Executive summary

Following the 2017 publication of Shifting perceptions: ESG, credit risk and ratings – part 1: the state of play, the PRI organised a series of roundtables, the findings of which form the basis of this report.

Although ESG factors are not new to credit risk analysis, the extent to which they are explicitly and systematically considered by fixed income (FI) investors is. They are also of increasing interest to policy makers amid growing realisation that ESG issues, such as climate change, can represent systemic risks to financial markets.

Ongoing dialogue is beginning to address misconceptions, including the difference between assessing the impact of ESG factors on credit risk and evaluating a bond issuer’s ESG exposure, or versus rules-based investing (such as exclusion). It is also highlighting the progress that CRAs – particularly the bigger players – are making through research and organisational changes, as well as transparency-related efforts and more explicit reference to ESG factors when these contribute to rating actions. Finally, it is drawing attention to new CRAs – some of which are not regulated yet – that provide dedicated ESG risk assessments or augmented analyses of creditworthiness.

Roundtable attendees generally agreed that, although considering ESG factors in FI assets is primarily a tool to manage downside risks, it is also becoming more valuable to enhance returns or for relative value investment strategies, as well as to highlight the importance of bondholder engagement. Commercial pressures from rising client demand are also mounting.

The roundtables were structured around the four investor-CRA disconnects identified in part one of the report series; but the discussions revealed that, more than just disconnects, these are common challenges that credit practitioners on both sides are encountering as they try to make ESG consideration more prominent or rigorous. Below are some highlights:

Materiality of ESG factors to credit risk

• While an assessment of governance factors has traditionally featured in credit risk analysis, both sides concur that they are in the early phase of formalising a systematic approach to considering environmental and social factors. Assessing where these are relevant and how they can impact balance sheets and cash flow projections needs more work. Participants discussed the value of using them as early indicators such as through exposing inadequate management oversight and potentially anticipating deteriorating credit conditions – even before traditional financial metrics worsen.
• The materiality of ESG issues from a credit risk perspective depends on many factors, such as the financial profile of an entity, its sector and geographical location, as well as the type and characteristics of a bond. Moreover, on the environmental front, the importance of differentiating between physical and transition risks (including policy developments) was highlighted.

Relevant time horizons to consider

• There is no silver bullet to identify the right time horizon over which to assess ESG factors in credit risk analysis. However, participants considered the benefits of gathering insight about future environmental and social policies to better evaluate the quality of governance, as well as the sustainability of business models.
• Due to the multi-dimensional nature of ESG factors, difficulties in modelling non-financial factors and capturing data interdependencies were cited among the biggest obstacles to ESG consideration in credit risk analysis. Specifically, the interplay between the following was flagged: 1) the long-term structural trends that tend to influence ESG risks; 2) the probability that ESG-related incidents will materialise and when; 3) the risk of these incidents reoccurring, and 4) their impact on an issuer’s credit fundamentals and its ability to adjust its business model by buying or selling companies and introducing or reacting to disruptive technology.

Organisational approaches to ESG

• Expertise and resources are improving among both investors and CRAs, particularly where there is senior management buy-in. The level of CRA participation and backing of the roundtables is a testament to this. However, building a formal framework to ensure that credit analysts systematically consider ESG factors is still a work in progress. Different approaches that could be taken were considered, including developing skills in-house, insourcing external expertise or outsourcing on an ad-hoc basis.
• Overcoming internal inertia is another obstacle. While some investors and CRAs are making headway, for other market players breaking down barriers, addressing siloed work practices and securing internal buy-in is challenging. Another hurdle is how to incentivise and reward analysts that are the best at unlocking ESG value because it can take decades for corporate strategies to produce tangible results, or for blow-up events to materialise.

Communication and transparency

• Communication and transparency specifically on ESG topics has been limited until recently, partly due to a lack of meaningful outreach or engagement, which is now improving. Gaps exist at different levels of the investment chain – not only between investors and CRAs but between asset owners (AOs) and asset managers (AMs) and, ultimately, bond issuers. Few participants were aware that some CRAs are making ESG factors more transparent in their methodologies and research, and of the rating changes which have occurred as a result.
• Several options on how to improve CRA communication were discussed, including how they present ratings and signal long-term risks. Ideas ranged from a separate ESG section within credit opinions to sectoral and scenario analysis. The benefits and drawbacks of a built-in approach, which is integrated but more challenging to demonstrate, were considered versus an add-on approach. Attendees reflected on their role in enhancing issuer ESG data disclosure.

Observations from the roundtables are complemented by examples from CRA credit rating opinions or recent research and eight investor case studies demonstrating how ESG factors can affect the assessment of creditworthiness. A section of the report is on the automotive sector – the focus of the Frankfurt roundtable – as this industry lends itself as a good example of the interplay between ESG factors in corporate credit risk. Finally, the report is corroborated by the results of a survey that participants were asked to take before attending the roundtables.

The forums focused on ESG factors in corporate credit risks but began considering asset classes, touching on some of the differences between corporate and sovereign credit risk. Part three in the series will report on these as well as explore the solutions that started to emerge to address the challenges faced by credit practitioners.

As ever, we welcome feedback on our work and encourage you to help drive the ESG in credit ratings Initiative forward.