ESG, credit risk and ratings: part 4 - deepening the dialogue between investors, issuers, and CRAs

The second phase of the ESG in Credit Risk and Ratings Initiative, which this report summarises, has deepened the dialogue that the PRI started between investors and credit rating agencies (CRAs) in phase one. It has also broadened the outreach to other stakeholders – primarily borrowers, but also ESG information providers and investment consultants.

It has provided a unique forum for investors, CRAs and corporate issuers to engage, at scale, over a large breadth of sectors and in a way that rarely happens collaboratively, as most conversations tend to be bilateral (e.g., between investors and companies; CRAs and companies; or investors and CRAs).^[1]

Key takeaways

• Appetite to continue dialogue: Investors, CRAs and issuers want to continue these conversations jointly, because they assess the materiality of ESG factors differently, depending on their perspectives and objectives.
• Creating a common understanding: The dialogue has been educational for all participants. It has promoted a common understanding of ESG metrics that are credit-relevant and has enabled them to start choosing those that should be disclosed as a baseline for credit analysis.
• Materiality varies, depending on sector, business model, company structure and size, as well as regulatory environment. An issuer’s individual characteristics, financial strength and whether it is aware of, and prepared to address ESG factors, also impact whether the latter are evaluated as risks or opportunities.
• Peer comparison remains challenging as credit risk is measured on a relative scale. The quality and availability of issuer ESG data is patchy, despite listed corporates improving their disclosure of information.
• E and S assessments are developing: While governance factors remain the most relevant to credit risk, participants are increasingly discussing how to manage environmental and social issues.

In addition, two other themes were repeatedly brought up:

• There is confusion among investors between credit and ESG ratings.^[2]  To address this, we have built a webpage that clarifies the distinction between them, but investors still need to better understand what they measure and when they complement each other.
• The impact of certain environmental and social factors, such as climate change or biodiversity loss, on issuers’ credit quality in the long term remains unclear, meaning that analysts need to increasingly rely on scenario analysis to inform their investment decisions.

We will continue to promote engagement between investors, CRAs and issuers to enhance transparency and address misconceptions, and will look at how to further expand the initiative to address these outstanding challenges.

About this report

 The growth of the initiative

The PRI has been working with investors and CRAs through the ESG in Credit Risk and Ratings Initiative to promote a more systematic and transparent incorporation of ESG factors in credit risk assessments since 2016 and commenced the second phase in 2020.

As of 31 December 2022, 183 investors with over US$40 trillion of assets under management (AUM) and 28 CRAs support the initiative. The range of investors and CRAs that have signed the ESG in Credit Risk and Ratings Statement is very broad and diversified globally, and the continued growth of supporters is a testament to the importance of this topic.

Figure 1: Signatories to the ESG in Credit Risk and Ratings Statement

The uptake by CRAs has been equally remarkable, growing from 6 in 2016, to 18 in 2019 and 28 in 2022. Indeed, the initiative is supported by the industry’s three largest CRAs (Fitch Ratings, Moody’s Investor Service and S&P Global Ratings), alongside regional and specialised ones that differ in size and resources.

As such, the extent to which they are incorporating ESG factors more explicitly in their methodologies, analysis and credit risk assessments varies. Regardless of these differences, they are all working towards the same goal in keeping with their commitments to the initiative.

Figure 2: CRAs supporting the ESG in Credit Risk and Ratings Initiative

In 2019, we released a set of recommendations for CRAs and investors  to start addressing the disconnects we identified at the start of the initiative (i.e. on ESG materiality, credit-relevant time horizons, how investors approach ESG incorporation, and transparency and communication). These have informed our work during phase two, as highlighted in Figure 4.

Figure 3: Phase one recommendations

Figure 4: Three areas of work during the second phase

Lessons learnt from issuer engagement

To explore how ESG considerations vary across debt instruments, improve the way companies disclose credit-relevant ESG data and create an opportunity for credit analysts and issuers to interact with each other, we hosted a series of workshops.

We convened credit analysts from fixed income investors and CRAs alongside issuer representatives, such as chief financial officers (CFOs) or heads of treasury, as well as chief sustainability officers. The workshops looked at investment grade and high-yield issuers from different geographies and sectors.

A full list of participating organisations can be found in Appendix 1.

