Dirty downgrades: how ESG can affect credit ratings

Environmental, social and governance (ESG) considerations are set to gain importance in fixed income investing, courtesy of Fitch Ratings. 

The credit rating agency already considers ESG factors in its ratings, but said such issues are set to become even more important. It will now judge corporates more closely by launching a new indicator that will be used to analyse 1500 non-financial corporates, reports sister publication Corporate Treasurer.

Similarly, Moody’s Ratings appears equally focused on highlighting ESG risk. Last year, it had warned that a significant proportion of existing debt in 11 sectors is at risk of being downgraded due to such concerns.

Institutional investors in Asia are becoming increasingly cognisant of the need to integrate ESG considerations into how they invest. In AsianInvestor's annual AI300 survey, 61.7% of non-bank investors said they already incorporated ESG factors into their investing to some degree, and 52.5% said they prioritised getting companies in which they invest to do better. 

Similarly, results from sister publications FinanceAsia's recent investor survey show nearly 38% of investors will increase their ESG investments in 2019. 

While the overall picture in any rating consideration is complex, some sectors are more exposed than others.

GROWING SCRUTINY

On Monday, Fitch Ratings said it would now outline ESG Relevance scores across all asset classes sometime in the coming quarter.

“The scores do not make value judgements on whether an entity engages in good or bad ESG practices, but draw out which E, S, and G risk elements are influencing the credit rating decision,” dsaid Andrew Steel, global head of sustainable finance at Fitch Ratings.

“Initial results show that 22% of our current corporate ratings are being influenced by E, S or G factors, with just under 3% currently having a single E, S or G sub-factor that by itself led to a change in the rating.”

Large corporates need to be increasingly mindful of the fact that they are being scrutinised through an ESG lens by multiple parties through including regulators, fund houses and increasingly regional asset owners such as Japan's Government Pension Investment Fund. 

Regulations are ramping up on carbon consumption, air pollution, water shortages, soil and water pollution, and land use among many others. The China Securities Regulatory Commission, for example, announced last year that as of 2020 it will require all listed companies to mandatorily declare environmental information. 

Last September, Moody’s Investors Service released a report analysing the environmental exposure in debt markets. It found that $2.2 trillion in rated debt have elevated credit exposure to such risks.

“Coal mining and terminals, and unregulated utilities and power companies have already experienced material credit pressure as a result of environmental risks,” said the team of Moody’s analysts.

“For the remaining nine sectors – automotive manufacturers, building materials, commodity chemicals, mining, oil and gas exploration and production, oil and gas refining and marketing, steel, and the new additions of shipping, and transportation and logistics – exposure to environmental risks could be material to credit quality within three to five years.”

In total, Moody’s says that 84 industry sectors representing $74.6 trillion in rated debt will suffer from environmental risk from some sort. The figure represents a 10% increase from the number found in the previous study in 2015.                               

QUALITATIVE ANALYSIS ISSUE

It’s unclear exactly how such rating agencies will rate corporates, considering the confusing mosaic of ESG factors – some are hard to measure while others are interlinked.

In a separate Moody’s report analysing green bonds – debt taken on usually by local governments for environmentally friendly projects – the agency conceded that attempts to analyse ESG financing would always face problems.

Such green bonds are evaluated by how they contribute to the United Nations Sustainable Development Goals (SDGs) – a set of 17 goals agreed by member states in 2015. However, any social impact data usually tends to be qualitative and project specific, the report said, while many SDGs have overlapping objectives muddling the picture.  

“Another key challenge facing the adoption of the SDGs is the likelihood of difficult trade-offs among these individual goals. For example, SDG 2, related to food security, is threatened when crops are switched for biofuels in developing countries,” the report said.

“There is no consensus about how certain goals and objectives should be prioritized over others. As such, the adoption of the SDGs by investors and issuers raises an important question as to how market actors prioritise competing and, potentially in some cases, conflicting goals.”

Other benchmarks for green bonds such as the Climate Bonds Initiative's "Climate Bonds Standard" help investors to quantify their investments, but with other benchmarks possibly clouding the picture a new qualitative benchmark must surely be welcomed. 

Still, Fitch Ratings’ ESG Relevance scores should help make the picture clearer. The rating agency says that a preliminary analysis unearthed over 22,000 individual E, S and G scores for publicly rated entities.

ESG considerations are now firmly in the investor's arsenal, and its rising importance is something both investors and issuers are coming to coming to terms with.

Additional reporting by Andrew Wright and Richard Morrow