The Prominent report, Shifting Perceptions ESG Credit Risk and Ratings Part One, the State of Play, provides a detailed briefing of the evolutional role of environmental, social, and governance factors in assessing credit risk analysis.
The report highlights why these considerations are a priority when it comes to credit risk and how credit rating agencies and investors are taking these factors into account when dealing with the challenges they face in integrating ESG into their methods.
The following talks about the scrutinized analysis of the report’s conclusions and final findings.
ESG factors have always been a critical part of the credit risk assessment as they make a direct impact on a borrower’s financial stability and long-term sustainability.
Why? That’s because:
- The sudden environmental risks like carbon emissions, greenhouse gases, and climate change can pile up to operational disruptions or increased usage of standard assets and regulatory costs.
- Employee productivity, legal liabilities, and reputations can become vulnerable to social risks, such as thinking about community relations or unhealthy labor practices.
- The quality of decision-making and integrity in financial reasoning can also be badly affected by governance risks like corruption and board independence.
To diminish this, we need to incorporate ESG into the credit risk analysis so we can figure out the hidden opportunities and risks that conventional financial metrics may overlook.
If we have a live example of it, then it would be:
- Utilizing USG’s best practices can significantly streamline operational activities, improve the longevity of financial performance, and minimize default probabilities.
- And it’s the vice versa again that is implemented for ESG. Practices can also bring abrupt credit downgrades, regular day penalties, and reputational damage to the companies.
Many new practices are being involved by investors and CRAs, which are increasingly allocating resources to ESG integration in credit risk analysis. But with the practices that are getting involved, we also need to note that:
1. Many of us try to embed the ESG analysis into the decision-making process, but it is far better and more advisory when it is on the investor side.
2. Investment firms still find it a challenge to secure internal buy-ins for ESG integration
3. As we know, ESG signals can reduce downside risks. That’s why some investors have started to utilize it to identify investment opportunities.
4. CRA credit rating agencies like S&P Global Ratings, Fitch Ratings, and Moody’s Investor Service are beginning to include ESG factors into their credit ratings. Some of the key highlights include:
- While many ESG factors are already incorporated in conventional credit assessments, they are not always explicitly enforced.
- CRA often uses features like ESG Credit scores to assess the materiality of specific environmental or social risks on creditworthiness.
- While measures are taken to enforce the ESG system evidence linking to ESG considerations in regard to the changes in credit rating results is still few in numbers and inconsistent.
However, we also need to acknowledge that there are various differences in the point of view between investors and CRAs.
- Number one, we have the disconnects in time frames. That is, CRAs always focus on short-term creditworthiness, which often lasts for 3 to 5 years. However, investors often go for a long-term view, such as climate transitions, for the ESG risks.
- Investors often think of the ESG factors as critical. However, they do not instantly impact the company’s ability to meet short-term debt obligations.
- With CRAs, there is a certain communication gap, and they need to improve on this and make it more streamlined on how the ESG factors are affecting their rating.
While there is a growing momentum with ESG integration, there are several hindrances when it comes to incorporating ESG into credit risk analysis. Some of them are:
- Investors or CRAs find it difficult to examine material risks accurately because sometimes there is incomplete data on ESG performance.
- Companies that are just emerging in the market or are smaller in scale often don’t have enough robust ESG disclosures.
- Long-term sustainability risks are often undermined by traditional credit rating methodologies. They are more focused on the side of short-term repayment abilities.
That not only overlooks significant social and environmental risks, but it can also materialize over a longer time horizon.
- ESG is still scattered across jurisdictions; however, in the regulatory landscape, it is getting more popular and evolving rapidly
- Maintaining compliance with prominent frameworks like the EU Sustainable Finance Disclosure Regulation (SFDR) makes it difficult for both issuers and investors.
- Integrating ESGfFactors systematically into the assessments may seem difficult because credit analysis often lacks the incentives to include them.
- The progress in achieving sustainability goals can also slow down due to internal reluctance within organizations.
However, these challenges can be easily addressed with some of the possible emerging solutions as discussed below:
- CRAs must document how specific ESG factors impact their credit ratings. This will improve transparency. This will help provide details on the impact of environmental risks on an issuer’s credit profile.
- Outlining scenario-based solution models can also help assess long-term risks more efficiently. For example, you can create a scenario on how climate-related regulations might affect a company’s cash flow over a time period of 10 years.
- It is often advisable to offer dual ratings. One will be based on additional credit metrics, and the second one can be adjusted to assess ESG performance in order to attain a more detailed assessment.
Collaboration between stakeholders can also be a potential solution because when the investors, regulators, CRAs, and issuers come up together, then only expectations around materiality and disclosure standards will align.
