In a study conducted by the Institute for Energy Economics and Financial Analysis (IEEFA) of 700 corporates has shown that the environmental, social and governance (ESG) conduct of a company has no direct bearing on its credit rating actions, which are focused on the short term. In essence, Hazel Ilango, an Energy Finance Analyst at the Institute found the proverbial fly in the ointment about current ESG practices.

The study outcome reveals how credit rating agencies are still evaluating companies the traditional way despite making an effort to produce detailed ESG scores and having come a long way in terms of their credit outlook on hydrocarbon related sectors. The rating framework may have been ESG-enhanced, Ilango says, but it remains a “repackaged concept” of long-established credit assessment principles.

“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 writes in her new report. Such companies may not suit investors who take the long-term view on investment, so even those that do not focus on ESG matters can be exposed to abrupt rating downgrades stemming from climate change.

Credit rating agencies have the potential to play an important role in driving sustainable debt financing, particularly in view of the need to carry out 70% of clean energy investment over the next decade to achieve net-zero emissions by 2050, according to an International Energy Agency estimate. As such, one critical step is to directly integrate ESG factors in their rating methodology, Ilango says.

She acknowledges that the three agencies examined in the report — S&P Global Ratings, Moody’s Investors and Fitch Ratings — are increasingly viewing risk through an ESG to assess an entity’s creditworthiness, as articulated in their development of ESG credit scores. However, that is not enough.

“Based on IEEFA’s analysis of 721 companies as of September 2022, we find that there is no direct relationship between their ESG credit scores and credit ratings,” Ilango says. “While the three agencies all provide detailed ESG credit scores to bond investors, it is difficult to establish a straightforward link between their ESG scores and credit ratings. Such scores merely represent a detailed and transparent ESG diagnosis on how these factors could impact the final credit outcome.”

She believes that if rating agencies had overhauled their conventional assessments by integrating ESG factors as a central component in addition to business, financial and supplementary risks, it would likely have prompted disruptive changes to companies’ ratings across sectors and regions. As things stand, bond investors cannot adequately assess an issuer’s long-term credit risk based on the credit rating alone. They also have to refer to the ESG credit scores to somehow gauge its ESG exposure.

Source: BIIA