The Principle of Responsible Investment (PRI) — a UN-backed body — has said that additional work needs to be done to understand the materiality of ESG factors when assessing credit risk.
This conclusion comes as the PRI seeks to “deepen the dialogue’ between fixed income investors, credit ratings agencies and bond issuers regarding ESG issues.
Since 2016, the PRI’s ESG in Credit Risk and Rating Initiative – supported by 183 investors with over US$40 trillion of assets under management and 28 credit rating agencies (CRAs) – has been encouraging a more systematic and transparent incorporation of ESG considerations in credit risk analysis. This was expanded in 2020, by including other stakeholders, such as corporate debt borrowers, ESG information providers and investment consultants.
This collaborative initiative has started to identify which ESG metrics are credit-relevant. One of the main conclusions is that the financial materiality of ESG factors for credit risk analysis varies, and can depend on a range of factors including sector, geography business model, time horizon and stakeholder perception.
The PRI says that while the governance pillar remains the most salient, the materiality of environmental and social issues is increasingly relevant for credit risk assessments. It add that there are close linkages between E, S and G factors, with investors, rating agencies and issuers aware that each should not be considered in isolation. For example, they was 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.
The PRI says additional work needs to be done to improve the availability, quality, consistency and reliability of relevant ESG data. Investors, CRAs and issuers would welcome more standardisation on ESG disclosure, with more effective channels of dissemination.
Active communication between credit analysts (at investor organisations and CRAs) and companies’ chief financial officers or treasury departments is important to understand challenges on both sides and facilitate a better exchange of information.
CRA supporters of the initiative reported that their involvement had resulted in a number of tangible improvements in how they operate, 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
- Broadening their outreach to relevant stakeholders, including rated entities, investors, regulators and ESG information providers
However, the PRI says there still needs to be more awareness of how rating agencies have adapted to better signpost and systematically incorporate ESG factors into their analysis. Dialogue is key in facilitating systemic change across the industry, by building a common language and helping overcome shared challenges.
ESG information providers play a major role in aggregating and analysing ESG data used by investors. They have been trying to tailor their products to fixed income instruments in recent years, but significant gaps remain, especially in terms of coverage and transparency. PRI has also been working on addressing the confusion among investors between credit and ESG ratings, which has been compounded by M&A within the industry.
The PRI adds that investment consultants also have a key role to play in the investment chain, in supporting asset owners to develop responsible investment practices. Currently, though many investment consultants have dedicated ESG resources and are developing relevant questionnaires, these resources tend to be too generic or focused on equities. As such, they 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
- Expanding their fixed income ESG coverage across instruments, strategies and geographies
PRI head of fixed income Carmen Nuzzo says: “Our work through Credit Risk and Ratings Initiative has provided an unprecedented space for credit rating agencies, fixed income investors and issuers to dialogue. We’ve established clearly that ESG factors impact credit risk, and that – while governance issues remain the most salient – the materiality of environmental and social issues is increasingly relevant, although varying by issuer, sector and geography. This growing awareness is half the battle. Rating agencies must go beyond better signposting and translate it into credit action; investors must use engagement more proactively as part of credit risk assessment whilst issuers should improve disclosure and preparedness to address existing and potential ESG risks. Doing so will facilitate a more comprehensive response to the challenges which ESG-linked issues entail, and therefore more effective risk management, which ultimately benefits all parties.”