While it is still too early to identify solutions to the problems frequently encountered by investors and CRAs when incorporating ESG factors in credit risk analysis, there are ripe opportunities for further work.
The roundtables have thus far only scratched the surface of an area deserving of much deeper investigation. Participants called for more focused sessions – by issuer type (e.g. sovereigns and corporates), sub-asset class (e.g. investment-grade, high yield and emerging markets) and by sector – as well as with a broader range of stakeholders, including bond issuers and ESG service providers.
The forums also revealed that there is still considerable confusion among market participants about the purpose of ESG analysis in credit risk and about basic but important concepts such as the differences between ESG consideration in credit ratings and the ESG assessment made by ESG score providers. Indeed, the two tools can be complementary for investors but are distinct:
- Credit ratings are opinions about the relative creditworthiness of a bond issue or its issuer, based on the likelihood of default and the financial loss suffered in the event of a default. They are formed based on quantitative and qualitative analyses and analytical judgement. They are provided by CRAs (typically paid for by a bond issuer when solicited) and are regulated products.
- ESG scores evaluate a security issuer (either of bonds or equities) according to their exposure and performance relative to ESG factors and compared to their peers. They are quantitative indicators; they are usually compiled by third-party service providers (typically paid for by investors) and are unregulated products. They provide useful material for investors to make informed decisions. However, unlike credit ratings, they do not capture the impact of ESG factors on the overall creditworthiness of an issuer and the issuer’s balance sheet and cash flow.
This distinction is important to clarify what CRAs should focus on. Investors seem to expect judgment on the quality of ESG information provided by a company, which is beyond the CRA institutional remit. However, it is important to stress that the purpose of CRAs is not to provide an ESG certification, nor to offer investment advice. Rather, the focus of credit ratings is on relative creditworthiness through assessing a bond issuer’s fundraising ability, its cash flow generation, and whether this is sufficient to honour debt commitment including at redemption – in full and on time. With that said, CRAs should continue to work on making ESG factors more explicit in credit rating opinions and on broadening their analysis to encompass new risks – to the extent that ESG issues are or become material to creditworthiness.
Participants appreciated the difference between credit ratings and ESG scores more during the roundtable discussions when thinking of the questions that credit practitioners need to ask when considering ESG factors in risk assessments. When assessing an issuer’s ESG performance, certain questions may also be pertinent to credit risk analysis assessment, but some are only relevant to the latter. For example:
|ESG factor||Overall ESG performance assessment||ESG assessment in credit risk analysis|
To bring clarity to the market, we plan to discuss how FI investors can use both tools, their weaknesses and what can be improved during a panel session at PRI in Person in San Francisco on 13 September 201817. The panel will feature representatives from investors, CRAs and ESG service providers.
Later in the year, the third report of the series will present the insight gained on the differences between ESG in corporate and sovereign credit risk that some of the roundtables focused on. It will also explore the solutions that started emerging during the discussions.
Download the full report
Shifting perceptions: ESG, credit risk and ratings – part 2: exploring the disconnects