ESG Gains Ground in Credit Risk Analysis in Australia

By Carmen Nuzzo, Senior Consultant, Credit Ratings Initiative, and Matthew McAdam, Head of Australasia, PRI

On 26 February, the Financial Services Council (FSC) and the Principles for Responsible Investment (PRI) co-hosted the first ESG in Credit Risk and Ratings Forum for members of the industry in Sydney. The forum, one of more than 10 the PRI has been undertaking as part of a global roadshow to educate and inform market participants about the links between environmental, social and governance (ESG) factors and credit risk, was well attended by over 25 credit analysts, fixed income (FI) portfolio managers and responsible investment professionals. Representatives from global credit rating agencies Moody’s Investors Service and Standard & Poor’s Global Ratings presented their approaches to assessing ESG factors in their ratings criteria, responding to calls from investors for more transparency in this area.

Once the exclusive focus of equity capital markets, ESG factors are now increasingly catching the attention of FI investors and credit rating agencies (CRAs) when they assess credit risk – a measure of the relative probability that the money an investor lends to a bond issuer will not be repaid timely or in full.

Admittedly, governance has traditionally featured in credit risk analysis. However, corporate scandals which have triggered sizable financial losses in recent years as well as the devastating effects of the global financial crisis are stark reminders of why a lack of proper oversight, transparency and accountability can negatively affect FI market pricing, volatility and, ultimately, returns.

Beyond governance, the business case for integrating ESG factors is becoming increasingly compelling as the effects of climate change and other environmental risks become more visible and data availability improves. Investors are also beginning to grasp how social factors – such as workforce diversity, labour conditions and employee engagement, training and development – can impact a company’s financial performance as well as its reputation.

Since many FI investors buy bonds for capital preservation, it is critical that – where material – these factors are systematically included in bond valuations and downside risk is managed. This need is particularly pressing for insurers and pension funds, which hold FI instruments for asset-liability management and have a fiduciary duty to their policy holders and beneficiaries.

Beyond stewardship and risk management, sophisticated investors are learning how to model ESG factors to spot market mispricing and opportunities. Indeed, some are beginning to create internal proprietary ESG indicators to help with bond pricing. They are also demanding more clarity from CRAs to understand what is already factored in their rating opinions to avoid double counting.

Encouragingly, investors and CRAs are allocating more resources to understanding ESG issues, including appointing dedicated analysts, publishing more thematic research and scenario analysis, and increasing budgets. This is one of the main findings of a recent report by the PRI, 'Shifting perceptions: ESG, credit risk and ratings – part 1: the state of play’. However, the report concluded that ESG integration is not yet systematic. Disconnects identified in the report include different views on the time horizon over which ESG factors are deemed material by CRAs; on the assessment of materiality among investors and CRAs; and investor tendency to focus on the overall financial performance of an issuer, not just on its default probability, as CRAs do.

Because of their unique position in the market, CRAs play a crucial role in promoting ESG integration, where these factors are deemed to be material to credit risk. Even if credit opinions represent just one input in an investor’s assessment of creditworthiness, they are closely monitored by market participants that may trade on potential upgrades or downgrades. Furthermore, credit ratings also often define or limit investment mandates and are used for a range of other market applications – such as the eligibility of collateral or credit enhancement in structured finance transactions – and by a variety of market players, including central banks.

Ultimately, changes must occur before ESG integration is carried out systematically by both investors and CRAs. How should credit analysts be incentivised and equipped with the right resources to broaden their analysis beyond traditional financial variables? Should investors and CRAs demand enhanced ESG data disclosure from issuers? And finally, given their role as gatekeepers, should regulators also have a role in ensuring CRAs consider ESG factors systematically and transparently in their rating opinions

These are all questions that this project, which now has the backing of 130 investors representing more than US$23 trillion in assets under management and 15 CRAs, seeks to answer.

With nearly US$97trn of bonds outstanding globally, the project has a substantial opportunity to make financial markets more sustainable, and the PRI and FSC look forward to sharing new developments as the ESG in Credit Ratings Initiative continues to progress over the coming quarters.