Environmental, social and governance concerns are becoming central to corporate finance.

Author: Jonathan Rogers

Credit ratings agencies (CRAs) are moving to include environmental, social and governance (ESG) considerations into their methodology, with a major push underway among CRAs in Asia coordinated by the United Nations-supported Principles for Responsible Investment (PRI).

Under its Credit Ratings Initiative, PRI aims to enhance the systematic integration of ESG factors in credit risk analysis and is facilitating dialogue between Asia-based CRAs and investors to isolate ESG risks to creditworthiness. CRAs participating in the initiative include Dagong, RAM Ratings, Japan Credit Ratings Agency (JCRA), China Chengxin Credit Management Co and Golden Credit Rating International. S&P Global Ratings and JCRA are committing to the ESG drive by hiring experts in the field and establishing dedicated analyst teams with the aim of making ESG central to their credit rating methodology. Moody’s Investor Services hired ESG specialists in February 2018.

The environmental element of ESG is the most consequential input into ratings methodology and the key downgrade risk for a variety of reasons. These reasons include event risk associated with environmental degradation, regulatory risk which threatens companies with stranded assets — the fossil fuel industry being a prime example — and disinvestment from an increasingly active ESG-conscious investor base.

Perhaps the most stark example of the growing importance of ESG to corporate credit ratings was the downgrade of Volkswagen by S&P after diesel emissions manipulation in the US was uncovered in September 2015. The company was downgraded twice by two notches in October and December of that year while the assessment of governance was revised downwards to reflect inadequate risk management frameworks of environmental and social risks.

Although Moody’s currently rates Volkswagen’s long-term debt A3 with a stable outlook, the agency observed in a March 2018 credit opinion that the company could continue to face negative repercussions due to the diesel emissions issue.

“The rapid growth of new environmental regulations and energy emissions standards, coupled with major technological shifts and growing consumer preferences for sustainable products, will have a tangible — and, in some cases, disruptive — credit impact on the most exposed sectors globally,” said Rahul Ghosh, senior vice president of Environment Social and Governance, at Moody’s in Hong Kong.

Meanwhile, the hectic pace of green bond issuance has made ESG considerations indispensible for ratings methodology. The green bond market has grown 80% per annum over the past five years according to S&P and two-thirds of issuers are now private entities whereas previously issuers were mainly states and governments. In 2018, green bond issuance is set to soar by around 60% in 2018 to the $250 billion mark according to Moody’s, up from the $155 billion issued last year. The need for appropriate credit ratings has increased in tandem with this growth.

“Green bonds have emerged as a formidable issuance vehicle over the past few years and this has certainly acted as a catalyst towards increased scrutiny on ESG in credit risk analysis in general,” said Carmen Nuzzo, senior analyst for the PRI’s Credit Ratings Initiative.

“One has to remember that green bonds represent a small fraction, albeit growing rapidly, of the outstanding bond universe which is huge and larger than the equity market capitalization. So ESG considerations should be factored in the assessment of the creditworthiness of green bonds as well as in that of any other mainstream bond.”

Progress is being made on modelling and data capture with respect to including ESG in the ratings process.

“The fixed-income community is highly quantitative and is beginning to build a formal framework around ESG considerations in credit risk analysis. It faces several challenges however, either because past data may not exist or, if they existed, they were not priced by markets. So back-testing is difficult.”

“Also, history does not always help, because some ESG factors are new, for instance cybersecurity. Finally, a lot depends time horizons which vary depending on the investment objectives,” said Nuzzo.

Moody’s in late 2015 conducted a review of the relative credit exposure of 86 sectors — accounting for roughly $68 trillion in rated debt globally — to environmental issues.

“The study showed that while the potential credit implications of environmental issues vary widely by sector, carbon transition risk is likely to have material credit implications over the near term for a subset of 14 sectors with roughly $3.2 trillion in rated debt,” said Moody’s Ghosh.

“This subset included unregulated power generation, coal mining and coal terminals, automobile manufacturers, independent oil and gas exploration and production, mining, steel, commodity chemicals, building materials, oil and gas refining and marketing, and power generation projects.”