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Environmental, Social, and Governance Considerations in Credit Rating

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In conducting rating assessment, Credit Rating Agencies look at a number of factors, including the institution’s existing level of debt, its character, its financial liquidity, a historical demonstration of its ability and willingness to repay loans, its financial ability to repay its debt as well as Environmental, Social and Governance (ESG) factors.

ESG is an area of business that has become increasingly important in determining the value of a business and its ability to create long-term value and positive outcomes. It is concerned with the impact an organisation has on its internal and external stakeholders across the Environmental, Social, and Governance elements of their organisational practices.

The quality of ESG disclosures cannot be overemphasized as it enables users, especially investors, to make informed decisions by identifying companies that may pose a risk or perform less well due to sustainability or ESG failings.

According to a recent report, a Rating Agency published a white paper focused on the ESG market revealing that it “believes that ESG factors that impact credit risk need better disclosure and there is no universally agreed-upon standard by which E, S, and G factors are weighted, or, in many cases, even measured.” Therefore, the disclosure and analysis of ESG factors are essential in credit rating reports.

On Thursday, 10th February 2022, the European Union’s securities watchdog stated that “Credit rating agencies need to improve how they refer to Environment, Social and Governance factors in their ratings used by investors to direct huge sums into sustainable funds.”

In light of the aforementioned, it is believed that Credit Rating Agencies should be able to facilitate improvement in the quality of disclosure from issuers as this is a key rating consideration.

According to other reports, Credit Rating Agencies should undertake the following to better integrate ESG factors into credit rating assessments:

  • Develop and disclose systematic methodologies for assessing material ESG considerations at the industry level
    Investors and issuers need clarity on what factors credit analysts specifically review for each industry. Methodologies should consider ESG-related risks to repayment, and the capability and willingness of management and the board to take adaptive actions in response to ESG-related risks and opportunities.
  • Provide transparency on how ESG considerations affected the credit rating review of each issuer
    Not every factor identified as material at the industry level will be a material determinant of the credit rating of a given issuer; well-capitalized issuers with healthy cash flow may be able to compensate in the near-term for ESG concerns. However, investors want to understand how the analyst reached their conclusion and what influence ESG considerations did or did not play.
  • Proactively identify and highlight systematic ESG risks that require greater attention by issuers and investors
    Credit Rating Agencies are well-positioned to look at industries and markets holistically across the credit spectrum and to highlight emerging and systematic risks that may be increasing in materiality. Through the use of scenario analysis and stress testing, a Rating Agency can help identify the potential impact of these risks, and create frameworks for enhanced disclosure by issuers.

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