ESG in credit risk: Workshop with sub-investment grade borrowers (Part 1)

All six discussion tables agreed that communication is key, echoing the sentiment expressed in the Paris workshop. Because the market is still in the early stages of complementing traditional financial analysis with specific, additive ESG analysis, participants agreed that engaging more closely on ESG topics is critical both for credit analysts and companies. This engagement should serve both to identify the most relevant information and to facilitate its effective delivery. Participants viewed the workshop as a good opportunity to initiate these conversations.

As a first step, credit analysts and issuers should seek to agree on credit-relevant reporting parameters. A dialogue is useful for both borrowers and investors:

• For borrowers - to better explain to credit analysts how they operate, what ESG factors they consider and how they prioritise data to disclose. Considerations might encompass differing stakeholder demands, confidentiality or commercial factors, and issues such as costs and resources.
• For investors - to improve their understanding of how materiality of ESG factors varies by sector and company. Also, to ask more pertinent questions and to ‘educate’ issuers about why their ESG demands are increasing, particularly in light of regulatory changes. These changes could have important implications, not currently fully appreciated,^[2] for companies’ ‘investability’.

Workshop participants noted that it would be useful for companies to adopt a standardised approach to communication and disclosure, so that analysts are able to collect comparable data sets based on mutually agreed metrics. They recognised, however, that data standardisation is extremely challenging and is likely to develop over time. Corporate representatives highlighted a correlation between resources and the effectiveness of communication, with larger companies able to assign more dedicated full-time employees to gather and disseminate ESG information, while smaller enterprises - the majority in the leveraged finance market - often rely on fewer employees who may have also significant other duties.

“The concern is that companies publish glossy policy documents with limited data to back up ESG claims & targets.”

Several analysts noted that senior management buy-in was a critical driver of communication and transparency. Corporate leaders committed to effective communication are able to provide higherquality and more consistent information. However, the perceived lack of connection between increased ESG transparency (including disclosure) and funding costs can create challenges in securing board-level support. Participants discussed the importance of tying executive remuneration to ESG performance as a first step in assigning responsibility and promoting accountability.

The financial materiality of ESG factors was recognised as a critical component of risk assessment, though participants acknowledged that challenges remained in determining materiality.

“It is necessary to reassess materiality periodically - as situations change - to check if the analysis still holds.”

Decisions on materiality vary significantly by sector. For example, the healthcare, telecoms and debt repurchaser sessions highlighted that social factors were more relevant than environmental factors. Conversely, paper and packaging group discussions focussed on environmental factors.

ESG factors also vary by company, depending on the specific business model. For example, in telecoms, ESG metrics may be material or immaterial depending on the specific position of the company in the value chain (for example, whether a company builds infrastructure or is a wholesale carrier). Furthermore, companies have differing the level of awareness of ESG risks and preparedness to address them. As one CRA representative noted, the ‘holy grail’ is understanding the right metrics and to focus on a comprehensive balance of risk assessment, rather than on a single score.

Finally, materiality considerations also differ with respect to stakeholders (including customers, the various elements of a supply chain, investors and regulators) and time horizons (for example, a climate-related issues, such as reaching carbon neutrality by 2050, are unlikely to affect the risk assessment of a five-year bond). They materiality assessment is also dynamic, as it can change over time.

Some participants noted that there was distinction to be made between a material disclosure and ‘required disclosure’; that is, disclosure driven by regulatory obligations. Regulatory disclosure may concern information not deemed highly material for a specific company or sector. For example, companies could soon be asked to measure and disclose their carbon footprints (including Scope 3 emissions, which remain problematic), as the number of countries targeting net-zero greenhouse gas (GHG) emissions over the next 25-30 years is growing (including France and the UK).^[3] Furthermore, the group discussed the need to try to tie materiality assessments more firmly to measurable outcomes or benchmarks such as the UN Sustainable Development Goals (SDGs).

