A seven-year PRI initiative with credit ratings firms on ESG suggests improvements on integration and transparency.
Credit rating agencies are having conversations with investors on ESG “that could not have happened a few years ago”, but many still feel that credit ratings do not adequately reflect ESG risks or are forward-looking enough, a new UN Principles for Responsible Investment (PRI) report has found.
The report has summarised a seven-year initiative led by the PRI to understand how ESG factors affect credit ratings and promote a systematic and transparent incorporation of ESG factors in credit risk analysis. It found that investors, credit ratings and issuers assessed the materiality of ESG factors differently, depending on their perspectives and objectives. But dialogue has also promoted a common understanding of ESG metrics that are credit relevant. Peer comparison remains challenging as credit risk is measured on a relative scale and the quality and availability of issuer ESG data is patchy.
The PRI said further dialogue was needed to achieve systemic change, “by building a common language and helping overcome shared challenges”.
Two recurring themes were also identified by the PRI: the impact of certain environmental and social factors on issuers’ credit quality in the long term remains unclear and confusion continues among investors on the distinction between credit and ESG ratings.
Speaking to ESG Investor, Sixtine Dubost, Senior Associate Investment Practices at the PRI, said, “They’re very distinct products, but can also be complimentary.”
She said credit ratings had been used by fixed income investors for decades to assess the probability of default of an issuer, and that ESG factors could affect the probability of default. On the other hand, fixed income investors have also started to use ESG ratings to inform their analysis. “We’ve seen the emergence of additional [ESG] products, which are sometimes produced by credit rating agencies that are an indicator on the ESG characteristics or ESG performance of an issuer.”
Dubost said the work of the PRI would be ongoing and had seen great progress over the past seven year. “We started with six credit rating agencies that supported our initiative and now we have 28,” she said, including the largest three: Moody’s Investor Services, S&P Global Ratings and Fitch Ratings.
She said the most important success from the initiative is more transparency from credit rating agencies on how ESG factors affect their ratings. “We’ve seen some publish a lot of ESG-related research and reports. And if they downgrade or upgrade an issuer, they make clear if it is an E, S or G factor that has had an impact on their decision-making.”
She added that more credit rating agencies had created dedicated teams focused on ESG and were communicating more on ESG with different stakeholders, including regulators.
An area identified where credit rating agencies needed to do more work was on time horizons. “In practice their ratings are limited in time from three to five years for corporate credit ratings, because the further ahead you go in time, the more uncertain the future becomes. So, having a rating for 30 years doesn’t make a lot of sense,” said the report.
But, Dubost said as issues such as climate change were more long term, there was a disconnect between the short term versus longer time horizons. “We’ve seen some work on scenario analysis, which can be a tool for a credit rating agency to lengthen their time horizons and make sure that longer term issues and factors are considered in their analysis.”
Last month, a study published by the Institute for Energy Economics and Financial Analysis (IEEFA) found that S&P Global Ratings, Moody’s Investors Service and Fitch Ratings were “increasingly viewing risk through an ESG lens” to assess an entity’s creditworthiness, including their development of ESG credit scores. But the IEEFA said it was difficult to establish a “straightforward link” between ESG scores and credit ratings, demonstrating the need for a more direct integration of ESG factors in their rating methodologies.