Materiality and visibility of ESG factors in credit risk analysis

Many investors believe that CRAs should take a more proactive approach to highlighting ESG considerations in their analysis.

Visibility of ESG risks in credit risk analysis

Views tend to differ most between investors and credit rating agencies (CRAs) on how to achieve greater transparency and the systematic integration of ESG factors.

Investors and CRAs struggle to agree on what is a reasonable time horizon to consider

Investors tend to align their time horizons with their investment objectives: some buy and hold long-term bonds until maturity (for instance for asset-liability management); others trade more frequently. For the former, a CRA’s long-term rating may not be forward-looking enough, while for the latter it could be too long-term. CRAs maintain that they are as forward-looking as possible, with a degree of plausibility.

Views on visibility are mixed

When talking about the visibility of risks, some investors ask CRAs to expand on the spectrum of ESG factors that they consider in their risk assessment, whilst others ask them to be more forward-looking.

Investor views

“It is difficult to have the direct time horizon [between investors and CRAs] linked together.”

Addenda Capital, Lambert & Minn

“If you say a certain risk is a risk from a profitability perspective but it is so far into the future that it doesn’t even feature in discounted terms, then it isn’t really relevant from a credit perspective.”

Aberdeen, Kuhn & Frings

“CRAs’ adjustments of ratings are not very frequent.”

Global Evolution, Hagen J.

“The risk of asset stranding in particular industries is becoming more immediate as time goes by and can be very relevant for credit assessment.”

Colonial First State Global AM, Spencer

CRA views

“As the time frame for a risk or event lengthens into the future, the consequences of the event become less certain, as does the importance of that risk relative to other risks faced by an issuer…With longer time frames, there is also less visibility into the impact that a particular risk will have on the overall cash flow-generating ability of an issuer or sector.”

Moody’s Investors Service

“Credit ratings for corporates have a shorter time horizon than the time horizon over which most ESG risks tend to materialise and this is causing perception issues. Commentators are saying we ignore ESG risk but this is not the case at all, it is just that many of the risks are not likely to crystallise in any material way in the rating time horizon. In our experience a foreseeable horizon is generally less than two years for a speculative-grade credit (rated ‘BB+’ and below) and no more than five years for an investmentgrade credit (‘BBB-’ and above), reflecting the fact that investment- and speculative-grade credits are differentially vulnerable to the many factors in the business, financial, natural, and social environments.”

S&P Global Ratings, Wilkins

“A credit rating time fame cannot be longer than three years – you can’t know what will happen in the long term.”

Scope Ratings AG, Theodore

Materiality of ESG factors to credit risk

Investors are not asking CRAs to provide early warnings on future defaults and “black swan” events, and they recognise that an assessment of ESG factors will not eliminate credit risk nor surprises. In the latter case, financial markets may even have an advantage as they can price unexpected information almost instantly, unlike CRAs which must follow internal procedures before adjusting an outlook or rating. Still, CRAs may have access to material non-public information, putting them in a relatively better position to assess risks.

In general, there appears to be demand from some investors for public discussion of ESG risks facing an issuer, irrespective of whether they are material to creditworthiness or not. However, just because an ESG factor may appear immaterial to credit risk, it does not mean that it may not become material in the future. For example, a company may meet the costs of an environmental accident easily, but if the frequency of accidents starts to increase (all else equal), its financial strength may deteriorate. Similarly, when considering the costs of fines that a heavy-polluting company could potentially face, credit analysts should also factor in the possibility that these fines could increase in the future, that heavier taxes could be levied, or that new capex might be needed as a result of legislative changes (possibly resulting in a loss of market share by the issuer during the transition phase). The potential consequences of underestimating these risks go well beyond financial penalties and include reputational risk, which can be long-lasting even when damage control measures are implemented promptly.

Investor views

“Ratings have weights assigned to the various indicators that reflect creditworthiness – these weights are arbitrarily set and are not evidencebased.”

Global Evolution, Hagen J.

“CRAs might not be looking broadly enough and might miss significant risks.”

Legal & General, Ogden

“I don’t completely agree with the statement that CRAs have systematically factored ESG criteria into their methodology. There is scope to better capture indirect, embedded ESG risks which are values/supply chain related… such risks appear to be increasing so may be more investment relevant going forward than in the past.”

BlueBay AM, Ngo

CRA views

“The impact of ESG risks is not always clear-cut in terms of materiality, scale and timing. Often issuers have considerable operational and financial flexibility and a track record of adjusting to emerging ESG risks without them becoming material to credit quality…ESG considerations are explicitly scored factors in some of our rating methodologies. In these instances, we regard ESG as material, industry-wide risks that justify explicit mention in the relevant methodology.”

Moody’s Investors Service

”There is an external perception that every visible ESG risk identified will have a direct rating impact. Rating deliberations, which are guided by our methodologies, ultimately place greater weight on factors that are significant and have long-term implications on the entity or issuer we rate.”

RAM Ratings, Dass