As the sustainable finance continues to mature into a core element of the financial services industry, investors and companies are contemplating a new framework for credit ratings and environment, social and governance (ESG) scores. What do these scores represent and how are they formulated? What does the future hold for such metrics? Ultimately, what impact will ESG have on a company's capital raising?
Experts from leading ratings and research agencies examine how ESG scores and credit ratings may impact a company's capital raising.
These are just a few questions that were explored at BNP Paribas' recent installment of its Sustainable Future Online Series. The virtual event was moderated by Hervé Duteil, Chief Sustainability Officer for the Americas at BNP Paribas, and the program featured experts from leading ratings and research agencies Fitch and Sustainalytics, whose differentiated approach provided a well-rounded and informed discussion about the world of credit ratings and ESG scores.
Tailored RatingsKicking off the discussion, Heather Lang, Head of Sustainable Finance Solutions at Sustainalytics, noted that her firm has consistently modified its approach to ESG scoring development over time to reflect changing market dynamics. "This has included emphasizing areas like risk alongside preparedness and performance," said Lang. Client demand has helped shape product offerings during this time, added Lang. "Our flagship ESG rating released in 2018 has an explicit focus on materiality, which was in large part derived from client feedback," she said.
Andrew Steel, Managing Director and Global Group Head of Sustainable Finance at Fitch, indicated a desire among clients to understand which elements of ESG were most relevant from a credit standpoint, as well as how the company came to that determination. "This has informed our effort to bring even greater transparency to bear, so that investors could clearly see how risk factors influenced our decision-making process," he said. Accordingly, every entity or transaction reviewed by Fitch comes with its own unique set of ESG relevance scores, covering a forward-looking period of two to give years. The scores also identify which elements of ESG risk impacted the rating decision. Fitch has created 96 sector-based templates across its asset classes, which identify specific ESG credit risks that are relevant to issuers or transactions for a standardized set of general ESG risk issues.
Steel commented that if an issuer's activity was ESG 'friendly' it did not necessarily mean that it would convey a credit benefit. He gave the example of two identical windfarm electricity generators - one that sold its electricity into a merchant market and one that sold its electricity under a tariff framework. Steel emphasized that despite being a 100 percent renewable producer of electricity, the producer selling into a merchant market would likely experience a negative impact on its credit profile, as it would be a pure price taker, given the intermittent and unpredictable nature of wind generation. This could make its credit profile less attractive than a thermal generator in the same market position. However, for the producer that benefitted from a guaranteed offtake and pre-agreed tariff mechanism, the impact from being a wind farm generator could be credit positive. "In short, you need to be very careful about making generalizations around ESG risks and weightings, which are very much specific to individual businesses and financial profiles," said Steel.
For its part, Sustainalytics utilizes publicly available data such as financial filings and sustainability reporting for its research, augmenting with credible media sources and third-party data providers. "Companies are then asked to provide feedback prior to publishing," explains Lang, "and it is worth noting that the level of responsiveness has increased over the years, as ESG has become more prominent."
Fitch employs a one-to-five rating scale to assess ESG relevance and materiality by company across 14 or 15 general ESG risk issue categories. Lower scores indicate no impact on credit within a given sector, while higher numbers (four or five) indicate material credit impact, with a score of five indicating an ESG issue that is unambiguously changing the current rating. "In this case the analyst would articulate to what degree the credit rating has been affected due to any ESG risk factors," said Steel.
Widening Appeal to Investors and IssuersAsset managers as well as some owners have long relied on ratings to make informed decisions, noted Lang. While institutional investors have typically been equity focused, in recent years the shift toward a more integrated, enterprise-wide usage of ESG has driven interest in other asset classes. Fixed income investors, for example, have been increasingly leveraging ESG factors to assess credit risk, bond selection and related activity. "Lenders have also used our ratings to identify potential ESG risk among borrowers, and some have begun linking interest rates to our ratings as performance targets for sustainability linked loans," said Lang.
Steel has seen growing demand among asset owners to boost reporting around ESG as it relates to the investment portfolio. "There are those investors who've already integrated the concept and essentially won't commit any capital without a complete ESG assessment process in place," said Steel. "Some less sophisticated smaller or medium-sized investors are only now coming to terms with ESG. It's that latter group that has informed our integrational approach, which we felt was the best way to introduce investors to the credit-specific aspects of ESG. [Our approach] gives investors a benchmark that shows the relative impact of ESG across a number of asset classes, from structured finance to corporates and beyond."
A Look AheadAs credit is likely to remain under pressure globally due to covid-19, ESG has a unique opportunity to prove its worth around credit scores over the coming quarters.
"When the crisis began, most of our issuers switched into liquidity management mode," said Steel, "however since that time the imposition of cross-country barriers has sparked more interest in the integrity of supply chains, which is something we believe is ripe for ESG analysis."
Whether or not the pandemic could slow ESG momentum is something that remains to be seen. "There have been plenty of positive signs, such as South Korea restating its commitment to green recovery and the EU outlining conditions around green support funding," said Steel. "However, the need to fund current priority areas like healthcare systems could lead to fewer renewable subsidies or, in certain regions, even some relaxation of green standards," he added.
Lang believes the social component of ESG will continue to gain traction, due in part to the impact of COVID-19. "Looking more broadly beyond credit ratings, we've seen a majority of ESG funds outperforming the market during the crisis," said Lang. Data from Morningstar (which recently acquired Sustainalytics) shows ESG assets reaching a record US$12.2bn through the first four months of 2020, roughly twice as much as the year-ago period. Given that ESG funds have historically fared better in down markets, observers like Lang remain sanguine over the near term.
"I think that the industry consolidation and regulatory change we've seen of late shows that ESG matters—that investors really do value this approach," said Lang. "As the segment expands, ESG has literally impacted the cost of capital, which is no small feat. Accordingly, we expect ESG to show continued resilience moving forward."