ESG and Credit: What We Need to Know
Jo Lock / Article / 03 January, 2023
The Covid-19 pandemic has not only triggered a robust debate into ESG, but also facilitated a key shift in the way both our societies and global financial services firms operate. We live in a world of scarce resources and economic growth in itself is not enough. Now, we are tasked with rebuilding our economies and enabling our businesses to place a greater emphasis on corporate purpose and governance as part of our credit decision-making and investment choices.
As the financial services industry gears up to respond to The Bank of England's 'green mandate' and changing customer demands, ESG has become a key topic of conversation in the Boardroom. So, companies need to take a much more proactive approach to embed ESG metrics into their strategies right from the start in order to survive and thrive under increasing corporate and regulatory scrutiny. Firms can accomplish this task by focusing on three pillars of sustainability - people, planet and profits - which indicate that economic growth is only possible if we have environmental protection and social progress in their evaluations. This brings us onto the topic of triple bottom line accounting, a phrase coined in the late 1990's. Companies must focus as much on social and environmental concerns as they do on profits.
Given recent developments, it's most important for analysts to understand how ESG risks apply to credit analysis and the challenges with integrating ESG issues as part of any credit assessment. In addition, it's crucial for credit risk specialists to understand how they can drive credit losses, climate risks and the specific regulations for banks. Assessing the materiality of both ESG risks and drivers is also key.
Let's start by providing some clarity around what we mean when we talk about ESG risks. Firstly, the E stands for environmental risk and includes things such as climate change, rising sea levels and water pollution. Then there's the S for social, which includes resource management, work rights, equality and diversity factors. Finally, it's the G for governance, which looks at Board independence, shareholder rights and corruption, amongst many other issues.
ESG is not new, it's been a theme since the early 2000's and has been used mainly in investment management up until recently, but until now we haven't specifically teased out these categories of risks and placed them under the credit spotlight. Credit analysis has always included ESG as part of the assessment of the credit worthiness of an obligor. For example, examining the legal, reputational and financial consequences of certain banking activities and practices. However, industry studies have shown that ESG integration techniques can help to identify unknown or undervalued credit drivers and that material ESG issues can be key drivers of credit quality.
If we turn to environmental risks, the most obvious risks have always been recognized with a tendency for focus on climate, but there are non-climate related risks that we need to consider too. Social risks are less developed in analysis and difficult to define, but perhaps most controversial and more prevalent than initially assumed as part of a thorough analysis. Governance is a topic which has been traditionally incorporated within our risk assessments and is perceived to be the factor with the largest impact on credit risk in general. The key difference when assessing ESG credit risk vs. traditional credit risk, however, is the timeline; ESG factors can take much longer to develop.
The European Banking Authority (EBA) defines ESG factors as Environment, Social or Governance matters that may have a positive or negative impact on the financial performance or solvency of an entity, sovereign or individual. In the credit world we are focusing on the impacts (either positive or negative) on counterparties or invested assets.
If we examine the bigger picture from a regulatory standpoint, the central banks and regulators are taking an active role in assessing ESG risks via the banking system, so it's really important that we understand how to analyse these risks. The EBA has provided a useful model in its report on the Management of ESG risks for Credit Institutions and Investment Firms, which helps risk managers to split their ESG and credit risk analysis into three areas: the risk drivers, the transmission channels though which they may become key financial risks, and five well-established financial risk categories themselves (which the banks have been reporting on for years), i.e. credit risk, market risk, operational risk, liquidity and funding risk and reputational risk. The EBA also considers that ESG impacts are not just institution specific but may affect the financial system and the economy as a whole with potentially systemic consequences.
So, having identified the risk drivers, let's take a closer look at these transmission channels. These are the causal links or chains that explain how the ESG factors we identify translate into financial risks for institutions, either via assets or counterparties, clients or suppliers. So, basically, these are the ways that any firm may feel the 'ESG pain' and these are all key metrics that we would need to look at in our credit analysis. Transmission channels may include: lower profitability, lower real estate value, lower household wealth, lower asset performance, increased cost of compliance and increased legal costs. It's important to take a long-term view of each of these channels as they are often very slow to develop and we should also define their materiality i.e. are they of sufficient magnitude to affect the credit profile? Do we need to act now, or can risk mitigants be put in place?
It is not easy for firms to assess their ESG-related financial risks. Whilst accounting standards mean that the ability of analysts to understand the financial dynamics of a business are well known, the same cannot be said for the ESG dynamics of a borrower. The lack of standardized metrics across borrowers means that most analysis tends to be piecemeal and comparing ESG across businesses is a challenge. There are some specific challenges that we face as analysts, which include: uncertainty, data scarcity, methodological constraints with historical data, a longer time-horizon, non-linear effects (the risk development may not be logical) and multi-point impacts. For the time being, credit risk managers and analysts may have to handle a lot of data, but deal with a lack of usable information.
Risk reporting is an opportunity for an organization to show that it is on top of its risks, that the management and the Board understand what the risks are and why they're taking them, that they have considered what they need to do about them and that they know that they are being managed according to plan. To date, credit analysis has been short-to-medium term only and we need to widen that time horizon, and crucially, we also need more forward looking ESG analyses and metrics. The management and quantification of climate-related risks is currently more advanced, whilst social and governance risks are mostly managed in a qualitative manner, but things are starting to change, mostly driven by regulations. The Sustainable Finance Disclosure Regulation (SFDR) coming into force in 2022 should help to improve the situation.
Basel regulation requires capital to be assigned to most of these risk categories, either by the standardized approach or internal model-based methods. So, if ESG risks are material enough, then they're ultimately going to feed into the capital calculations of affected banks. That is why ESG should not be treated as a separate section in any credit analysis; it is like a mosaic - interwoven through the whole analytical piece with connections that reach into every aspect of analysis.
ESG and credit are closely intertwined; ESG risks can and do impact the probability of default, exposure at default and loss given default. Furthermore, an institution's failure to accurately address ESG issues can lead to reputational damage, misconduct risk, pricing errors, lower investor confidence, liquidity issues and higher funding costs. Whereas, on the positive side, the successful management of ESG risks should in theory lead to a more sustainable business with an improved credit profile, lower cost of capital and lesser risk of loss.
About the Author
Jo Lock brings two decades of credit industry experience, specializing in credit risk management in financial institutions. Prior to joining Fitch Learning, Jo worked in risk management roles in the financial services sector covering portfolios across Europe, Africa, the Middle East and Asia Pacific regions at companies including BNP Paribas, Canadian Imperial Bank of Commerce and Northern Trust. Jo holds a degree in Commerce with German from Birmingham University.