ESG conduct has no direct bearing on credit rating actions

A new study suggests that the ESG conduct of a company has no direct bearing on its credit rating actions, which are focused on the short term. The study of more than 700 corporates by the Institute for Energy Economics and Financial Analysis (IEEFA) reveals “cracks in credit rating methods”, the institute said. The study outcome reveals how credit rating agencies are still evaluating companies the traditional way despite making an effort to produce detailed ESG scores and having come a long way in terms of their credit outlook on hydrocarbon related sectors, said Hazel Ilango, an energy finance analyst at the IEEFA. The rating framework may have been ESG-enhanced, she said, but it remains a “repackaged concept” of long-established credit assessment principles. “A company can have a weak ESG credit score, be carbon intensive or 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,” said Ilango. She added that such companies may not suit investors who take the long-term view on investment, so even those that do not focus on ESG matters can be exposed to abrupt rating downgrades stemming from climate change. Ilango said credit rating agencies have the potential to play an important role in driving sustainable debt financing, and one critical step is to directly integrate ESG factors in their rating methodology. She acknowledges that the three agencies examined in the report – S&P Global Ratings, Moody’s Investors and Fitch Ratings – are increasingly viewing risk through an ESG lens to assess an entity’s creditworthiness, as articulated in their development of ESG credit scores, but she does not think that is enough. “Based on IEEFA’s analysis of 721 companies as of September 2022, we find there is no direct relationship between their ESG credit scores and credit ratings,” Ilango said. “While the three agencies all provide detailed ESG credit scores to bond investors, it is difficult to establish a straightforward link between their ESG scores and credit ratings. Such scores merely represent a detailed and transparent ESG diagnosis on how these factors could impact the final credit outcome.” She said she believes that if rating agencies had overhauled their conventional assessments by integrating ESG factors as a central component in addition to business, financial and supplementary risks, it would likely have prompted disruptive changes to companies’ ratings across sectors and regions. As things stand, she added, bond investors cannot adequately assess an issuer’s long-term credit risk based on the credit rating alone. They also have to refer to the ESG credit scores to somehow gauge its ESG exposure. “Climate change risks expose bond investors not only to the physical climate, but also to transition risk with the shift toward a low-carbon economy. Therefore, corporates that are susceptible to such risks may have a higher potential for default,” she explained. According to Ilango: “Just as businesses and risk managers are expected to think beyond the short term, so should credit rating agencies. However, this challenges the conventional perception of a credit assessment.” Ilango suggests carrying out standalone ESG risk assessment through qualitative scoring of environmental and social impacts on long-term creditworthiness, just as agencies are already doing in examining governance. “Rating agencies can also introduce double-rating measures. For example, they can give a company a ‘BBB’ rating based on the conventional credit assessment, then issue an upgrade or an ESG-adjusted rating to an ‘A’ to recognise its substantial decarbonisation strategy and robust social and governance attributes,” she said.

ESG conduct has no direct bearing on credit rating actions

Study reveals ‘cracks in credit rating methods’

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