Figure 5: Workshop participants

The purpose of the workshop series was to:

• promote consensus around credit-relevant ESG issues for corporate borrowers;
• align expectations around ESG disclosures; and
• improve communication between credit analysts and issuers.

The conversations were framed around the three pillars presented in Figure 6 and were guided by talking points we prepared in advance (see example in Appendix 2).

Figure 6: Areas of focus when considering credit-relevant ESG factors. Source: PRI, based on a resource from the Société Française des Analystes Financiers (SFAF)/European Federation of Financial Analysts Societies (EFFAS).

“The event went into more depth than I expected (and certainly more so than others I have attended), as the conversation moved from high-level considerations to more involved ones.”

Issuer participant

The main conclusions from the discussions are summarised below.

Financial materiality depends on factor

The financial materiality of ESG factors is a critical component of credit risk assessment, although investors still struggle to determine what affects issuers’ probability of default the most.

The workshop discussions highlighted that financial materiality can differ depending on many factors.

Figure 7: Factors affecting the materiality of ESG issues for credit risk

SECTOR	For example, companies in the food sector shared that they pay particular attention to deforestation and need complete oversight of their value chains, while banks focus more on ESG issues related to litigation and human resources.
GEOGRAPHY	Some ESG issues, such as those related to diversity, equity and inclusion, appear more credit-relevant in certain geographies than others.
BUSINESS MODEL	For example, in the telecoms industry, a company might consider ESG factors differently depending on whether it builds infrastructure or operates networks.
VALUE CHAIN POSITION	Some issuers provide services or products that are intermediate components in a broader value chain and can contribute to the low-carbon economy transition – chemical companies, for example. In such cases, investors need to consider the potential negative impact of some ESG factors against the positive contribution of others in determining how financially material they are.
TIME HORIZON	For example, climate-related issues, such as reaching carbon neutrality by 2050, are unlikely to affect the risk assessment of a five-year bond. Factors can become more or less material over time and credit analysts must reflect this in their assessments.
STAKEHOLDER PERCEPTION	Companies, investors, CRAs and other stakeholders (e.g., regulators, clients) may not always agree on what constitutes material information. For example, participants from the mining sector identified water as a material issue but said they faced demands from some investors to prioritise disclosing information on greenhouse gas (GHG) emissions.

“It was very interesting to hear views of different stakeholders [on] this topic, and I particularly liked to hear companies asking so many questions.”

Investor participant

Governance remains key

Governance has traditionally been regarded as most material to credit risk and has been extensively incorporated into credit rating models and valuations for corporate bonds.

In addition to typical metrics (such as the composition and independence of boards, the frequency of its meetings and the track record of the company strategy), analysts explained during the workshops that they are now considering some new key performance indicators (KPIs). These include:

• board diversity;
• accountability for sustainability strategies (including clear management functions and responsibilities, checks and controls);
• transparency (for instance on procurements); and
• corporate culture.

Participants also emphasised considering a company’s ownership structure, as it can impact the transparency and time horizon of its business strategy, its internal culture, use of leverage and remuneration policies – factors that are important when assessing governance.

Credit analysts shared that they regularly use information such as a company’s board composition to assess its complexity. Family-owned companies tend to be more flexible and faster in making decisions. They can also be more open to taking medium- and long-term risks and are not impacted by the short-term share price dynamics that affect listed companies. However, they can be less transparent.

During the workshops, investors encouraged issuers to be more transparent and to credibly demonstrate how they address ESG issues in their operations. They can do this by providing education and training across their organisations, so that employees understand how sustainability is embedded in their daily activities. One insurance company has started doing this by introducing ESG-linked KPIs and incentives for all employees.

E, S and G factors are tightly linked

Investors, CRAs and issuers are increasingly aware that E, S and G issues are interlinked, and should not be considered in isolation. For example, they are concerned about the social and economic costs of a low-carbon transition and the potential conflict between climate and societal goals if such a transition is not just and inclusive.^[3]

This was particularly prevalent when workshop participants discussed the exposure of insurance companies to climate change risks. While insurers could stop providing coverage for wildfires, for example, to reduce their balance sheet exposure to such risks, this would not reduce the risk itself.

Furthermore, failing to protect people and businesses dealing with increasingly frequent wildfires (due to climate change) could lead to reputational damage – a risk that could become financially material.^[4]  It would also run counter to the principles of financial inclusion and a just transition, such as ensuring that individuals and companies have access to enough resources to make the necessary changes to their businesses.

