Why credit ratings need to reflect ESG

Credit ratings agencies are increasingly meeting demands from fixed income investors to better reflect ESG factors in their credit-risk analysis and bond pricing.

“There is a lack of awareness amongst investors of the huge amount of visible progress CRAs, particularly the large ones, have made” in this area, says Carmen Nuzzo, senior consultant, Principles of Responsible Investment and author of the third and final report in the PRI’s ESG and credit rating initiative, which has worked with 18 CRAs and global investors over the last two and a half years to help encourage ESG reporting in CRA analysis. The potential for positive impact is huge, given that global bonds are the largest asset class in capital markets, she says.

High-profile losses at a growing number of corporations because of credit ratings that haven’t reflected poor ESG management have been a key driver of this change. For example, ESG-related risk wasn’t reflected in Pacific Gas and Electric’s credit rating before the California utility filed for bankruptcy in the wake of its liability for last year’s devastating wildfires. Also, Moody’s now rates Cape Town municipality Baa3 and at risk of a downgrade, because of drought in the region.

CRAs are increasingly building ESG teams, researching and publishing such risks and clarifying how ESG features into their methodology. Fitch’s introduction of ESG Relevance Scores demonstrates this. Produced by its analytical teams, the scores transparently and consistently display the relevance and materiality of ESG elements to the ratings decision and will initially apply to more than 1500 non-financial corporate ratings. Elsewhere, S&P Global Ratings has announced it will have a new ESG-dedicated section in each corporate rating commentary.

“CRAs have moved a long way,” Nuzzo says.

More to do

Despite these changes, the PRI’s research has revealed enduring “disconnects” hindering progress. CRAs focus on ESG risk only in the context of its impact on the relative probability of default by the bond issuer, yet fixed income investors also worry about other factors, like volatility. Admittedly, not all ESG factors are material to credit risk; some won’t trigger an issuer or issue default. But all could negatively affect the trading performance of a bond and may become material in the future.

Investors are also confused about the difference between a credit rating and an ESG score. The scores services providers like MSCI and Sustainalytics produce measure the issuer’s exposure to ESG risk, credit ratings measure the risk of default and the strength of the balance sheet. Nuzzo advises investors to use both products.

“CRAs can’t do what ESG services providers do and vice versa,” she says. “Investors need both to evaluate the investment but should not confuse their purposes.”

The confusion of ESG scores and CRA analysis is particularly acute in green and sustainable development goal bond issuance, where proceeds are allocated to a specific project, Nuzzo explains.

Investors also want CRAs to evaluate longer-term risk. CRAs typically view corporate bonds using a three- to five-year time horizon, which extends to 10 years for sovereign bonds. Investors seek more long-term guidance, which would include many ESG factors linked to secular or long-term trends that are difficult to capture.

“CRAs say they base their assessments on forecasts and there is only so much they can extend into the future, otherwise they lose plausibility,” Nuzzo says. “But investors say they want more signals on risks that may not be material now but may appear later on.”


The evolving landscape includes ongoing analysis of whether CRAs should integrate ESG risk by building it into their credit ratings or with an ESG score that highlights risk separately. CRAs are also beginning to put into place frameworks that allow them to analyse risk systematically, but accessing accurate and standardised data to create models has made this difficult.

“You have to remember that the fixed income community is very quantitative when it comes to price and risk assessment, much more so than equity investors,” Nuzzo says.

She warns, however, that the amount of data that is starting to flow could also leave CRAs and investors unsure what is relevant to them.

The lack of standardised data makes comparisons difficult, which is particularly challenging because CRAs’ analysis is based on relative bias; for example, a rating assesses a company’s probability of default relative to other companies with similar characteristics.

“We don’t have this level of standardised data disclosure or standardised terminology,” Nuzzo says. “At the moment, ESG means different things to different investors and there are different attitudes in different regions of the world.”

Extracting data will get much easier if CRAs nurture a culture of engagement, she says.

“As part of their due diligence, CRAs speak to companies and have access to more information than investors,” she says. “They are now beginning to have these conversations on ESG topics, too.”

CRAs’ role here is important because unlike equity investors, who engage via voting rights, bond investors don’t tend to engage with issuers.

“It is not in their culture,” she says, urging bond investors to become more active and have “conversations” with issuers. “It will take time to see the movement of capital change and investors reward those companies that do well and penalise those that are not mitigating or managing ESG risks.”

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