Environmental, social and governance (ESG) risks--and opportunities-- are a material part of credit analysis, whether for banks or insurers, or for sovereign and local and regional governments (LRGs). The ESG acronym is increasingly coming to the forefront with investors, regulators, and politicians around the globe. And for good reason--these three letters encapsulate myriad risks (and opportunities) that affect the creditworthiness of rated issuers. Some, like governance risks, have existed for a very long time in one form or another. Others, like social or environmental considerations, are not new, but have gained importance recently. This is due to changing regulations (prudential or environmental) or simply evolving behaviors and preferences from customers and citizens.
S&P Global Ratings performed a two-year review of ESG factors, and how they influenced, positively or negatively, the creditworthiness of rated global sovereigns, LRGs, banks, and insurers. For that period, from July 31, 2016-July 31, 2018, we found 147 cases globally where these factors resulted in a rating action. The conclusion is clear: ESG factors affect all types of issuers, everywhere. Furthermore, governance risks, based on our observations, were behind the majority (65%) of these rating actions. Our existing criteria already allow us to accurately analyze how issuers are faring on this ESG front and reflect this in ratings.
ESG: Simple Acronym, Complicated Risks
E Risk: The most tangible
Environmental risks (E risks) can influence the creditworthiness of issuers in multiple ways. The Task Force on Climate-Related Financial Disclosures (TCFD), a group of experts commissioned by Governor of the Bank of England, Mark Carney, divided them into two subgroups, as part of its final report from June 29, 2017:
- "Physical risks," which include the direct financial and operational implications for organizations or sovereigns from natural catastrophes, but also long-term climate change; and
- "Transition risks," which include all the policy, legal, technological, and reputational challenges from the transition to a low-carbon economy, and their associated costs.
For sovereigns, LRGs, insurers, and banks, we are tailoring these definitions below given their diversity.
We consider environmental degradation or a diminishing natural resource base unlikely to undermine economic and social indicators or political institutions such that it would destabilize the sovereign rating within a horizon of 5-10 years. That said, we believe that climate change and other ecological issues could have significant implications for sovereign ratings in the decades to come. Although it poses a negligible direct risk to sovereign ratings in advanced economies for now, on average, ratings on many emerging sovereigns (specifically those in the Caribbean or Southeast Asia) will likely come under significant additional pressure. One example came with the weakened economic growth prospects in the Turks and Caicos Islands following the devastating impact of hurricanes Irma and Maria in 2017, which resulted in an outlook revision to stable from positive in June 2018. Of course, what happens in emerging and developing countries can have repercussions for advanced economies as well, for example, through trade and migratory flows.
Concentrated economies can also face big ESG repercussions. A sovereign or LRG with high agricultural output is more susceptible to weather-related events, and ones with resources depending on an environmentally unfriendly industry (such as mining) could suffer from limited budgetary flexibility and contingent liabilities.
Environmental factors could affect sovereign creditworthiness in other ways--for instance, countries reducing their reliance on imported energy in favor of renewable energy could find external metrics improving.
With respect to insurance, S&P Global Ratings identify the intricate and complex relationships with greenhouse gas emissions, climate change, natural resource contamination and scarcity, pollution, and biodiversity impact on insurers' operating models and their exposure through their counterparties via investments and insurance contracts with other (re)insurers. Our focus on E risk within insurance ratings goes beyond weather-related phenomena, given that most insurance business models, by definition, are exposed to natural catastrophe risks across sectors (for instance, property damage, fatality, or medical spending). With E risk, we look to anticipate additional operational costs for insurers due to inability to operate or recover from investments vulnerable to environmental issues. As well, insurers may incur sizable claim settlements due to climate-related liability exposure. Climate change could end up affecting human mortality and morbidity in significant ways. Rising temperatures, heavy rains, and droughts can pose health risks, possibly leading to increased deaths. For example, populations exposed to areas affected by extreme heat or poor air quality could experience a shift in health threats stemming from reduced food and water quality.
