ESG in credit risk: Workshop with Swiss issuers

Good governance continued to be hailed as a fundamental prerequisite for sustainable developments. Echoing previous discussions, participants stressed that it remains the most credit-relevant of the ESG categories and a key feature of traditional risk assessment. It is also important to assess the oversight of environmental and social issues, highlighting the interdependencies of the three.

However, in addition to typical metrics (such as the board composition, the independence of its members, the frequency of its meetings and the track record of a company strategy), analysts are now considering some new key performance indicators (KPIs). These include board diversity; company accountability for sustainability strategies (including clear management functions and responsibilities, checks and controls); transparency (for instance on procurements); and corporate culture.

One issuer representative noted that whilst the scrutiny on gender diversity had clearly increased in the past few years, questions about the board’s ethnic and racial diversity had started emerging after the revival of the Black Lives Matter movement in 2020. As a result, the company had started thinking about how to better reflect its global footprint at the board level. Another company representative added that they had recently recruited staff to focus on sustainability and ESG, adding to evidence from other workshops that new dedicated roles are being created.

“Enhancing board diversity has no cost implications but it requires more imaginative hiring solutions. Career progression may also take years of mentoring and investment in human capital.” — Corporate borrower

Echoing previous workshops, participants noted the importance of data in assessing ESG risks, and the problems that can arise from a lack of clear disclosure requirements.

Participants also discussed the use of third-party data by investors and CRAs. While they agreed this can be a useful tool, they also noted it should not replace analysis by internal credit analysts. One investor observed, however, that reliance on third-party vendors for technical assessments is likely to increase when assessing environmental risks, given neither investors nor issuers have expertise in this area. Another added that investors would struggle to conduct stress tests on holdings internally, unless they had a dedicated team to do so.

It was agreed that setting an ESG strategy was an iterative process, and that until an external ESG data standard is created, issuers will have to define their strategies and then look to substantiate or adjust them using available data. To this extent, communication with analysts is crucial to make future plans clearer and enable analysts to make a forward-looking, rather than a static, analysis.

“The key is to have a discussion with company management and engage with materiality frameworks, even though we may not always arrive at the same judgment on ESG consideration.” — Investor

Several participants focused on the potential credit risks posed by litigation, although there was divergence in whether they considered it an environmental, social or governance risk. Specifically, in the chemicals sector, it was noted that the potential for regulation to forbid the production, sale or use of certain products or chemicals was harmful to the credit risk of companies as it could trigger future litigation, directed at them or within their supply chains.

One CRA representative pointed out that the materiality of litigation depended on the jurisdiction involved, as well as whether the litigation was public and reported in a company’s financial results.

Speakers observed that the financial and reputational risks posed by litigation were difficult to assess and price due to the fact that they often relate to historic events or controversies, and may not represent an issuer’s current management or business approach. Nevertheless, the fines related to such litigation can be financially material, and can be considered when looking at how a company mitigates losses. For the same reason, analysts may find it difficult to determine the true extent to which an issuer’s management or business strategy has changed, if litigation related to past wrongdoing is ongoing.

“Consumer preferences have changed a lot over the past few years and so has the scrutiny on companies’ supply chains and sourcing, boosting the risks of litigation.” — CRA

Participants highlighted that the long-term nature of many ESG issues, particularly environmental risks, makes it difficult to set appropriate targets – or to make lending conditional on meeting ESG criteria.

Still, especially on environmental issues, some participating companies noted that they had begun to set targets for carbon emissions (including, in one case, for Scope 3), waste and water. Two corporate representatives noted they had started reporting information according to the recommendations of the Task Force for Climate-related Financial Disclosures, and stress-testing the resilience of their business against the transition to a low-carbon economy. But one representative added that certain calculations are limited in projecting future actions and their results.

Participants noted that while the use of covenants has been rare, because quantitative easing has made funding relatively cheap, they could play a greater role in the future – encouraging companies to consider ESG targets and key performance indicators (KPIs). There was broad agreement that, at least for now, this type of conditionality has little impact on the cost of capital, but it does carry potential reputational benefits. One investor argued that there could be a risk of greenwashing if financing was conditional on meeting short or medium-term targets that are not credible.

CRAs are also starting to address the gap between long-term ESG issues and shorter-term financial metrics, with one participant indicating that they assess and differentiate companies based on the vulnerability risks they could be exposed to between 2025 and 2050. Another described combining two tiers of analysis: one focusing on the megatrends (such as ecological transition, demographic shifts) that will potentially impact issuers’ credit quality and another looking at shorter-term forecasts which tend to inform credit rating opinions. Finally, one CRA started calculating ESG scores along with credit ratings to capture this long-term dimension.

“We are not sure whether the transition to a low carbon economy will be slow or rapid…the key is to have a discussion with the company’s management to understand its strategy and planning.” — Investor

The discussions highlighted several considerations specific, but not unique, to the industries of the companies represented – debt repurchasing (iQera), retail (Casino), shipping (CMA-CGM), rental equipment (Loxam) and facility management (Atalian). These are outlined below: