From disconnects to action areas

What is new is the growing recognition that more information and better tools to conduct analysis are available. Scrutiny of governance factors has changed, with investors taking a more inquisitive approach to how corporate boards address long-term strategies - including those related to the environment and human capital – as well as the impact of business models on society. The concept of value creation and sensitivities to reputational risks are also changing.

Environmental and social factors are also attracting more attention. Climate-related risks, once perceived as a distant threat, can no longer be ignored as they become more frequent, more intense and easier to quantify. Issues such as biodiversity and sustainable infrastructure are also gaining prominence. Social risks, including those that may affect intangible assets such as brand and reputation, are climbing up the agenda.

These factors are starting to be priced, requiring new performance attribution work to identify and quantify their role in driving positive or negative returns. Finally, other risks are nascent, such as changing consumer preferences, meaning their drivers need to be monitored.

ESG data availability has increased and disclosure is slowly improving, as well as the accuracy of how data are measured, and access to publicly-available information. At the same time, more work is needed to better factor in the impact of ESG factors on credit risk, as their implications become clearer. This is not straightforward, however, as many ESG factors are intangible.

Moreover, ESG dynamics are more multi-dimensional for FI assets than is the case in equity markets. For example, the potential materiality of ESG factors varies depending on the financial strength of the entity that issues a FI instrument, the type of issuer (sovereign or corporate), and the maturity and structure of a bond. Finally, these considerations cannot prescind from others factors, such as inflation developments, prospective central bank policy interest rate changes, liquidity conditions and foreign exchange movements.

The roundtables discussed how ESG consideration is a framework that helps investors to price, and CRAs to rate, risks more accurately, as ESG signals can often act as a leading indicator before risks (and opportunities) are flagged by traditional financial metrics. Credit risk-returns may be attractive even once relevant ESG considerations are factored into cash flow projections and the discount rate. Therefore, the ESG lens can be used to enhance credit risk assessment in mainstream FI investing and not necessarily as a strategy that is purely based on exclusion or thematic rules. It also helps practitioners to fulfil their accountability, due diligence and fiduciary duties.

For example, when assessing the bond issued by a polluting corporate issuer, credit practitioners may not just focus on how much CO2 the company emits but also on the material impact – including financial, regulatory and legal factors – of those CO2 emissions. Depending on the maturity of the bond, they may decide to invest in it, if the return is high enough to compensate for the risks that they are taking.

At the same time, investors could engage with the company to challenge its long-term business model and penalise or reward it at the time of refinancing, depending on the steps that the company is planning or implementing to make its business model more sustainable. This is a different approach from excluding that bond from a portfolio tout court or investing the bond’s proceeds to finance a project with a positive environmental impact.

Albeit slowly, there is growing recognition that ESG factors may alter the estimate of collateral values and recovery rates. What is also increasingly apparent in this regard is the need to make different loss assumptions if assets become stranded because of climate-related risks, new regulations, technological developments, changing social norms and in the interpretation of existing legislation.

Against this backdrop, through a series of interviews with investors and CRA analysts at the start of the initiative, in part one the PRI identified four main apparent disconnects i.e. areas where investors and CRAs seemed to have different views on how to incorporate ESG factors in credit risk analysis, or where more clarification and discussion was needed.

Some initial differences in views were linked to misconceptions about objectives, however. For example, CRAs assess the relative likelihood of the default of a debt issuer or issue and associated losses in such an event. But default risk is one of many risks that can affect bond price performance, with investors more focused on valuations, and some also on impact. It follows, then, that the integration of ESG factors also introduces different challenges for investment and credit rating purposes. For example, how should ESG factors be weighted alongside financial factors? And, how does the time frame of ESG factors impact rating or investment decisions? As for investors, how are such ESG factors priced and over what period of time?

Other disconnects were linked to a lack of investor awareness of the efforts that some CRAs have been making to clarify methodologies and boost research on ESG topics, or demystify confusion about terminology. ESG has become a useful, catchy acronym, but comprises a variety of factors that can be categorised differently, and no minimum market standardisation exists.

Finally, it also transpired that several disconnects were in fact shared challenges, and hence they were better addressed as areas where action is needed, as both investors and CRAs try to:

• map material ESG factors in their analysis;
• quantify and model ESG factors in credit risk analysis as more tools become available;
• balance short-term versus long-term credit considerations; and
• improve engagement, signposting, outreach and collaboration on ESG topics.

The figure outlines the initial (seeming) investor-CRA disconnects and how, through the PRI forums, it emerged that they were linked to a variety of other factors, requiring action.