With Environmental Awareness On The Rise, Companies Seek To Adapt To New Risk, Academic Panelists Say

Written By: Susan Gray, Laurence Hazell and Dmitri Sedov
Written by Susan Gray, Laurence Hazell and Dmitri Sedov

Institutional investors are looking for new ways to decarbonize portfolios and shift capital to more sustainable assets without sacrificing returns, said panelists at S&P Global's most recent Academic Council meeting. The significant increase in mandated capital with the environmental, social, and governance (ESG) focus has led S&P Global Ratings to develop new evaluation tools that aim to provide relative measures of environmental and social impacts, climate resilience, and corporate governance that investors can use in their own assessment of a project's or company's long-term value and financial performance.

S&P Global Ratings proposed asset- and entity-level sustainability evaluation frameworks in September 2016 and has been seeking feedback to ensure that the tools are useful to capital market participants (see "Proposal for a Green Bond Evaluation Tool", and "Proposal for Environmental, Social and Governance (ESG) Assessments.

In particular, the asset-level Green Evaluation will give investors "a more complete picture of the relative environmental attributes of their portfolios and their exposure to climate risks," panelists said. The evaluation proposal goes beyond current assessments of transparency and governance of a "labeled green" bond and takes into account the location of the investment as it relates to the carbon intensity of the local grid; environmental cost of construction and decommissioning; technologies used; and an asset's lifetime.

The entity-level ESG Evaluation is intended to assess a company's impact upon the natural and social environments it inhabits; the effects of those environments upon it; and the governance mechanisms the company has in place to manage and oversee both risks and opportunities that are identified through the ESG assessment.

Listed industrial companies comprise the initial phase of calibrating the ESG Evaluation framework as they have a greater environmental footprint as well as a significant diversity of social impacts. Subsequent phases will include a wider census of corporate entities, including financial institutions.

Although these initiatives present a relatively novel way to evaluate companies, sustainability isn't new to financial markets. It's been a factor in credit and financial analyses for over two decades. Since 1999, S&P Dow Jones Indices--a division of S&P Global--has been a leading provider of sustainability indices that meet various investor needs. S&P Dow Jones Indices pioneered a number of innovative concepts such as carbon-efficient, ESG smart beta, long-term value creation, and other indices based on industry-specific and financially material criteria.

The global debate on environmental, social, and governance impacts continues to intensify, leading to many regulatory initiatives and nongovernmental proposals. The Paris Agreement, effective Nov. 4, 2016, has set a target to limit the rise in global temperature to no more than two degrees Celsius above pre-industrial levels.

This has significant cost and credit implications for issuers, many academic and S&P panelists said.

Consequently, many corporations are reevaluating their sustainability practices and making efforts to reduce their carbon footprint. "Labeled green" bonds is currently the principle debt financing instrument, where the proceeds are exclusively applied to carbon-reduction projects. Panelists expect the market for this financing tool to grow to over $100 billion in 2017. Although still nascent and relatively small, this market will expand significantly, S&P Global Ratings and guest panelists believe, in part thanks to the new Green Evaluation framework that is being designed to assess all bonds (not just those labeled "green") for their environmental impact and climate resilience.

As currently envisaged, both Green Bond Evaluations and the ESG Assessments will provide periodic monitoring after the initial scores are set.

Academic Council members had a variety of questions regarding these proposed frameworks. One question was how S&P Global Ratings will assess companies with a larger carbon footprint, such as those in the oil and gas, extractive, and manufacturing sectors. Will relative performance as well as absolute performance be analyzed? S&P Global Ratings attendees responded that net positive and net negative impacts of projects financed by a green bond would be one way that absolute and relative impacts will be calculated.

Another question raised by Academic Council members related to the various weightings of the pillars of ESG assessments and whether, for example, governance should not receive the highest weighting on the basis that board and management direct corporate conduct and bear the key responsibility for a company's environmental and social footprint.

S&P Global Ratings attendees responded that ESG assessment weightings are under constant review at this preliminary stage but noted that if a management and governance assessment was weak, then this would cap the environmental and social risk management assessment pillar as weak. In addition, a company's social risk profile is a significant contributor to the overall assessment as well.

S&P attendees emphasized that analysts and rating committees currently take into account environmental, social, and governance risks in credit ratings when they judge them material to a rating or outlook. S&P Global Ratings assess ratings impacts of matters such as climate change (e.g. rising sea levels), pollution (e.g. legal liability and regulatory infractions), resource depletion, and employee, customer, and community relations, along with governance deficiencies that adversely affect corporate reputation, which in serious cases could impair access to the credit markets.

Academic Council panelists recognized that ESG market opportunities and challenges are complex and are not always broadly understood. A key goal for S&P Global is to push for greater transparency through better sustainability data, tools, standards, and benchmarks to help investors make more informed decisions.

Writer: Beth Steffens