Credit rating agencies do not look sufficiently at the long-term impact of environment, social and governance (ESG) factors, according to a new study – Can Credit Assessments and Sustainability Coexist – from the Institute for Energy Economics and Financial Analysis (IEEFA).
Hazel Ilango, an energy finance analyst at the US based think tank, analysed over 700 companies who received credit ratings from the big three credit rating agencies – Fitch Ratings, Moody’s Investors and S&P Global Ratings.
She found that while all three agencies have taken important steps to integrate ESG into their assessments of an entity’s creditworthiness as illustrated by their development of ESG credit scores, this did not go far 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 said. “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.”
Ilango noted the three rating agencies were still evaluating companies the traditional way despite making an effort to produce detailed ESG scores.
As a result, the study said that even investors who are blasé about a company’s ESG credentials could still find themselves exposed to abrupt ratings downgrades stemming from climate change over the long term.
“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 said.
Her research showed that such companies may not suit investors who take the long-term view on investment. Even those that do not focus on ESG matters can be exposed to abrupt rating downgrades stemming from climate change.
Ilango noted the principal challenge is a mismatch between ESG factors and the credit ratings time horizon. Credit rating agencies would typically factor in the impact of a carbon emissions tax, for example, but would not incorporate the potential cost of an extreme weather event because of the uncertainty of its timing.
In other words, some of the serious risks associated with climate change such as transition risk, may end up outside the scope of a ratings assessment because it’s too far in the future.
“The current methodology does not drive debt financing to sustainable initiatives, and bondholders may continue to finance businesses that have fundamentally poor sustainability standards,” the report stated.
It added, “If this ‘business as usual’ credit framework is followed, real-world challenges such as climate change and social inequality will continue.”
Ilango proposed an overhaul of ratings assessments to take into consideration long-term ESG risks.
She also suggested rating agencies possibly introduce dual ratings, one based on conventional credit assessments and another that factors in ESG factors.
The IEEFA’s report comes on the back of a discussion paper – Climate Vulnerability in Corporate Credit Ratings, published by Fitch Ratings in mid-February.
The ratings agency is seeking formal feedback by 31 March on possible plans to incorporate climate risks within its credit ratings through what it calls a climate vulnerability scores.
These scores are based on exactly what the IEEFA is requesting – a long-term outlook of the impact of climate risks on a business and sector.
Ranging up to 100, the score indicates whether various factors could have an “existential” impact on default.
The methodology is underpinned by the UN Principles for Responsible Investment’s Inevitable Policy Response Forecast Policy Scenario, a model for estimating how prepared industries and sectors are for changes in government climate policy.
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