Forward-thinking investors in sustainable ventures are calling on credit rating agencies to more seriously consider environmental and social information when making their analyses.
In May, the UN-backed Principles for Responsible Investment (PRI) — a group of influential investors and credit rating agencies — kicked off a major project to look at environmental, social, and governance (ESG) factors in the credit rating process in “a more systematic way.” 100 investors and six credit ratings agencies, including S&P Global Ratings and Moody’s, have agreed to participate in the project, marking the growing consensus on the need for a more holistic approach to investment and risk assessments.
The Project
Last year, a PRI survey of 99 investors revealed that 78% want to see more emphasis put on ESG in credit ratings. In response, the group released a “Statement on ESG Credit Ratings” announcing the start of a two-year program including a wide range of investors and credit rating agencies. Participating organizations will engage in a series of ratings forums to grapple with the tough issues surrounding the connections between ESG factors and credit ratings.
A primary goal of the project is to create more transparency for both investors and credit rating agencies, says Archie Beeching, a Senior Manager at PRI. “Where investors might talk about climate-related risk,” Beeching tells Bloomberg, “a rating agency is probably thinking about litigation risk, cost of capital or regulatory risk.” Getting all parties aligned and using the same language will help facilitate a better understanding of how ESG factors affect creditworthiness.
ESG Implications
Understanding how issues like climate change, natural resource management, and corruption influence the assessment of creditworthiness is critical because of the essential role credit rating agencies play in the world’s $100 trillion debt capital markets, according to PRI.
The group has roughly 1,500 investor signatories, about 600 of whom lean heavily on fixed income in their portfolios — totaling roughly 10% of their assets, Bloomberg reports. These kinds of assets are particularly important for pension funds and those seeking a reliable source of investment income.
“The risk in fixed income is all about getting your interest paid and your principal back when the bond matures. Investors are concerned about material risks in their portfolio that would affect that,” says Beeching.
Learning from the Past
Looking at ESG factors when making credit analyses gives investors a more detailed assessment of that risk. Considering the fact that PRI has more than 400 signatories with investments in corporate and sovereign debt, it’s clear that the more specific the insights, the better. PRI also hopes a more transparent dialogue will help avoid major crises like the Great Recession of 2008, which was spurred by bad sub-prime mortgages and the sovereign debt crises in Greece and Italy.
A real consideration of ESG can help rating agencies understand risk in a more nuanced way, and therefore identify financial risk that might otherwise slip through the cracks. In particular, the growing challenges surrounding climate change need to be included in assessments, says Beeching, especially in the wake of the COP21 Paris talks.
PRI hopes rating agencies will commit significant time and money to considering ESG factors over the next two years; regardless of the final outcome, it promises to be a period of thoughtful dialogue and significant adjustment for all parties involved.