According to CRAs, companies that can, instead, capitalise on the opportunities presented by this challenge, such as developing new products or using innovative strategies to better manage their risks, will stand out to credit analysts and may, as a result, receive higher ratings.

To summarise, while materiality differs across sectors and companies, the overall links between ESG factors and credit risk require further work from companies and analysts to better understand which data, KPIs and metrics are needed in addition to the ones traditionally used for financial analysis.

Data availability and quality are still challenging

Good data allows investors to make informed investment decisions, CRAs to better assess issuers’ probability of default and companies to build efficient businesses. However, our workshop discussions confirmed that the availability, quality, reliability and consistency of data is a perennial problem.

Investors and CRAs struggle to access relevant data and – where it exists – its coverage is limited, often outdated, or incomparable between sectors and companies.

This can partly be explained by the plethora of reporting standards and frameworks (e.g., Sustainability Accounting Standards Board (SASB), Task Force on Climate-Related Financial Disclosures (TCFD), Global Reporting Initiative (GRI)) that all require different information. For issuers, having to report on these and respond to many requests from investors, CRAs and ESG information providers can be a time-consuming burden.

The workshop discussions emphasised that striking a balance between disclosure and resource allocation was important.

Companies and investors both expressed frustration with ESG information providers: on the significant number of information requests and sometimes seemingly arbitrary scoring, and the lack of focus on financial materiality and equity bias, respectively.

Consequently, investors with the resources to do so said they preferred to assess issuers using raw data, rather than ESG ratings from providers.

Credit analysts want standardised, comparable information but also need to recognise the circumstances and challenges that companies face around disclosure, depending on their ownership structure and size.

Larger listed issuers tend to have more resources to dedicate to collecting, computing and sharing ESG data than smaller private issuers. Investors might also find it more difficult to access information from these companies (prevalent among high-yield issuers) as they are not subject to the same reporting requirements as public entities.

Workshop participants agreed that they need better and more standardised disclosure on ESG topics from issuers, with more effective channels of dissemination. They pointed to the International Sustainability Standards Board, a new standard-setting board, as potentially being able to deliver that data standardisation.

More engagement needed to improve communication

Active communication between credit analysts (at investor organisations and CRAs) and companies’ CFOs or treasury departments is important:

• for borrowers to better explain how they operate, what ESG factors they consider and how they prioritise which data to disclose;
• for analysts to better understand how ESG materiality varies by sector and company and to educate issuers about why their ESG-related requests are increasing, particularly in light of regulatory changes.

Efficient engagement between credit analysts and issuers should serve to identify and facilitate a better exchange of information.

The workshops highlighted that while companies’ corporate finance staff, i.e. CFOs or heads of treasury, interact with CRAs on a regular basis, they have fewer opportunities to meet with fixed income portfolio managers and credit analysts, as company engagement is more commonly done with equity investors.

Furthermore, investors feel that companies communicate financial metrics (including material ESG data) primarily to respond to shareholder queries, and that the information is typically not geared towards their needs.

Consequently, some investors say that they rely on CRA data for certain aspects of their analysis.

Relying on reported data is not enough, participants agreed. Face-to-face meetings are important to make sure that the information disclosed is reliable and backed by concrete actions, therefore minimising the possibility of greenwashing.

Investors welcomed the idea of issuers organising specific conferences or management meetings targeting bondholders, while joint engagement, involving equity and fixed income investors from the same organisations, was also highlighted.

Finally, additional stakeholders such as company advisors (lawyers, sell-side originators, debt capital market desks etc.) should also be involved in these conversations to make ESG disclosure more transparent and to disseminate ESG data more effectively.

“Many of the points raised [cover] pretty complex topics and will require work over time; a continuation of such workshops under the – neutral – helmet of [the] PRI is very important in my opinion.”

CRA participant

Progress made by CRAs

To understand the impact the initiative has had on participating CRAs, we surveyed the supporting organisations. Of the 22 CRAs that responded, 91% found that joining the initiative has improved how they incorporate ESG factors in their credit risk assessments, helping them do so more transparently and systematically.

