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March 14, 2023updated 17 Mar 2023 10:27am

Are ratings agencies doing enough to factor in ESG risk?

Are ratings agencies doing their job? Bond investors are under pressure to know how physical and transition risks will impact them.

By Daniel Flatt

ratings agencies, ESG, credit risk
A long road ahead. Are credit ratings agencies doing their jobs properly by incorporating ESG risk into traditional analysis? (Image by Piyaset via ShutterStock)
  • The IEEFA believes how ratings agencies have incorporated ESG into ratings has had no meaningful effect.
  • Criticism of the agencies focuses on the short-term duration of credit assessment.
  • Fitch Ratings’ new Climate Vulnerability Scores are considered a useful new approach but still don’t go far enough, says IEEFA.

If bond investors didn’t already have enough on their plate, they are now under pressure to understand how physical and transition risk born from climate change could impact the risk of default within their portfolio.

Naturally, many will rely on credit ratings agencies to support such assessments. However, financial experts are piping up claiming that such agencies are not doing enough to justify that trust.

In a report published on 14 March titled: “Can Credit Assessments and Sustainability Coexist”, the Institute for Energy Economics and Financial Analysis (IEEFA), a US-headquartered think-tank, lays out its argument that credit ratings agencies, notably Fitch Ratings, S&P Global Ratings and Moody’s, are failing to satisfactorily incorporate ESG risk into traditional credit ratings methodology.

To clarify, the IEEFA is not saying agencies aren’t factoring in ESG risk with credit risk at all, because many, if not all, clearly are. However, criticism stems from how material ESG factors are in influencing credit assessments.

On this, the IEEFA says: “The way agencies have incorporated ESG into credit analysis has had no effect on their conventional credit assessment.”

On the surface, however, it would seem that quite the opposite is happening. In S&P’s “ESG in Credit Ratings February 2023” publication, the agency reports that 14 credit rating actions in the month were ESG-related, down from 16 in January.

Moody’s is similarly active. According to a CFO Dive news report in November last year, approximately one out of five companies saw a credit ratings downgrade after Moody’s assessed adherence to ESG “best practices”. More than half of speculative-grade entities saw their credit rating decline after a review of ESG performance.

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Short-term vs long-term

At the heart issue here is not how (although the how is a bone of contention with the IEEFA) but when ESG factors become relevant within credit ratings decision making. As is typical with credit assessments, agencies are looking at the ability for companies to pay their debt in the short to medium term.

The IEEFA does acknowledge this. It states: “Only credit relevant ESG factors that are visible, likely to materialise, and have a significant impact on creditworthiness in the short term (three to five years) are considered in the credit assessment.”

In other words, some of the heavy duty risk associated with climate change, for example, such as transition risk, may end up outside the scope of a ratings assessment because it’s too far in the future. The IEEFA may be sympathetic to the difficulties of assessing such risk beyond what agencies are schooled, but is anxious it has to be done.

To that effect, the IEEFA says of the big three agencies: “The current methodology does not drive debt financing to sustainable initiatives, and bondholders may continue to finance businesses that have fundamentally poor sustainability standards. If this ‘business as usual’ credit framework is followed, real-world challenges such as climate change and social inequality will continue.”

Climate vulnerability

The IEEFA’s report comes on the back of a very interesting discussion paper published by Fitch Ratings in mid-February. Titled, Climate Vulnerability in Corporate Credit Ratings, the agency is seeking formal feedback by 31 March on possible plans to incorporate climate risks within its credit ratings through what it calls a climate vulnerability scores.

These scores are based on exactly what the IEEFA is requesting – a long-term outlook of the impact of climate risks on a business and sector. Ranging up to 100, the score indicates whether various factors could have an “existential” impact on default. The methodology is underpinned by the UN Principles for Responsible Investment’s “Inevitable Policy Response Forecast Policy Scenario”, a model for estimating how prepared industries and sectors are for changes in government climate policy.

Fitch says: “[We have] developed ClimateVS in response to a need by fixed-income investors for a long term   view of transition risks – recognising that similarly rated issuers may have different transition risks, the implications for instruments of differing maturities, and strategies open to investors to manage these risks.”

In a trial of its methodology, Fitch established that by 2035, of those companies which could expect to see a possible credit downgrade, the majority came from the oil and gas and energy sectors. This was based on its assumption there would be “significant long-term changes to demand for oil and gas.”

Fairly self-evident maybe, and, as Fitch admits, by far an exact science as the time horizon is so far out, but it is useful, nonetheless. However it does not satisfy IEEFA in so far as the ClimateVS scores don’t materially impact credit ratings – rather, they sit alongside them.

Hazel Ilango, an energy finance analyst at IEEFA, tells Capital Monitor: “While a climate vulnerability score is a good step in the right direction, rating agencies can do more by integrating sufficient analysis of future earnings scenarios or anticipated impact to cash flows from a climate risk perspective as part of the core credit assessment.”

The future for ratings agencies

The IEEFA has put forward suggestions as to how ratings agencies could more formally integrate ESG into their existing credit ratings methodologies, but evidence so far indicates the big three may not wish to go much further than they already are.

At this point, it is important to underline how important credit ratings are to financial markets. As witnessed 15 years ago, the failure of ratings agencies to understand – or admit – the risks bubbling up in US housing market was a contributing factor in the global financial crisis.

A failure not to properly factor in physical, social and transition risks born from climate change into the ability for a company pay its debts does seem like another crisis in the making. Investors should be asking questions of their ratings agencies now, not later.

[Read more: More attacks on ESG ratings as sceptics sharpen knives]

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