Like insurers, banks could be vulnerable to what the TCFD would define as "acute risk," that is, deterioration in the quality of its loan exposures or securities investments and attrition of its revenues base immediately after a severe natural catastrophe. But it could result from loan portfolio concentration, or securities investments in potentially environmental unfriendly sectors (such as mining and arctic drilling), whose main players could see their financial health deteriorating if the legal, technological, or reputational context changes rapidly.
S Risk: The broadest and most developing factor
For organizations, social risks (S risks) and opportunities are those linked to the interactions between a company, its stakeholders, and the broader society, whose behaviors, priorities, and expectations evolve. It encompasses the analysis of turnover (in particular of key personnel), the firm's reputation as an employer and how it manages its people, and the vulnerability to long disruptions due to inefficient social dialogue, like through prolonged or otherwise bitter strikes. But it also captures changing consumer preferences and priorities, which new technologies and social media can exacerbate, rapidly reshaping and transforming industry dynamics and competitive positions. We believe that, for banks and insurance companies, mis-selling practices and other type of conduct risks (such as those perceived as abusive commercial practices, especially vis-à-vis individual customers) are an important social risk, for which we believe regulators and the society in its entirety are less inclined to accept.
For sovereigns or LRGs, predictable policymaking is often linked to the cohesiveness of civil society, as demonstrated by social mobility, social inclusion, the prevalence of civic organizations, the degree of social order, and the capacity of political institutions to respond to societal priorities. Social cohesion-related factors can also include conflicts and terror attacks. Social inclusion fosters the stability and effectiveness of policymaking, and underpins a productive economy where skills and jobs bolster growth, national savings, and public finances. On the other hand, where a country has a significant shortfall in basic public services and infrastructure, its public finances are likely to come under prolonged stress. Changes in social cohesiveness often trigger, follow, or go hand-in-hand with material governance changes.
G Risk: The factor that most frequently arises in our analyses
Governance risks (G risks) are not new and their impact can be severe for commercial organizations, sovereigns, or local and regional governments.
When evaluating institutions and governance for sovereigns and local and regional governments, we consider the effectiveness, stability, and predictability of policymaking, political institutions, and civil society. We also analyze institutional accountability and transparency, which has a direct bearing on sovereign or LRG creditworthiness. Transparent, accountable institutions reinforce the stability and predictability both of political institutions and the political framework. Monetary policymaking, particularly central bank independence, can also be significantly affected. Having transparent processes and data is similarly important because this enhances the reliability and accuracy of information. It also helps reveal any major shifts in a country's policymaking or the timely emergence of threats to a sovereign or LRG's creditworthiness.
For private-sector players such as banks, finance companies, and insurers, we believe board member composition, vision and values, and transparency offer insight to governance effectiveness. Our evaluation on G risk focuses on the balance of authority, independent oversight,
awareness of risks at all levels, and quality of internal control and risk management functions. We also believe that a board with diverse skills and backgrounds that reflect the needs of the business and its diverse set of stakeholders (such as customers, employees, and community members), is more likely to succeed. Timely and adequate disclosure of a company's operating and financial performance and governance facilitates stakeholder understanding of that company's prospects. Openness regarding nonfinancial performance (for example, taxation) is also key to understanding material ESG risks and opportunities. Finally, independent reputable auditors can provide stakeholders comfort regarding the quality of internal control and risk management functions.
How Our Criteria Capture ESG Factors
S&P Global Ratings incorporates these considerations into its ratings methodology and analytics, enabling 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. We continuously monitor the impact of ESG factors, as we do all relevant factors, on an entity's credit profile.
Our ratings are forward-looking and incorporate our financial forecasts. These forecasts reflect the period over which we consider we have a clear 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 up to two years for speculative-grade corporate entities (those rated 'BB+' and below) and no more than five years for investment-grade issuers ('BBB-' and above). We also consider whether the credit profile is sustainable beyond those periods. If we have a high degree of certainty about risks or opportunities that happen beyond the typical forecast period, we factor those into our ratings, and potentially our financial forecasts, as appropriate.
Therefore, we factor the impact of ESG risks and opportunities, if sufficiently visible and material, 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. Our qualitative rating considerations could still capture these factors if we are fairly certain 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 issuer's fundamentals change.