Overall, CRAs have improved in several ways, including:

• better identifying and showcasing the impact of ESG issues in their analyses and ratings;
• expanding and dedicating resources to build ESG teams, train or hire analysts and develop analytical tools; and
• broadening their outreach to relevant stakeholders, including rated entities, investors, regulators and ESG information providers.

Figure 8: Changes made since the initiative launched*

Credit analysis

Since the initiative started, and especially in the last few years, the realisation that some ESG issues can present systemic risks to financial markets and should be embedded in their assessment of issuers has grown.

Research clarifying the credit-relevance of ESG factors and themes has increased. Almost half of the responding CRAs now include dedicated sections that discuss the ESG risks and opportunities to an issuer’s credit profile in their credit rating opinions.

Five percent conduct separate ESG discussions as part of their rating committees, while 18% explain how they integrate ESG considerations in their methodologies. Nonetheless, almost a quarter of CRAs have not made any changes to the way they conduct credit risk assessment.

Figure 9: Changes to credit risk assessment process

The majority of CRAs admit that regulatory requirements have also played a role in them making ESG factors more transparent and systematic in credit risk analysis, with 82% indicating that the strongest pressure has come from the European Union.

The European Securities and Markets Authority’s technical advice and guidelines on sustainability considerations in credit ratings have helped guide CRAs’ ESG disclosures in press releases and reports. Since March 2020, CRAs operating in the EU have had to disclose whether ESG factors were a key driver behind a change to a credit rating or rating outlook.

In markets where the regulation is less binding (or sometimes non-existent), such as Asia and Central and South America, CRA respondents observed that they are being pushed by the market to consider ESG factors more systematically, with many investors and issuers starting to request better practices of them.

Figure 10: Impact of regulation on use of ESG factors

Figure 11: Where regulatory pressure is coming from

Organisational changes

CRAs have significantly improved their tools and resources over the last three years. Just over two-thirds have created new roles to oversee ESG incorporation across their organisations, while 41% have increased their ESG capabilities by acquiring or merging with an ESG information provider or peer.

Figure 12: Organisational changes made*

Alongside this market consolidation, CRAs have expanded their offerings – 64% now produce ESG ratings that are separate to their credit risk assessments, for example.

While this reflects their efforts to more explicitly highlight how ESG factors impact credit rating opinions, it has also contributed to confusion among market participants about what ESG ratings measure, how they should be interpreted and how they differ from credit ratings. Even if different departments (and sometimes, legal entities) are responsible for producing these indicators, the distinction between them remains unclear to many investors.

Figure 13: ESG ratings produced

Communication and transparency

Communication and transparency around ESG topics were limited at the start of the initiative and consequently, at the end of the first phase, we recommended that CRAs enhance their outreach on ESG topics.^[5]

CRAs say that taking part in this initiative has helped them to:

• clarify how sustainability issues feature in their methodologies (36%);
• justify the new ESG-related questions they ask issuers (23%); and
• inform issuers or clients about new product offerings (9%).

Figure 14: Role of initiative in helping CRAs increase their ESG outreach to rated entities

As regulated organisations, CRAs should remain independent when assessing rated entities, to avoid any conflict of interest.^[6]  However, they can discuss relevant topics with issuers, and can assess financially material ESG factors to determine how they impact issuer creditworthiness. In addition to justifying new ESG-related questions, because of their participation in the initiative, the survey results show that CRAs have such conversations with rated entities more often (see also Figure 8).

Almost 70% of CRAs have launched dedicated ESG platforms and webpages, to disseminate ESG-related reports, events and methodology information. Nearly all these pages (80%) are freely accessible.

To inform investors and other stakeholders of these developments, we launched a comprehensive resource outlining CRAs’ latest ESG-related activities at the beginning of 2020. The quarterly update compiles:

• research reports related to credit-relevant ESG considerations;
• a selection of CRA opinions that have been driven by ESG factors or that contain a dedicated ESG paragraph;
• events focused on ESG factors and credit risk organised by CRAs or in which they have participated;
• information related to how CRAs incorporate ESG factors into their credit rating methodologies.

Remaining challenges

Despite the significant progress made by CRAs in maintaining their commitment to the initiative, 86% say they still face some persistent challenges to incorporating ESG factors in credit risk assessment.

