Investor-CRA disconnect 1: materiality of ESG risk

An overview of the PRI’s observations on the investor-CRA disconnect related to materiality of ESG risk.

Key messages:

ESG in credit risk analysis is seen as a useful tool to manage downside risks but increasingly appreciated as a way to generate alpha.
Governance is a relevant credit factor for all issuers. The materiality of environmental and social factors depends on their severity and on an issuer’s sector and geography.
Building an incrementally more quantitative ESG framework is the current biggest challenge credit practitioners face.

What we observed:

One size does not fit all. When discussing the materiality of ESG factors to credit risk, participants recognised that no two investors have the same wants and needs. Their motivations, investment objectives (for example, some seek more duration than others and consequently are more sensitive to long-term risks), mandates (investment-grade versus high-yield) and strategies (alpha versus beta investing) must all be considered.

Not only a risk management tool. Most participants agreed that ESG consideration is helpful to manage downside risks but some are beginning to use it to enhance portfolio returns. The most advanced investors have started to create proprietary internal credit scores to monitor risks as well as to underweight or overweight securities.

Governance is key. Participants concurred that governance plays the most critical role in credit risk analysis. This is because it influences management decisions, including: business development strategies; environmental and labour force policies; size, diversification and competitive position; and financial policy (including the degree of leverage). Strong and transparent governance can help to mitigate risks, including those related to fraud, and reduces conflicts of interest.

Need for systematic scrutiny. Attendees agreed that environmental and social factors must be scrutinised more systematically, particularly as leading indicators of future risks and opportunities. There have been few cases where an issuer has defaulted as a result of environmental and social incidents, but the latter have sometimes acted as early warnings of shortfalls in governance.

Sectoral and regional relevance. There was strong agreement that the materiality of environmental and social factors depends on sectors and regions. Participants believed more research is needed in both areas. Most were unaware of the research notes that CRAs have started to publish, particularly on issues related to climate change. Likewise, few attendees – with the exception of the US roundtable – knew about the work that the Sustainability Accounting Standard Board (SASB) is conducting at the industry and sector level, which can be a useful starting point. Indeed, the SASB has already elaborated on sustainability accounting standards for 79 industries in 11 sectors, helping public corporations disclose financially material information to investors.

Augmented risk analysis. There is growing awareness of the need to broaden risk analysis. Participants concurred that they should be on the lookout for new threats as the ESG landscape evolves. On the environmental front, attention should go beyond pollution and CO2 emissions to also focus on issues such as plastic waste and water scarcity. In terms of governance and social issues, there are emerging risks that should be monitored, with cyber security a hot topic.

Challenges
Building a framework. Participants generally agreed that ESG integration in credit risk analysis has been done more or less intuitively so far, but that it is slowly becoming more structured and requires more quantitative work. Several challenges were identified, including defining relevant metrics, the accessibility and reliability of data, and the need to be more disciplined in incorporating non-financial factors in risk assessment. Another challenge relates to modelling new risks for which past data may not be useful. More positively, making ESG analysis more quantitative going forward should become easier as corporate disclosure increases. Some investors observed that this is already happening with environmental factors in light of proliferating data, and that lessons can be learned for governance and social factors too. Plurality of reporting requirements causing inconsistency and comparability issues. During one of the roundtables it was highlighted that the Governance and Accountability Institute found that 82% of S&P 500 companies issued CSR or sustainability reports in 2016 versus just 20% in 2011. However, standardisation will only take shape when it is adopted at scale by all corporates, and adoption will only happen once a standard is accepted. The latter could be helped by adherence to the recommendations of the Task Force on Climate-related Financial Disclosure (TCFD). Assessing the sustainability of business models. On the one hand, practitioners discussed the need to be able to identify new trends and gain a better understanding of the impact of new technologies, products and potential regulatory changes. On the other hand, they need to be able to anticipate when these disruptors are relevant enough to impact credit risk. Moving away from geographical comfort zones. Participants observed that some investors may miss opportunities because they tend to prefer local issuers, as they are more familiar with local management, their modus operandi and jurisdiction – a point discussed in Canada and Australia in particular. In some countries, stewardship codes may provide reassurance, but there are only a few of them (such as in the UK or Japan). A corollary to the above is how to asses multinationals. It was noted that with globalisation and in an era of fast information dissemination, contagion effects from incidents at offspring companies can be big for parent companies and vice versa.

Challenges

Building a framework. Participants generally agreed that ESG integration in credit risk analysis has been done more or less intuitively so far, but that it is slowly becoming more structured and requires more quantitative work. Several challenges were identified, including defining relevant metrics, the accessibility and reliability of data, and the need to be more disciplined in incorporating non-financial factors in risk assessment. Another challenge relates to modelling new risks for which past data may not be useful. More positively, making ESG analysis more quantitative going forward should become easier as corporate disclosure increases. Some investors observed that this is already happening with environmental factors in light of proliferating data, and that lessons can be learned for governance and social factors too.

Plurality of reporting requirements causing inconsistency and comparability issues. During one of the roundtables it was highlighted that the Governance and Accountability Institute found that 82% of S&P 500 companies issued CSR or sustainability reports in 2016 versus just 20% in 2011. However, standardisation will only take shape when it is adopted at scale by all corporates, and adoption will only happen once a standard is accepted. The latter could be helped by adherence to the recommendations of the Task Force on Climate-related Financial Disclosure (TCFD).

Assessing the sustainability of business models. On the one hand, practitioners discussed the need to be able to identify new trends and gain a better understanding of the impact of new technologies, products and potential regulatory changes. On the other hand, they need to be able to anticipate when these disruptors are relevant enough to impact credit risk.

Moving away from geographical comfort zones. Participants observed that some investors may miss opportunities because they tend to prefer local issuers, as they are more familiar with local management, their modus operandi and jurisdiction – a point discussed in Canada and Australia in particular. In some countries, stewardship codes may provide reassurance, but there are only a few of them (such as in the UK or Japan).

A corollary to the above is how to asses multinationals. It was noted that with globalisation and in an era of fast information dissemination, contagion effects from incidents at offspring companies can be big for parent companies and vice versa.

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Relevance of social factors to credit risk also varies across industries. How environmental and climate risks and opportunities factor into corporate ratings - an update, November 2017, S&P Global Ratings

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Illustration of how climate change can financially impact the property and casualty (P&C) insurance sector. Source: Climate change risks outweigh opportunities for P&C (re)insurers, 15 March 2017, Moody’s Investors Service

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