Do Credit Ratings include ESG? Greg Readings

A whole industry has sprung up and continues to develop to provide data to investors on environmental, social and governance (ESG) issues, including various ESG ‘scoring’ or ‘rating’ systems. These services differ in methodology and aims so it’s important to understand what they’re offering and what any such rating represents (a topic for another day). One type of rating which will be much more familiar to treasurers is the traditional credit rating, mostly supplied by the ‘big three’ credit rating agencies: Fitch, Moody’s and S&P.

Credit ratings and ESG ratings are different products – the former being an opinion on the relative credit risk of an entity (probability of default and/or loss given default) and the latter an estimate of an entity’s ESG characteristics or exposure to ESG risks. But do ESG risks influence credit ratings and are the main rating agencies building these into their credit assessments?

The simple answer is yes. The agencies committed via the UN Principles for Responsible Investment to incorporate ESG issues into credit ratings and do so in their credit assessments where they believe these to be relevant. Materiality is a key theme; to be meaningful for ratings, ESG factors need be material to the likelihood of default/credit loss. The agencies have gone about this by translating their analysis into scores or indicators which highlight how ESG issues influence their credit opinions:

  • Fitch uses ‘ESG Relevance Scores’
    • Ranked on a 1-5 scale, from ‘Irrelevant’ to ‘Highly Relevant’, indicating materiality to the credit rating
  • Moody’s uses ‘ESG Issuer Profile Scores’ & ‘Credit Impact Scores’
    • Ranked on a 1-5 scale, from ‘Positive’ to ‘Very Highly Negative’, reflecting the perceived ESG exposures and the impact on the credit rating
  • S&P uses ‘ESG Credit Indicators’
    • Ranked on a 1-5 scale, from ‘positive’ to ‘very negative’ influence on credit rating analysis

It should be emphasised that these indicators are neither credit ratings nor ESG ratings (indeed, the agencies also offer separate ESG rating services), rather outputs which highlight the impact of ESG considerations on the rating, aimed at enhancing transparency.

For example, Fitch does not make judgements on how ‘good’ or ‘bad’ an entity’s ESG practices are, rather it considers how the different elements of ESG will impact the credit rating. An entity with large ESG risks could still receive a middle score (‘minimally relevant’) if those risks are deemed to have little credit rating impact. The agencies have also started to include more commentary on ESG issues within credit reports and rating actions, where relevant.

In general, the agencies make it clear that governance issues tend to have more influence on credit ratings than environmental and social risks. However, they recognise that credit risks from environmental issues will rise as growing awareness of the economic and social costs of environmental risks drives policy, investor and corporate action.

ESG issues being considered is one thing, but are they ever the main reason for credit rating changes? One of the agencies suggests that ESG factors were key influences in approximately a sixth of their rating actions last year. These most frequently related to non-financial companies and sovereigns.

So ESG considerations are indeed driving movement in some credit ratings, although not usually for financial institutions. Of course, a credit rating is simply an opinion on the relative credit risk of a counterparty, and the agencies’ assessment of ESG risk impacts are as (perhaps more?) subjective as any other part of that opinion. Indeed, their methodologies are heavily caveated and have come in for some criticism, with one study concluding that “a company’s ESG conduct has no direct relationship whatsoever to its credit rating” but will undoubtedly evolve over time as the market for ESG data continues to mature.

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