Participants also commented on the need to credibly demonstrate how operational processes address ESG issues. There was broad support for more education and training across organisations, so that employees understand how their daily activities relate to the company’s ESG status. Furthermore, investors indicated that they would look for companies to incorporate ESG accountability from the board level down, with linked targets and compensation.

“Does ESG go to board level? Do directors and senior management have ESG factors written into their compensation factors? Investors want to see companies living ESG.”

Credit analyst participants highlighted governance as a key factor in the analysis of corporate processes and behaviours. In fact, a CRA representative noted that governance in 2019 was by far the most frequently material issue in the estimated one third of rating actions that had ESG factors as key drivers.

“Investors need disclosure of where the company is now and where it is going to credibly show how it is managing ESG risks… If companies do not address ESG, we see it as a material risk factor.”

Participants generally agreed that, while third party provider solutions were at times helpful in assessing materiality, they were seldom sufficient to be effective on their own. Given the complexities involved, companies often work with third party providers, but even with this support the process can be arduous.

Both corporates and credit analysts agreed that, while data were a key enabler of insight, challenges remained in respect of their availability, quality and comparability. In addition, participants agreed that more disclosure was required on ESG topics, with both companies and investors seeking standardisation in this area. Both groups expressed a desire for ESG disclosure to be incorporated into securities issuance processes and ongoing reporting.

Companies from all sectors noted that they were required to manage a significant number of ESG-related data requests, both from information providers and investors, with a sharp uptick in requests over the past 18 months. They stressed that a balance must be struck between the need for disclosure and allocation of resources, a particular issue in the sub-IG market segment. Investors noted, however, that forthcoming EU regulation may force them to start screening out companies that do not provide key information.

Corporate attendees reported that they often do not understand requests received from ESG data providers and are unclear over their role and utility. They reported that requests are often disconnected from the realities of the sector. Given that collection and transmission is resource intensive, this was a significant concern. Credit analysts noted that they do not widely use vendors’ ESG scores but prefer to use data provided directly by issuers and undertake their own proprietary analysis.

“Issuers noted that it would be helpful if it were clearer what ESG issues they needed to report to investors and when.”

Several participants cited the need for key performance indicators (KPIs) to enable higher levels of standardisation. According to some credit analysts, comparability is improving for individual companies, enhancing investors’ ability to analyse ESG factors over time, but it is not improving within or between sectors. Participants also cited identifying quantification metrics, data availability, interpretation of reporting requirements, reporting periods, and geography-specific characteristics as factors that inhibit comparability.

Companies want to provide information but are often restrained by a lack of quantitative metrics, although some are emerging. For example, in respect of governance, data are available in relation to board composition, executive remuneration, diversity and inclusion numbers, and compliance frameworks (though they are standardised for listed companies but not for private companies).

“Corporates want to give information but don’t know how. Some standards would be helpful, as investors and credit ratings agencies ask a lot of questions and corporates spend a lot of time and resources answering.”

Echoing observations from the Paris workshop, participants noted the need for more effective dissemination of information. Company representatives said that they disclose significant ESGrelevant information through multiple reports, including annual and corporate social responsibility (CSR) reports. Indeed, in some geographies (notably Germany) non-financial reporting is now mandatory for some companies.^[4]

Analysts, on the other hand, said they see the proliferation of information across various dissemination channels as an obstacle, and would prefer data to be harmonised and consistent. Still, participants did identify potential synergies between companies’ existing regulatory disclosure requirements and the type of disclosure that investors wish to see; for instance, debt repurchasers already submit to the regulator records of customer complaints. As these are material to investors, from a governance and social perspective, the disclosure could be disseminated more broadly.

Workshop participants discussed potential transmission mechanisms for data disclosure and sharing. Several highlighted the benefits of involving legal counsels, so that data points could be incorporated into bond prospectuses or loan documentation.

As was the case in the first workshop in Paris, the discussions highlighted several considerations specific to the industries represented. Indeed, investors and corporate borrowers agreed that a sector-level emphasis is vital to conduct a comprehensive analysis of financially-material ESG topics. Below we present a short selection of the specific factors and, where relevant, related KPIs that were discussed in each of the sector groups.