Environmental, social, and governance (ESG) risks and opportunities can affect the capacity and willingness of an entity to meet its financial commitments in many ways.
S&P Global Ratings incorporates these considerations into its ratings methodology and analytics, which enables analysts to factor in short-, medium- and long-term impacts--both qualitative and financial--into their considerations at a number of points in their credit analysis. For example, over the past two years (between July 16, 2015, and Aug. 29, 2017), environmental and climate (E&C) concerns affected corporate ratings in 717 cases, or approximately 10% of corporate ratings assessments and resulted in a rating impact (an upgrade, downgrade, outlook revision, or CreditWatch placement) in 106 cases. Some of these rating actions were triggered by specific events, while others were based on developments that we felt were likely to occur over a longer time horizon.
This represents a marked increase in the frequency with which E&C factors have affected corporate ratings compared with our previous study, published on Oct. 21, 2015. Our recent study shows that 717 research updates have featured E&C factors in their analysis, versus 299 in our October 2015 study. Similarly, an E&C factor was key to a rating action in 106 recent cases, versus 56 in the previous study. We believe this difference could reflect, in part, more instances where E&C risk factors are proving to be material to credit quality. We monitor the impact of ESG factors, as we do all relevant factors, on an entity's credit profile. Our view will evolve as new information becomes available, or as the issuer's fundamentals change.
Our ratings are forward-looking and they incorporate our financial forecasts. These forecasts reflect the period over which we consider we have a clearer view of an entity's potential financial performance, taking into account capital structure, and the potential impact of relevant factors (including ESG risks and opportunities). Generally, our forecasts cover a time horizon of up to two years for speculative-grade corporate entities (that is, those rated 'BB+' and below) and no more than five years for investment-grade entities (rated 'BBB-' and above). We also consider whether the credit profile is sustainable beyond those periods. If we have a high degree of visibility and certainty about risks or opportunities that may crystallize for an issuer beyond the typical forecast period, we factor those into our credit ratings, and potentially into our financial forecasts, as appropriate.
Definition Of An Issuer Credit Rating
An S&P Global Ratings issuer credit rating is a forward-looking opinion about an obligor's creditworthiness, which focuses on the obligor's capacity and willingness to meet its financial commitments as they come due. We also assign issue ratings to certain obligations of the obligors. The factors that we incorporate into each rating are described in detail in our criteria for each sector.
Therefore, the impact of ESG risks and opportunities would, if sufficiently visible and material, be factored into our financial forecasts. In some cases, our view of the materiality and visibility of ESG risks and opportunities, and how effectively an entity is mitigating those risks, extends beyond our forecast timeframe. These factors may still be captured in our qualitative rating considerations if we have a high degree of visibility and certainty about their risks and opportunities. We monitor the impact of these ESG factors and our view will evolve as new information becomes available, or as the insurer's fundamentals change.
ESG Risks In Our Analysis
Our corporate analysis typically considers ESG risks in the context of the company's business risk profile, financial risk profile, and management and governance assessment. A corporate entity's capacity and willingness to meet its financial commitments as they come due depends on factors such as:
- The size and stability of its earnings and cash flows relative to its financial commitments; and
- The current, future, or potential emerging risks and opportunities that could change the entity's earnings, cash flows, and financial commitments.
Therefore, when assigning corporate ratings, we consider factors such as the strength and durability of an entity's business, the size and structure of its financial commitments, its liquidity, and the quality of its management and governance. We also consider credit risks that could weaken the entity if they crystallize.
ESG risks and opportunities are most often considered in our assessment of the company's:
- Business risk (specifically, its competitive position);
- Financial risk (through our cash flow/leverage assessment and financial forecasts); and
- Management and governance.
The management and governance assessment includes consideration of environmental and social risk management, as relevant. At the industry level, we also consider industry-specific key credit factors, which may include the effectiveness of ESG risk management.
Our sovereign analysis will typically consider ESG factors in the context of the assessment of institutional quality and governance effectiveness, itself a key part of the overall analysis. Institutional quality and governance effectiveness is a key sovereign rating factor that typically accounts for roughly a quarter of the indicative sovereign rating. Social factors also function as an integral indicator of the quality of institutional effectiveness. Our view of social cohesion is linked to economic growth. In examining how environmental factors affect sovereign ratings, we typically consider a five- to 10-year time horizon.
Although climate change poses a negligible direct risk to sovereign ratings on advanced economies, on average, ratings on many emerging sovereigns (specifically those in the Caribbean or Southeast Asia) would likely come under significant additional pressure over time. Of course, in an integrated world such as today's, what happens in emerging and developing countries can have indirect repercussions for advanced economies as well, for example, through trade and migratory flows.
U.S. Public Finance
Our U.S. public finance analysis will typically consider ESG factors in the context of management effectiveness and planning. Our assessment of U.S. municipalities, states, and not-for-profit enterprises specifically includes a focus on their management and the effectiveness of their long-term planning. Where relevant, this includes our analysis of the quality of their climate risk assessments, identification by management of changes in climate regulation, and possible effects on the key credit factors outlined in our criteria.
Our financial institutions analysis will typically consider ESG factors in the context of the Banking Industry Country Risk Assessment (BICRA), risk position, and governance assessments. Our analysis of ESG risks and strengths permeates our bank rating methodology. The starting point for assigning a rating to a bank in a given country is the anchor we derive from our BICRA methodology. In applying this framework, we seek to identify deficiencies in a banking system's governance and transparency, or material systemwide effects related to climate change.
As part of our analysis of a bank's business position, we also form a view of its governance. ESG factors are also included in our assessment of a bank's risk position, which incorporates risks that are not captured directly in our capital model.
Our insurance methodology typically considers ESG factors in the assessment of industry and country risk; in our analysis of the insurer's competitive position; in our capital analysis; and in the assessment of management and governance and enterprise risk management (ERM). Our insurance methodology takes a similar approach to our corporate and bank criteria frameworks, weaving analysis of ESG risks and opportunities into several aspects of the overall rating process. For example, we incorporate ESG concerns into our assessment of insurance industry and country risk and into our analysis of each insurer's competitive position, as appropriate. We also explicitly incorporate a risk charge to capture the impact of one-in-250-year annual catastrophe losses in our capital model and assess management and governance and ERM for rated insurance entities, including ESG risks where relevant.