INSIGHT by the Institute for Energy Economics and Financial Analysis (IEEFA)
Just as businesses and risk managers are expected to think beyond the short term, credit assessment practices must evolve to ensure that the rating system, too, promotes sustainability.
The environmental, social and governance (ESG) conduct of a company has no direct bearing on its credit rating actions, which are focused on the short term, a research study of more than 700 corporates has shown.
The study outcome reveals how credit rating agencies are still evaluating companies the traditional way despite making an effort to produce detailed ESG scores and having come a long way in terms of their credit outlook on hydrocarbon related sectors, says Hazel Ilango, an Energy Finance Analyst at the Institute for Energy Economics and Financial Analysis (IEEFA).
The rating framework may have been ESG-enhanced, she says, but it remains a “repackaged concept” of long-established credit assessment principles.
“A company can have a weak ESG credit score, be carbon intensive or lack a clear carbon transition pathway, and yet be assigned a high investment-grade rating due to its high ability to repay its debt in the next three to five years,” Ilango writes in her new report. Such companies may not suit investors who take the long-term view on investment, so even those that do not focus on ESG matters can be exposed to abrupt rating downgrades stemming from climate change.
“A company can have a weak ESG credit score, be carbon intensive or lack a clear carbon transition pathway, and yet be assigned a high investment-grade rating due to its high ability to repay its debt in the next three to five years.”
–Hazel Ilango, Analyst at the IEEFA
Credit rating agencies have the potential to play an important role in driving sustainable debt financing, particularly in view of the need to carry out 70% of clean energy investment over the next decade to achieve net-zero emissions by 2050, according to an International Energy Agency estimate.
As such, one critical step is to directly integrate ESG factors in their rating methodology, Ilango says.
She acknowledges that the three agencies examined in the report — S&P Global Ratings, Moody’s Investors and Fitch Ratings — are increasingly viewing risk through an ESG lens to assess an entity’s creditworthiness, as articulated in their development of ESG credit scores. However, that is not enough.
“Based on IEEFA’s analysis of 721 companies as of September 2022, we find that there is no direct relationship between their ESG credit scores and credit ratings,” Ilango says. “While the three agencies all provide detailed ESG credit scores to bond investors, it is difficult to establish a straightforward link between their ESG scores and credit ratings.
“Such scores merely represent a detailed and transparent ESG diagnosis on how these factors could impact the final credit outcome.”
She believes that if rating agencies had overhauled their conventional assessments by integrating ESG factors as a central component in addition to business, financial and supplementary risks, it would likely have prompted disruptive changes to companies’ ratings across sectors and regions.
As things stand, bond investors cannot adequately assess an issuer’s long-term credit risk based on the credit rating alone. They also have to refer to the ESG credit scores to somehow gauge its ESG exposure.
Proposed Models for Integrating ESG Factors in Ratings
These challenges do not have a quick fix, given the complexity around credit evaluation. However, environmental and social issues are gaining traction and deserve more attention. Ilango believes that the conventional rating methodology requires an overhaul to include long-term risk and produce a tangible outcome on credit ratings that account for ESG factors.
“Just as businesses and risk managers are expected to think beyond the short term, so should credit rating agencies. However, this challenges the conventional perception of a credit assessment,” she says.
Ilango suggests carrying out standalone ESG risk assessment through qualitative scoring of environmental and social impacts on long-term creditworthiness, just as agencies are already doing in examining governance.
“Just as businesses and risk managers are expected to think beyond the short term, so should credit rating agencies. However, this challenges the conventional perception of a credit assessment.”
–Hazel Ilango, Analyst at the IEEFA
Rating agencies can also introduce double rating measures. For example, they can give a company a “BBB” rating based on the conventional credit assessment, then issue an upgrade or an ESG-adjusted rating to an “A” to recognize its substantial decarbonization strategy and robust social and governance attributes.
In addition, rating agencies could take a more granular approach to ESG considerations by including and publishing scenario analysis to quantify long-term trends and risk trajectories.
“In our report, we’ve explored possible models for how to better integrate ESG in credit rating assessments,” Ilango says. “The aim is to study the possibility of creditworthiness and sustainability coexisting in a credit rating assessment.”
Read the report