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Can credit rating assessments and sustainability coexist?

March 14, 2023
Hazel Ilango
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Key Findings

Credit rating agencies do not make value judgement, but rather how ESG factors impact creditworthiness. Until then, companies that are negatively impacting the environment will continue to be highly rated. On the other hand, sustainable companies will not receive a rating uplift despite its decarbonization.

Disclosing or providing detailed ESG diagnosis is not the same as integrating ESG factors into credit ratings, since the former does not trigger a credit rating action.

Conventional Corporate Credit Assessment + ESG Risk system would provide transparency and calibrate ESG risks for debt investors.

The current credit rating model is short-sighted and not intuitive enough to provide an early warning signal ahead of a climate-related crisis. An issuer that faces heightened ESG risks in the long-term, particularly climate-related risks, may experience an abrupt rating downgrade sooner than expected. This severely impacts bondholders and triggers potentially significant bond sell-offs.

Executive Summary

As environmental, social, and governance (ESG) factors become more prevalent in investments, credit rating agencies have sought to be more transparent about how these factors are considered in their traditional credit rating assessment. ESG considerations in credit ratings is not intended to measure a company’s sustainability impact, but rather how credit relevant ESG risk can ultimately impact the ability of a company or entity to repay debt.

One tool developed to improve transparency is the ESG credit score, which aims to articulate or quantify ESG factors in credit rating analysis.

The way agencies have incorporated ESG into credit analysis has had no effect on their conventional credit assessment. These ESG credit scores do not cause a rating upgrade or downgrade. As a result, there have been no significant rating changes for all sectors globally since the ESG enhanced credit rating methodology.

If ESG considerations are deemed to have a credit risk or benefit but do not result in a tangible and timely credit rating change, what is the purpose of ESG considerations in credit ratings (or ESG credit score)?

The current “ESG-enhanced” rating framework is simply a repackaged concept of an already established credit assessment principle.

Under this framework, an entity’s credit rating would remain the same but there is an additional ESG credit score component that helps disclose potential ESG risks that may impact a credit rating coupled with other prevalent credit factors. 

This approach suggests that a company can have a weak ESG credit score, be carbon intensive, 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. 

The International Energy Agency Net Zero Emissions by 2050 Scenario estimates that around 70% of clean energy investment will take place over the next decade and this largely hinges on the widespread mobilization of low-cost debt. A credit rating is an important factor to consider when deciding on capital structure. The higher the credit rating, the more easily issuers can obtain funding and the lower the cost of debt.

As it stands, the current credit rating methodology is a disadvantage for companies that are pursuing a sustainable transition. Credit assessment needs to be improved, and entities that pursue sustainability initiatives should be incentivized by enhancing low-cost financing to accelerate the clean energy transition. 

Notably, only credit relevant ESG factors that are visible, likely to materialize, and have a significant impact on creditworthiness in the short term (three to five years) are considered in the credit assessment. Whereas ESG risks, particularly environmental risks that are deemed to be uncertain long-term projections and difficult to quantify are not incorporated. While these risks are considered material, they have little impact on assigned credit ratings today due to its relatively short-term assessment.

Environmental risks, such as transition and physical risks, are more difficult to assess due to the longer time horizon, greater uncertainty, and the challenge to quantify these risks into potential financial losses. That said, these risks will continue to build up to become certain and material, affecting an entity’s debt repayment capacity as the transition to a low-carbon economy accelerates and the negative effects of physical climate change become more apparent. As a result, bond portfolios are faced with increased downside risk over time.

For example, in 2019 S&P and Moody’s downgraded Pacific Gas and Electric Company (PG&E)’s rating due to its challenging environment, as it faced billions of dollars in liabilities related to wildfires (physical risk). Following a series of wildfires between 2015 and 2018, PG&E filed for bankruptcy on 29 January 2019. PG&E is widely considered to be the first “Climate Bankruptcy”, and it is unlikely to be the last, as climate change exacerbates natural disasters, resulting in more frequent and intense wildfires, storms, and flooding. 

This underscores that what is currently deemed uncertain risk could result in a multi-notch downgrade and, eventually, bankruptcy, which can severely impact bondholders. Consequently, there could be more abrupt rating changes on the horizon under the existing credit rating mechanism.

Just as businesses and risk managers are expected to think beyond short-termism, so should credit rating agencies. In particular, credit assessment practices must evolve to ensure that the ratings system, too, is sustainable. The credit rating system should be more resilient to ESG-related shocks, particularly the impact of climate change. A credit rating evaluation would benefit from including long-term risks and/or opportunities to provide early signals.

ESG integration is now a critical component of the investment process. As a result, the conventional rating methodology requires an overhaul to include long-term risk and produce a tangible outcome on credit rating due to ESG factors. This report provides possible new models for how ESG can be better integrated in credit rating assessments. These include instituting a standalone ESG risk assessment, a double rating analysis or plausible sensitivity analysis. 

While there is no quick fix to address these challenges given the complexity around credit evaluation, environmental and social issues are gaining traction and deserve more attention. As such, the suggested models aim to explore the possibility of creditworthiness and sustainability coexisting in a credit rating assessment.

Hazel Ilango

Hazel Ilango was previously an Energy Finance Analyst, Debt Markets at IEEFA. Hazel partnered with analysts and allies to disseminate expert research to media and target audiences.

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