The main obstacle is data, whether limited issuer disclosure on credit-relevant ESG information (59% of CRAs) or a lack of historical data on how ESG factors impact the performance of ratings (14%). CRAs are limited in the assessments they can conduct and how easily they can compare year-on-year or peer issuer data.

More than two-thirds of those CRAs also have difficulty incorporating ESG factors in their ratings for certain types of fixed income instruments, especially private and securitised debt^[7]  – two complex categories for which disclosure is the most limited.

Figure 15: Most challenging asset classes for ESG incorporation in credit ratings*

Almost a quarter of participants also struggle with modelling the uncertainty and/or visibility of ESG risks. CRAs cannot assess ESG risks whose impact may go beyond the typical time horizon that most credit rating opinions are based on. Indeed, the further these extend into the future, the more uncertain they become.

This is problematic for investors that require credit-relevant information linked to long-term ESG trends, such as climate change.

Due to this disconnect, investors insist on CRAs extending the forward-looking component of their credit opinions. Some agencies have started lengthening the time horizons they use in their scenario analysis,^[8]  for example, but a lot more work needs to be done to address this.

READ THE LATEST CRA QUARTERLY UPDATE

Engaging ESG information providers and investment consultants

ESG information providers

Fixed income investors increasingly use a range of ESG data and information, beyond traditional financial metrics, to make investment decisions, and ESG information providers play a key role in aggregating and analysing this data from issuers.

To understand how fixed income investors use ESG information providers, we surveyed 59 asset owners and investment manager signatories in 2020.

Three-quarters of respondents used third-party ESG resources as an input into their proprietary ESG assessments, rather than using them as primary ESG data without conducting internal analysis. This suggests that fixed income investors are becoming more sophisticated, by building their own ESG research and analytical systems, for example.

Figure 16: Investor uses of third-party ESG resources

Most investors said they were satisfied with ESG information providers’ products and services related to developed markets, investment grade corporate and financial sector issuers, but that there were major gaps for all other issuer types.

These included high-yield and emerging market corporates, leveraged loans, private debt issuers, US municipal bonds, and structured products.

Following this survey, we engaged with 20 ESG information providers, grouped in six categories: large providers, those acquired by CRAs, climate specialists, controversy specialists, data specialists and sovereign specialists.

We wanted to:

• better understand how useful third-party data and product offerings are for fixed income investors and where they need to improve; and
• clarify how their methodologies differ from those of CRAs and how transparent they are.

Providers have been trying to make their products more relevant to debt instruments in recent years – having been historically tailored to meet the needs of equity investors. They acknowledged that significant gaps remain and intend to address these.

Their products do not reflect the complexity of fixed income instruments, which differ in credit quality, duration and characteristics, or their issuers (corporate, sovereign, and sub-sovereign).

Furthermore, the underlying methodologies behind their assessments lack transparency – such as which ESG factors are assessed, and the weightings they assign to them.

This has significant implications for portfolio construction and asset allocation and is reflective of wider challenges the responsible investment industry faces in having consistent, reliable, and comparable ESG data – a crucial component of developing a sustainable financial system.

As explained in Progress made by CRAs, ESG ratings and credit ratings are distinct but complementary products, and market participants have expressed confusion about what the former measure, among other things, often because some of the issues that they capture overlap.

Moreover, this confusion has increased further due to M&A activity in the sector, with some CRAs buying ESG information providers (and offering both credit and ESG ratings) and vice versa.

In light of this ongoing market consolidation, we have created a publicly accessible webpage, mapping the products that ESG information providers offer, what they measure, and how this differs from their credit ratings.

Figure 17: ESG information provider market consolidation between 2000 and 2022. Source: See footnote^[9]

Ultimately, it is the responsibility of investors to choose and interpret the relevant ESG information and incorporate it in their investment decisions.

This task is not easy, in the absence of standardised data and with multiple issuer reporting frameworks – such as the GRI, CDP, SASB or TCFD.

We have discussed the issue of standardisation (or the lack thereof) extensively in our workshops convening investors, CRAs and corporate debt issuers, as highlighted in Lessons learnt from issuer engagement.

Investment consultants

We engaged with investment consultants as they are critical stakeholders in the investment chain, advising institutional asset owners on a range of issues, including the selection, appointment and monitoring of external managers.

They can play a key role in supporting asset owners^[10]  to develop responsible investment practices, and to assess their investment managers’ ESG incorporation and stewardship approaches.

