This is a real challenge for rating agencies. Environmental, social and governance (ESG) risks have a direct influence on issuers’ credit quality. But how does one quantify ESG criteria and integrate it into their credit ratings? Moody's is increasingly integrating extra-financial elements into its credit quality analyses.
"We are working to refine and be more transparent and coherent regarding the integration of these criteria," said Yasmina Serghini, Head of the ESG working group at Moody's and Head of Corporate Finance in Europe. Upon examining their score, it is necessary to understand the risks involved, their relevance and their longevity."
Developing a common language
Members of the United Nations-supported Principles for Responsible Investment (PRI) are working on developing a common framework for ESG criteria. They have just published a report, in which Moody's participated, on ESG criteria in rating agencies’ credit analyses.
In January, Moody's independently published its own methodological guide on how its teams account for ESG criteria in their analyses. "We had to develop a common language internally to produce an analytical framework that everyone can understand," said Serghini.
A work in progress
Such integration is far from simple. Moody's started working on it just before the COP 21 in 2015, but it remains a work in progress. Today, around one hundred employees regularly work on the ESG analytical device that is to be set up. The main difficulty to overcome is time considerations.
Rating agencies are tasked with assessing the ability of an entity (government, company, etc.) to repay its debts in full and on time. They analyse the default risk of an issuer over a relatively short time frame. However, certain ESG risks may have a much longer time horizon, leading to significant uncertainties about their impact on the issuer's strategy. "It's hard to extrapolate for a risk 30 years from now," said Serghini, "a lot of things can happen between the first year and the last year, which is much less the case for a five-year risk."
ESG criteria already effecting credit ratings
The solution for Moody's is to analyse materiality risk, its true nature, and then incorporate it into the rating. Risks that exist in the more distant or those that are more difficult to quantify are not ignored, according to the agency. "A financial rating results from a quantitative and qualitative analysis,” said Serghini. “When a risk is distant, it is normally included in the qualitative dimension of the analysis."
Standard & Poor's (S&P) claims to have already integrated ESG criteria into its credit analyses for several years. But since February 2019, the group has decided to add a specific section to its credit reports to explain how ESG criteria were considered in their rating decision.
The effects of these new methodologies by rating agencies are proving very real. Entities have already seen their credit rating penalised due to extra-financial risks. This is the case for Cape Town, South Africa. Their water crisis led Moody's to maintain a negative outlook for the city's Baa3 rating. S&P estimates that between 2015 and 2017, more than 1,000 credit ratings were significantly impacted by environmental or social factors.
Arnaud Dumas @ADumas5