This article first appeared in Personal Wealth, The Edge Malaysia Weekly on February 25, 2019 - March 3, 2019

It has not always been clear how environmental, social and governance (ESG) factors affect bond credit ratings as the way these risks are evaluated in a credit analysis process is not easily discernable. While all material risks — including ESG factors — are taken into account when a credit rating is published, most of the time it is too general and not entity-specific, says Andrew Steel (picture), managing director and head of sustainable finance at Fitch Ratings Inc.

That is why Fitch decided to introduce a new scoring system. Its ESG Relevance Scores aims to show how such factors impact credit ratings.

With the tool, investors will be armed with more granular information on how ESG elements affect rating decisions across all asset classes. The scores are also sector-based and entity-specific.

“It is important to clarify that these are not new groupings of risks that are suddenly being taken account by analysts. The overall credit analysis process has already incorporated these risks within the different areas of qualitative and quantitative analysis, but they were not easily identifiable as a unique grouping of risks or transparently displayed for investors to see how the identified E, S and G risk categories impacted credit risk decisions,” says Steel.

For starters, the ESG Relevance Scores will be used to assess more than 1,500 non-financial corporate ratings globally. It will be rolled out to cover all entities that Fitch rates such as banks, non-bank financial institutions, insurance players and those involved in public, global infrastructure and structured finance.

With the launch of the scoring methodology, Fitch has become the first credit rating agency to systematically publish an opinion on how ESG issues are relevant and material to the credit ratings of individual entities. The scores will be made available in the public domain and the agency will publish them on an ongoing basis as an integrated part of its entity credit research.

“Our ESG Relevance Scores will enable investors to see how each element influences the rating and for them to make judgements on whether they agree with our assessment of the credit impact on an entity-by-entity, as well as sector-by-sector, basis. The results published in the Excel dashboard illustrate the impact that these [ESG] factors currently have on our publicly available corporate ratings,” says Steel.

It is crucial to note that the scores do not make value judgements on whether an entity engages in good or bad ESG practices, but draw out which E, S and G risk elements are influencing the credit rating decision, he adds.

The individual ESG relevance scores range from 5 (those that currently have a direct impact on the rating) to 1 (those that have no credit impact or are irrelevant to the sector from a credit perspective).

“The scores are important to investors who are trying to assess the exposure the entities have to ESG risk as they clearly indicate what aspects of E, S and G are from a fundamental credit analysis perspective. The scores also indicate what is influencing the rating decisions (those with scores of 5s and 4s), whether they are actively being managed by the issuer to have minimal credit impact (3s), or those that are currently not impacted from a credit perspective (2s and 1s),” says Steel.

He points out that of the 1,534 publicly rated entities, 22% have been given scores of 4 and 5. “The results of our review show that ESG factors affect a meaningful number of issuer credit profiles across all regions and major corporate sectors. The proportion of issuers with at least one factor score of 4 or 5 ranges from 16% for utility players to 35% for food and beverage and tobacco companies,” he adds.

A review published after the scores were launched found that governance risks proved to be the most likely to have an impact on credit ratings (35%). This was followed by social (27%) and environmental factors (20%).

According to a report entitled ESG Corporate Rating Influence Varies, but Rarely a Sole Rating Driver, 21% of companies in developed markets and 26% of those in emerging markets have a score of 4 or 5.

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