We surveyed 31 asset owners and 15 investment consultants to understand how:

• asset owners use investment consultants to select, appoint and monitor their external fixed income managers;
• asset owners view the ESG-related fixed income advisory services that consultants provide;
• investment consultants assess the ESG incorporation practices of external fixed income managers, and rate their level of expertise in doing so; and
• aligned both parties are on the materiality of ESG factors in various fixed income sub-asset classes.

We found that although many investment consultants have dedicated ESG resources and are developing ESG questionnaires for investment managers, they are often generic or focused on equities, where responsible investment practices are more advanced.

As such, investment consultants must adjust their due diligence processes to better meet clients’ fixed income needs, including:

• improving their communication with the investment managers they assess;
• strengthening their initial and follow-up ESG assessments; and
• expanding their fixed income ESG coverage across instruments, strategies and geographies.

Although asset owners were satisfied with the ESG knowledge level of their investment consultants, providing them with more guidance on their ESG policies and investment objectives could help improve the services they receive.

Figure 18: Investment consultants’ ESG knowledge in fixed income according to asset owners

Both groups recognise the importance of ESG factors for fixed income assets, but they need to better understand how material ESG factors are for bond risk assessment, especially credit risk.

They also need to take a more nuanced approach to assessing bondholder engagement, which – although different from shareholder engagement – can help fixed income investors make more informed decisions and fulfil their duties as responsible stewards of capital.

Although investment consultants have been making significant efforts over the past few years to consider ESG factors more systematically in their manager analysis, a lot more work lies ahead – especially for fixed income assets.

They need to adjust their organisational approaches to better reflect ESG considerations, making sure that these issues are embedded at all staff and activity levels. Ultimately, asset owners need to ensure the services they receive from their consultants align with their own investment strategies and objectives.

Figure 19: Relevance of ESG considerations in fixed income for asset owners and investment consultants (aggregated)

Conclusion

Although the ESG in Credit Risk and Ratings Initiative has come a long way since its launch, there still needs to be more awareness and understanding of how CRAs have adapted to better signpost and systematically incorporate ESG factors into their analysis.

As investors and borrowers are also trying to enhance the risk assessment of their investment decisions and business models, respectively, the workshop series revealed that deepening the understanding of when ESG factors are material and how they impact credit risk requires more stakeholder collaboration and engagement.

Continuing this investor-CRA-borrower dialogue is key to creating a shared understanding of credit-relevant ESG factors, building a common language and recognising shared challenges, especially as ESG issues and their salience evolve. Participants should prioritise developing a common set of standard ESG metrics.

During the second phase of the initiative our focus has largely been on the credit risk of corporate borrowers and we have taken a sectoral approach. Going forward, we intend to:

• expand our focus to public finance and structured products;
• gain a better understanding of how credit-relevant time horizons vary; and
• take a thematic approach to explore how specific ESG issues impact credit risk and metrics.

On the latter point, for climate-related risks, for example, the market is starting to look at the cost of asset or collateral impairment caused by extreme climate events. There is much less focus on how emission-curbing measures – required for the transition to a low-carbon economy – impact issuer balance sheets.

Transitioning towards more sustainable business and growth models, whether to adjust to new trends or regulatory developments, requires issuers to make changes that can create near-term costs and a temporary decline in credit quality. In contrast, the associated benefits – including financial savings – may only become apparent over a longer period, and while their credit ratings may recover, issuers are not always rewarded for becoming more resilient to ESG risks.

To address this mismatch, credit analysts should assess issuers’ long-term prospects, rather than their short-term performance. At the same time, issuers should improve how they communicate their strategic planning and disclose relevant data, so that credit analysts can better understand and monitor their sustainability trajectories. This will inform our work going forward.

Finally, we also aim to diversify our work by region, in response to the growing PRI signatory base and because ESG attributes and the financial strength of issuers to address them can vary by geography.

By leveraging the PRI’s convening power, the initiative will continue to provide a forum for fixed income investors, for whom credit remains a primary concern, to enhance risk assessment, unmask unpriced factors and reward issuers with sustainable business and growth models.

Appendix 1: Workshop participants

Appendix 2: Example of discussion guide

CREDITS: Authors: Sixtine Dubost, Carmen Nuzzo | Editor: Jasmin Leitner | Design: Will Stewart