The ESG Risk Atlas
May. 21 2019 — To calibrate the relative ranking of sectors, we use our environmental, social, and governance (ESG) Risk Atlas (see "The ESG Risk Atlas: Sector And Regional Rationales And Scores," published May 13, 2019). The Risk Atlas provides a relative ranking of industries in terms of exposure to environmental and social risks (and opportunities). The sector risk atlas charts (shown below) combine each sector's exposure to environmental and social risks, scoring it on a scale of 1 to 6. A score closer to 1 represents a relatively low exposure, while 6 indicates a high sectorwide exposure to environmental and social risk factors (for details see the Appendix). This report card expands further on the Risk Atlas sector analysis by focusing on the credit-specific impacts, which in turn forms the basis for analyzing the exposures and opportunities of individual companies in the sector.
Environmental Exposure (Risk Atlas: 2)
Environmental factors have infrequently affected health care companies' credit quality. Extreme weather or supply disruptions can affect some manufacturers, but to date this has rarely caused credit deterioration. Pharmaceutical product, medical device, and life science product manufacturing involve hazardous substances and can produce byproducts that could harm the environment. Environmental remediation and failure to comply with regulations can be costly or cause plant shutdowns, which could affect product supply.
Social Exposure (Risk Atlas: 3)
Social factors are prevalent in our credit analysis on health care companies because most health care companies are either providing a service to the community or a product to treat a human ailment. While many of these treatments, products, and drugs can benefit society, they can also be costly to the government or taxpayers, payers, and consumers.
In developed countries, aging populations put cost pressure on health care systems. Improving health outcomes while raising the cost effectiveness of therapies are increasingly becoming twin goals for health care companies. In some markets, including the U.S., public debate focuses on the accessibility and affordability of medicines and quality care and relatedly the transparency of prices. Increasingly, payers are advocating that health care providers and manufactures be compensated for the value they bring, to better align incentives.
In the U.S., given health care's importance to the economy and society, we believe potential changes to reimbursement and access will likely be mostly incremental, rather than dramatic, over the next five years. We view the potentially seismic downside risk that would likely occur from proposals such as Medicare for all as highly unlikely. In addition, we expect any potential drug pricing reform in the U.S. would only moderately burden EBITDA margins for pharmaceutical companies, because we believe the significant social benefits from the industry will lead to a balanced approach that supports continued investment in research and development (R&D) and attractive levels of returns and profitability. (For more information, see "Health Care Washington Watch: Which Government Proposals May Affect Ratings?," published April 18, 2019; and "Which Pharma Company Ratings Could Be At Risk If U.S. Drug Pricing Reforms Become Law?," published Oct. 31, 2018).
Social risks around drug pricing and affordability in Western Europe are less controversial due to high levels of regulatory involvement, and often the nationwide setting of drug formularies and price lists. That said, tight government pricing, regulation, and inflexible policy choices might result in disincentives and misallocation of resources in new drug and therapy development in these markets.
We believe pharmaceutical companies that are highly innovative, invest in R&D, meaningfully improve disease treatment, are thoughtful of public opinion in developing their pricing strategies, and have a reputation for clinical excellence and regulatory compliance have more sustainable business models. In contrast, those that have a limited pipeline and rely on acquisitions, primarily develop and manufacture lifestyle drugs or raise prices significantly may face greater challenges.
For many U.S. health care companies, efforts to reduce system costs will likely require many companies to evolve. This will also contribute to reimbursement risk, which already constrains ratings on providers, particularly hospitals, which deliver the most expensive of health care services. Reimbursement cuts, lower rate increases, efforts to move more volume to the lowest-cost sites of care, a greater uninsured population, and adverse shifts in payer mix can diminish the financial profile of these companies. We view adapting companies as having stronger business risks. In Western Europe, health care service providers, such as hospitals, face similar risks to those in the U.S. Those risks center around reimbursement and its impact on volume and mix of services offered.
Medical device manufacturers face less direct reimbursement risk, but cost stress facing hospitals can lead to indirect pressure on these companies. Similarly, life science companies also only face indirect reimbursement risk (their growth can correlate to the growth of lab testing and R&D spending of other health care companies), although some life science companies have some exposure to government funding levels.
Medical device manufacturers and pharmaceutical manufacturers must ensure the quality and safety of their products because safety issues could be life-threatening or debilitating. The risk of litigation related to safety matters could impair credit quality. For example, pelvic mesh-related legal settlements have affected device manufacturers' credit quality, although this is starting to subside. Currently, the proliferation of opioids has become a public health issue in the U.S. and could hurt the credit quality of some pharmaceutical manufacturers and distributors (for more information, see "The Opioid Crisis: Growing Litigation Concerns For The Health Care Industry," published Oct. 2, 2018).
Data protection has become a notable social risk in light of emerging data privacy and protection laws. This risk is more near term and more quantifiable in terms of mitigation than other social risks in the sector. This means that it's likely to be already priced into health care companies' cost structures.
Governance is company-specific and is often influenced by a company's culture and ownership str`ucture. At the sector level, the health care industry is highly regulated; the government is an important payer for health care services and products. There are also regulations involving safeguarding patient information, safety testing, monitoring and manufacturing quality, and marketing compliance. Noncompliance with these regulations, improper billing for services and products, aggressive marketing tactics, pricing manipulation, and failure to protect patient privacy have surfaced within the sector and can affect ratings.