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Risk Management

Measuring ESG Impact on Credit Risk

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January 29, 2019

Fitch’s new ESG scores help corporate finance manage credit risk

Risk ManagementIn what appears to be a first, Fitch Ratings recently introduced scores indicating the relevance of environmental, social and governance (ESG) factors on corporates’ credit ratings.

Fitch acknowledges that ESG risks’ impact on credit ratings is generally low—less than 3%, but whatever impact arises could end up being disproportionately higher.

The major rating agencies have published their methodologies for evaluating ESG risk, which has become increasingly important to consumers and governments, which now means it’s important to corporate treasurers.

This was evident at a second-half meeting of NeuGroup’s Treasury Investment Managers’ Peer Group, where members discussed using ESG criteria in formulating their portfolios. One member of the group said his company was already using some criteria, although wouldn’t go into specifics. “We have sectors that we won’t buy,” he said, and discussed owning the “right things” while avoiding “the wrong things.” Another member added that credit managers “should have this sensibility in their models.” Nonetheless, all agreed that figuring out what’s right and wrong from an investing standpoint can be tricky.

And measuring the potential impact on a credit rating can be similarly tricky. Up to now, there hasn’t been a tool for companies to measure its impact on a specific company’s credit risk. Fitch’s ESG Relevance Scores for corporates aim to change that.

“We’ve trained our analysts to extract from our methodology the risk elements that are related to these factors, and then to score them according to whether they are impacting the rating or not,” said Andrew Steel, head of global sustainable finance at Fitch.

In advance of meeting Fitch analysts, corporate-finance managers will have access to a sector-specific template showing elements that could impact credit, and therefore know which elements of ESG the analysts are interested in.

The score doesn’t gauge how good or bad the company is in terms of ESG overall, but instead how ESG impacts its credit rating on a scale of 1 to 5. Scores of ‘1’ or ‘2’ indicate no impact on credit rating, because it’s irrelevant to the sector or the company in the sector; a score of ‘3’ indicates a minimal credit risk impact on the company or its effective management of it to cause no credit impact; and scores of ‘4’ or ‘5’ indicate ESG is either an emerging risk or a contributing factor to the credit decision.

“So, when the treasurer, CFO and CEO talk to our analysts about their company’s rating reviews, they will see much more easily how we frame the analysis of these types of risk within our overall credit analysis,” Mr. Steel said. “And it is consistent and specific by sector, which hasn’t existed until now, particularly on the credit side.”

Mr. Steel noted that Fitch has identified industry-specific risks within each of the 52 corporate sectors it analyzes as well as more general risk issues across all those sectors that are “roughly aligned” with the Sustainable Accounting Standards Board’s (SASB) definitions.

“People analyzing these risks must be able to reference what we’re doing back to an external framework somehow, and the most common one is the SASB’s,” Mr. Steel said.

If certain risks simply don’t apply to an industry, say water and waste management in the airline industry, then the sector would receive a bottom score of ‘1’. However, if governments globally decide to more stringently regulate how airlines get rid of waste, prompting fines, then Fitch would likely bump up the score to a ‘2’. And if the penalties become significant that score would increase to ‘3’, with Fitch expecting companies to manage that risk; if a company fails to manage it, damaging its credit profile, then a ‘4’ or even a ‘5’ could become appropriate.

A benefit from Fitch training its analysts to provide ESG scores is that corporate finance executives will always deal with the same analyst and can discuss ESG in the context of the company’s overall credit.

“It will be easy for them to see in advance what the analysts are interested in, and if they look at the scores of their company and its peer group, it makes it easier to see what actions they might take to improve their credit profile,” Mr. Steel said.

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