Stockholm (NordSIP) – At a Forum organised by the UN-supported Principles for Responsible Investment (PRI) in Stockholm hosted by Öhman last week, a presentation by Credit Rating Agencies (CRAs) and ensuing roundtable were held to address environmental, social and governance (ESG) consideration in Credit Risk and Ratings. On location to discuss Shifting Perceptions: ESG, credit risk and ratings – part 1: the state of play, the first PRI report on the issue, was Carmen Nuzzo, Senior Consultant with the PRI Credit Ratings Initiative and one of the authors of the document. Nuzzo kindly sat down with NordSIP following the event to outline the findings in the ‘Shifting Perceptions’ report and explain some of the advances regarding the integration of ESG into credit risk analysis.
The PRI ESG in Credit Ratings Initiative is an undertaking that aims to enhance the transparent and systematic integration of ESG factors in credit risk analysis. The Rockefeller Foundation funded the project, launched in 2016 with a Statement, which so far 127 investors worth over USD 22 trillion of AUM and 14 CRAs support. The Statement is aspirational, as Nuzzo explained, meaning that the PRI does not tell investors or credit rating agencies how or when to incorporate ESG consideration in credit risk analysis. Instead, it uses the instrument to encourage investors and CRAs to be more actively engaging with each other and to be more transparent and systematic about what they do.
The report (the first of three) published earlier this year evaluates how CRAs and investors are currently approaching ESG. It is a collaborative effort based on interviews conducted in the early part of 2017, with the input of an advisory committee made up of institutional investors and representatives of credit rating agencies. Its findings provide the platform for discussion at a series of Forums – roundtables organised by the PRI aimed at credit risk analysts, fixed income portfolio managers and strategists, with the participation of CRA representatives to explain how they incorporate ESG factors in their credit ratings – of which the Öhman event was the latest this year.
‘State of Play’ emphasises what a credit rating is and what it is not. There is still confusion in the market about what CRAs do by contrast with service providers who give ESG scores, measuring how well companies or countries perform on ESG factors. Service providers do not assess credit risk, Nuzzo explained. The report distinguishes between ESG factors that may affect the bond performance as a whole and ESG factors that may affect only default risk, which is one of the many risks of bonds. The largest global CRAs, such as Moody’s Investors Service or S&P Global Ratings, are leading the pack because they “have been doing quite a lot in terms of refining methodologies and publishing increased research on the topic,” Nuzzo says.
Another smaller group of CRAs specialised by product (some may concentrate on sovereign and not corporate products, for example) or regions are beginning to catch up as well, though they still lag the larger global agencies. Chinese CRAs, such as the China Chengxin or Dagong Global Credit Ratings Group, are placed in a separate category altogether because they focus solely on green bonds for the time being and not more broadly on ESG integration.
Between Investors and CRAs
Overall, ESG integration into credit risk analysis is still nascent or partial, despite it being more advanced in Nordic countries (such conclusions are a generalisation, as Nuzzo organisational because progress by investors varies and some are more advanced than others). Moreover, as ESG analysis is often advisory in nature, opinions are given but are not always taken into account or systematically integrated when it comes to performance or portfolio allocation. There is a lack of systematic collaboration between ESG analysts and credit analysts and Portfolio Managers. Finally, investors, in general, are interested in the overall bond performance and not just what ESG factors impact upon credit risks, which is different from what CRAs focus on. Investors still want to see more transparency from CRAs, and for them to do a broader credit analysis than they currently do.
On the other side, the research found that many ESG factors have traditionally been incorporated into credit risk analysis in the sense that they may exist without having been labelled as such, but now increasingly are. Where the largest CRAs have been making progress, they acknowledge that they need to communicate better what they are doing or explain their framework to make their actions more explicit and create more transparency. Since the financial crisis, they have refined methodologies and research into how ESG factors incorporate into, for example, environmental risks by comparison to past efforts. Some CRAs are beginning to develop new products similar to ESG scores, Nuzzo says, in addition to traditional credit ratings.
Nuzzo identified four areas of disconnect that need to be addressed going forward:
Visibility of ESG risks: CRAs formulate a credit opinion with varying time-horizons depending on the instrument that they assess, but typically averaging three-five years for corporate bonds and ten years for sovereign bonds. Investors, however, demand more long-term analyses of ESG risks, while CRAs can only make projections so far into the future with a degree of plausibility.
Materiality of ESG risks: are all ESG factors that affect default risk equally important, or are some more important than others? Are there sector or geographical differences that need to be taken into account?
Transparency: investors do not appear to be aware of the efforts that CRAs are currently making to be more explicit. Moreover, within investment houses there can be a lack of communication between ESG analysts and credit analysts and/or portfolio managers, so the flow of information is not always yet as systematic as it could be.
Approach: do investors need a separate product altogether to complement traditional credit rating analysis or do they want a built-in product, which may be more useful but also more difficult to distinguish in terms of transparency once it’s embedded? A separate product with separate scores would perhaps be more tangible but would serve a different purpose.
The rating forums Nuzzo is conducting are designed to discuss these disconnects and organizational approaches to ESG that can be taken. How can incentives be made to take ESG risk into account to get senior management’s buy-in, or how can training on both the investor and CRA side be supplemented, so they complement each other better? This round of analysis will culminate in the publication of the next PRI report in the series early next year, which will focus more on the challenges that investors and credit agencies are encountering. The final report will then focus on recommendations and visions into the future. Future updates will be posted on the PRI ESG in Credit Ratings Initiative website, as well as reported here on NordSIP.
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