Moody’s, Fitch Ratings, S&P Global called out for failing to reflect climate risks, ESG factors in credit ratings
- A study of 721 companies in climate-intensive industries found no direct relationship between ESG scores and credit ratings, research firm says
- The conventional rating methodology requires an overhaul, says the Institute for Energy Economics and Financial Analysis
Rating agencies must overhaul their credit-assessment methods to integrate environmental, social and governance (ESG) factors and better reflect risks from the looming climate crisis, according to a report by the Ohio-based Institute for Energy Economics and Financial Analysis (IEEFA).
While credit-rating companies increasingly view risk through an ESG lens to assess an entity’s creditworthiness, the way they have incorporated ESG factors into credit analysis has had no effect on their conventional credit assessments, according to the report released on Tuesday.
IEEFA’s analysis of 721 companies in the oil and gas, utilities, automotive-manufacturing and coal-mining industries as of September found no direct relationship between the companies’ ESG credit scores and their credit ratings.
“ESG integration is now a critical component of the investment process,” Hazel Ilango, energy finance analyst at the IEEFA, said in the report. “As a result, the conventional rating methodology requires an overhaul to include long-term risk and produce a tangible outcome on credit rating due to ESG factors.
“As ESG factors have grown in importance in financial markets, integrating them in conventional credit-rating assessments is a critical step towards a more sustainable financial system.”
Conventional credit ratings only evaluate an entity’s creditworthiness or its ability to repay its debt, and do not measure a company’s ESG performance or sustainability, according to the report.
Credit ratings are critical to bond investors’ decision making, as a higher rating indicates that the issuer is likely to repay the bond in full, while a low credit rating suggests that the issuer may default or miss scheduled payments, according to the report.
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The International Energy Agency estimates that around 70 per cent of clean-energy investment over the next decade will need to be carried out by private developers, consumers and financiers to drive the world on a path to achieve net-zero emissions by 2050.
IEEFA acknowledged that the approach rating agencies have taken to develop ESG sector framework disclosures and ESG credit scores is “commendable”, but argued that more tangible rating action is needed.
ESG credit scores by Fitch Ratings, S&P Global Ratings and Moody’s Investors provide a description of how the ESG factors have relevance to or impact on the final credit rating, according to the report. However, these scores do not have a direct link to the credit rating, and the tangible impact of these ESG factors on the credit rating remains ambiguous.
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Current methodologies do not drive debt financing to sustainable initiatives, and bondholders may continue to finance businesses that have fundamentally poor sustainability standards, according to the IEEFA. If this “business as usual” credit framework is followed, challenges such as climate change and social inequality will continue, according to the report.
“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,” Ilango said in the report.
Such companies may not suit investors who take a long-term view on investment, as they could be exposed to abrupt rating downgrades stemming from climate change, she added.
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A Moody’s spokesperson said the ratings agency seeks to “incorporate all material credit considerations, including ESG issues, into credit ratings, and to take the most forward-looking perspective that visibility into these risks and related mitigants permits”.
A Fitch Ratings spokesperson said the company’s primary mandate was to create ratings transparency for investors.
“We continue to focus on how we can add new information and transparency to the broader discussions around ESG,” the spokesperson said. “Fitch Ratings analysts are not passing judgment on how good or bad an entity’s ESG practices are, but rather are focusing on how the different elements of ESG impact the credit rating assigned to the entity.”
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S&P Global Ratings declined to comment.
IEEFA’s Ilango suggested carrying out stand-alone ESG risk assessments through qualitative scoring of environmental and social impacts on long-term creditworthiness, similar to what agencies are already doing in examining governance.
Rating providers could also introduce double ratings, giving a company a rating based on the conventional credit assessment with an upgrade or ESG-adjusted rating to recognise robust ESG attributes, said Ilango.
