How sustainability risks factor into credit ratings

As the desire for investors and financial institutions to demonstrate integration and awareness of sustainability issues has grown over recent years, so has the market for providing data and insights relating to these topics. This is where “ESG service providers” step in. Called many names, including “ESG ratings agencies” or “ESG data providers”, and offering a broad range of products including scores, ratings, benchmarks, data and even consultancy, the fast-growing industry around sustainability-related insights can cause confusion. Indeed, a recent review carried out by ISOCO specifically highlighted financial market participants’ potential misunderstanding of data and ratings from ESG service providers as a source of financial risk.

The growing ESG data market: a source of confusion

While discussions around the potential need for regulation of ESG service providers in the EU and the UK have focused on users’ interpretation of the information, the growth in the industry has also caused confusion among the entities being rated. Although not needing to directly act on the information themselves, corporates are increasingly aware of the importance of ESG data and its use by their financing partners and investors. Not only are corporates being scored and rated by ESG service providers, their ESG performance is increasingly factored into traditional credit ratings. Adding perhaps more complexity for those under the microscope, these traditional credit rating agencies have also started to access the ESG service provider space over the past few years, with Moody’s acquisition of the French sustainability rater Vigeo Eiris and both S&P and Fitch launching their own specific ESG ratings, separate from the traditional credit ratings.

With unique aims, impacts and use cases, it is important for both sets of stakeholders, financial market participants and corporates alike, to understand the differences between ratings from ESG service providers and the integration of ESG into traditional credit ratings.

The difference between ESG in credit ratings and ESG ratings

The aim of traditional credit ratings is to assess a company’s credit quality by providing an opinion on the risk of default. The aim of ESG service providers generally differs, however. Offering a range of products, ESG service providers’ aims generally fall within the bounds of evaluating a company’s exposure to and management of sustainability-related risks, to assessing the company or product impacts on the wider environment and society, and vice versa.

Although many common terms are used by both sets of evaluations, the different approaches and aims mean that outcomes can be distinct, and should be treated as such. We have identified and outlined three areas of differentiation between the approaches that credit ratings and service providers tend to take when evaluating “ESG”: materiality, weighting of topics, and scope and timing.

Materiality

Materiality commonly refers to the sustainability aspects seen as relevant for a sector or company. As credit ratings aim to assess credit quality, assessments tend to be highly based on financial materiality, focusing on issues that may impact future cash flows. ESG service providers generally adopt a broader understanding of materiality by not only considering sustainability risks that may affect the company, but also how the company may impact the outside environment and external stakeholders.

While ratings from ESG service providers have historically had a greater focus on the outside-in perspective of financial materiality, they are increasingly seeking to portray a broader definition of materiality by attempting to capture the company’s non-financial externalities. Often dubbed  “double materiality,” this approach is frequently based on a view of the company’s sector- or subsector-specific sustainability-related impacts. 

As a result, credit ratings often tend to better capture downside sustainability-related risks, providing a more granular view of how organisations may be negatively affected by issues such as physical asset risks or increased regulatory costs. While ESG service providers do also take downside risks into account, they tend to provide more scope for exposure to external factors to impact the rating. Such factors may include exposure to sustainability-related opportunities from long-term societal trends, positive impact of a product or service on the external environment or society, or contribution to the low-carbon transition.

Weighting of topics

It is well-documented, and often highlighted during debate, that ratings published by ESG service providers have to date shown very low correlation across providers. In part, this difference can be attributed to different weightings being applied across the spectrum of environmental, social and governance issues that are assessed by ESG service e providers. Furthermore, different ESG service providers also weigh aspects such as exposure vs. management and forward vs. backward looking metrics differently, each according to their own in-house methodology and approach to the specific type of ESG rating being provided

The divergences in outcome as a result of different weightings and views applied are even more stark when comparing ESG service providers, as a group, with traditional credit ratings’ integration of ESG factors. Credit ratings generally rely more on more well understood, reported and widely-available data points such those relating to compliance or board composition, for example. As a result of what the traditional credit ratings are aiming to achieve with the integration of ESG factors, there is a greater focus on metrics that can be more directly linked to potential future cashflows. The ESG service providers, however, have a more open-ended mandate and are able to incorporate a broader set of potential future scenarios, such as broader societal sustainability trends or longer term transition impacts.

Scope and timing

Differing approaches to materiality and weighting of ESG factors also result in a difference in the scope of assessments. Credit ratings generally take into account all sustainability risks that could directly affect the specific company and are, through other dimensions, also assessing macroeconomic political risk to a higher degree. From a timeline perspective, credit ratings often have a shorter time horizon and are updated more frequently than ratings from ESG service providers. While traditional credit ratings aim to incorporate future ESG trends, these are often too far ahead and far too complex to be said to have a direct material impact on credit quality.

Inclusion of ESG criteria in credit ratings by the Big Three

All three credit rating agencies define the sustainability issues included in the credit analysis as ESG factors that have a direct impact on credit quality. There are, however, differing approaches to accounting for interaction between distinct sustainability data points, whether themes are seen to have individual impact or whether a positive performance on one ESG factor can outweigh a negative performance in another. The factors can be both based on a whole sector or a specific entity and are mostly based on current and past performance with forward-looking elements. All three agencies give space to both negative impact (risks) and positive impact (opportunities), although it is stated that in most cases the assessed ESG factors lead to negative rather than positive implications.

An overview of potential factors taken into account by S&P, Moody’s and Fitch’s credit ratings

Illustration: Selected ESG factors for credit ratings across the S&P, Moody’s and Fitch

Our recommendation to corporates is to build your sustainability strategy on the internally material topics and actual sustainability commitments the company makes, in line with the general business strategy. ESG ratings should therefore not impact the strategy, but provide a compass for whether you are sufficiently disclosing sustainability efforts and for how external viewers see material topics for your industries. Likewise for credit ratings, they should not guide your sustainability strategy, but we recommend general awareness of the ESG factors assessed by the rating agency and how well these factors are addressed.