both products are “completely separate offerings” from its credit ratings.
“A credit rating is a forward-looking opinion about the ability and willingness of an issuer … to meet its financial obligations in full and on time,” said an S&P Global spokesperson. An ESG Evaluation, on the other hand, “provides a cross-sector, relative analysis of an entity's capacity to operate successfully in the future and is grounded in how ESG factors could affect stakeholders and potentially lead to a material direct or indirect financial impact on the entity.”
Issuers pay for the ESG Evaluation separately from the credit-rating fee, and each service uses different analysts. All market participants can access ESG Score through subscriptions to Xpressfeed from S&P Global Market Intelligence, a service providing investors with data, research, news and analytics. S&P Global says the ESG Score does not impact a credit rating and is “not an input into and therefore does not impact an ESG Evaluation.”
Charging issuers for their credit ratings has long been an issue that rings alarm bells when there is financial-market stress, such as the 2008 financial crisis. Pierron said that the highly standardized data and methodologies used by the rating agencies results in a correlation between the various credit ratings, creating a consensus that reduces conflict-of-interest concerns.
Paid for by issuers, the ESG Evaluation service faces a similar perception of conflicting interests and could taint ESG Score as well, without the credit-rating elements to mollify investor concerns.
“With ESG ratings [provided by non-credit raters], the situation is very different, with limited correlation between ratings across providers, non‐standardized and missing data, heterogeneous rating methodologies, etc.,” Pierron said. “Hence, there is a clear lack of consensus, which could reinforce the debate around conflict of interest - especially as a number of ESG rating providers have implemented an 'investor pays' business model and would therefore likely highlight the situation.”
Long-Term Impact
Steel at Fitch said COVID-19 has had a short-term impact on ESG factors, such as labor management and short-term carbon emissions, but the long-term credit implications for ESG remain unclear.
As economies start to recover from the crisis, Steel said, weaker finances will likely affect entities' ability to manage some ESG risks, and more limited fiscal resources will test governments ESG policy priorities. For developed markets, recent policies and market trends could potentially accelerate low-carbon transition, but a 'brown recovery' remains a high risk in emerging markets.
Moody's left open the door for significant long-term impact. The spokesperson noted that the COVID-19 pandemic has not changed the emphasis the agency places on ESG.
“However, the magnitude and widespread impact of the pandemic has resulted in a large number of rating actions over a short period of time,” the spokesperson said. “We continue to evaluate the impact of the pandemic on all issuers we rate, including as it relates to material ESG considerations.”
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