UN-supported PRI aims to tie in ESG factors into credit ratings process

The PRI has established the ESG in Credit Ratings Initiative with the aim of enhancing the systematic integration of ESG factors in credit risk analysis

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The United Nations-supported Principles for Responsible Investment (PRI) is embarking on a major push with global credit ratings agencies (CRAs) with the aim of making the incorporation of environmental, social and governance factors a standard for CRA ratings methodology.

The PRI has established the ESG in Credit Ratings Initiative with the aim of enhancing the systematic integration of ESG factors in credit risk analysis, with an emphasis on transparency. Some 130 investors managing over US$26 trillion of assets have signed up to the initiative, as have 15 CRAs; the initiative remains open to new signatories.

A dialogue is ongoing between CRAs and investors under the facilitation of the PRI to cultivate a common language, isolate ESG risks to creditworthiness and iron out investor-CRA disconnects. 

Asian CRAs participating in this programme include Dagong, RAM Ratings, Japan Credit Ratings Agency, China Chengxin Credit Management Co and Golden Credit Rating International.

Forums have been held in Tokyo, Singapore, and Hong Kong and later on in the year the PRI will be releasing a report with the findings from these forum dialogues.

“ESG factors are already incorporated to a large extent in the CRAs’ methodology. The challenge is to make them more explicit, as they may not be labelled as such, and recognising early enough new emerging risks,” said Carmen Nuzzo, senior consultant at the London-based PRI’s Credit Ratings Initiative.

The risks presented by ESG factors across a variety of debt issuance sectors are looming with greater intensity than in the past, some on a relatively short time horizon, others out to five years and beyond.

Discussions held under the initiative have focused on the impact of ESG factors on credit risk and comprehensively evaluating a bond issuer’s ESG risk exposure. A fundamental shift in the mindset towards the ESG/credit ratings relationship is seeing the thinking moving beyond the existence of a tool for downside risk mitigation to one that facilitates enhanced returns and the execution of relative value investment strategies.

The downside risks comprise event risk related in the main to environmental factors - the risk of disasters and sudden asset quality deterioration - and regulatory risk presented by government initiatives to reduce emissions, limit environmental damage and maximise corporate compliance with social and governance norms. 

A clearly delineated case of ESG downside ratings risk would be the S&P downgrade of Volkswagen (VW) after the revelation in September 2015 of the auto manufacturer’s diesel emission manipulation in the US, highlighting in the process governance shortfalls at VW.

Some 11 million VW-produced vehicles were recalled, and a two-notch downgrade was initiated by S&P over the subsequent two months, and in the process, VW’s stock and bond prices fell.

According to Moody’s, unregulated power generation, coal mining and coal terminals are highly exposed to environmental risk in the medium term, while automobile manufacturers, oil and gas explorers, commodity chemical manufacturers and oil and gas refiners face long-term risk, beyond a five-year time horizon.

Conversely, companies which prioritise ESG and execute on its considerations accordingly can enjoy ratings upgrades and portfolio inflows.

With regard to incorporating ESG transparency into the ratings process among debt issuers, the developed economies are further along the process in terms of providing disclosure to the CRAs, while the developing markets -Asia and China in particular - continue to lag their developed peers.

“There is definitively an improvement in transparency in developed markets, and, in some instances, even too much non material information which is not relevant for financial markets. In the case of Asia, specifically, the problem is that debt may be issued by private, non-listed companies or State-Owned Enterprises, so disclosure is more problematic,” said the PRI's Nuzzo.

 

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Date

30 Jul 2018

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