(Editor's Note: This article has been updated to clarify that we do not apply ESG credit indicators to entities rated 'SD' or 'D' and to update the description of ESG credit indicators. )
Following our recently published methodology on environmental, social, and governance (ESG) principles in credit ratings (see "Environmental, Social, And Governance Principles In Credit Ratings," published Oct. 10, 2021), we intend to provide additional disclosure and transparency by applying ESG credit indicators to publicly rated entities. We published ESG credit indicator report cards for the corporate and infrastructure, banking, and insurance sectors from mid-November to January for individual companies, and we will begin implementation of other asset classes in spring 2022 continuing into 2023. Following the initial release of the report cards, we plan to incorporate and update the ESG credit indicators in our issuer-specific credit rating publications to complement our existing credit rating analysis and surveillance. Below we explain the definitions and application in determining the ESG credit indicators.
Our ESG criteria seek to enhance transparency in how and where we capture ESG factors in credit ratings through the application of sector-specific criteria. Our ESG credit indicators provide additional disclosure by reflecting our opinion of how material the influence of ESG factors is on the various analytical components in our rating analysis through an alphanumerical 1-5 scale (see Table 1).
Given an ESG credit indicator is an alphanumeric representation of the qualitive assessment of ESG factors' impact on creditworthiness produced as part of the ratings process, accordingly the application of--or change of--an ESG credit indicator cannot in itself trigger a credit rating or outlook change. However, the impact of ESG factors on creditworthiness could contribute to a rating action, which in turn could lead to a change in the ESG credit indicator. Through the release of ESG credit indicators, we aim to further delineate and summarize the relevance of ESG factors to our credit analysis by isolating our opinion of their credit influence and separating it from the non-ESG factors affecting the credit rating.
|ESG Credit Indicators|
|Influence on credit rating analysis||Environmental credit indicator||Social credit indicator||Governance credit indicator|
|Source: S&P Global Ratings.|
The above scale has a negative skew. This is deliberate and reflects our view that ESG considerations that are material to our rating analysis have a negative influence more often than a positive one. A neutral ESG credit indicator (E-2, S-2, or G-2) does not necessarily mean that ESG factors are not relevant; it only means that it is currently a neutral consideration in our Credit Rating analysis. For example, a negative environmental consideration in one area of our analysis (such as industry risk), may be counterbalanced by a positive environmental consideration reflected in another area of our analysis (such as competitive position if the entity is better positioned than its industry peers).
Environmental, Social, And Governance Credit Indicator Definitions
|Environmental Credit Indicators|
|E-1||Environmental factors are, on a net basis*, a positive consideration in our credit rating analysis, affecting at least one analytical component¶†.|
|E-2||Environmental factors are, on a net basis*, a neutral consideration in our credit rating analysis†.|
|E-3||Environmental factors are, on a net basis*, a moderately negative consideration in our credit rating analysis, affecting at least one analytical component¶†.|
|E-4||Environmental factors are, on a net basis*, a negative consideration in our credit rating analysis, affecting more than one analytical component¶ or one severely†.|
|E-5||Environmental factors are, on a net basis*, a very negative consideration in our credit rating analysis, affecting several analytical components¶ or one very severely†.|
|*"On a net basis" means that we take a holistic view on exposure to environmental factors and related mitigants. ¶Analytical components include criteria scores and subscores (including the key analytical elements to assess them). "Affecting" means leading to a different outcome for an analytical component or lower/higher headroom for an analytical component. †For structured finance transactions, environmental credit indicators express our view of the influence of environmental factors on any of the five key rating factors in our analytical framework before accounting for any benefit of legal or structural mitigants.|
|Social Credit Indicators|
|S-1||Social factors are, on a net basis*, a positive consideration in our credit rating analysis, affecting at least one analytical component¶†.|
|S-2||Social factors are, on a net basis*, a neutral consideration in our credit rating analysis†.|
|S-3||Social factors are, on a net basis*, a moderately negative consideration in our credit rating analysis, affecting at least one analytical component¶†.|
|S-4||Social factors are, on a net basis*, a negative consideration in our credit rating analysis, affecting more than one analytical component¶ or one severely†.|
|S-5||Social factors are, on a net basis*, a very negative consideration in our credit rating analysis, affecting several analytical components¶ or one very severely†.|
|*"On a net basis" means that we take a holistic view on exposure to social factors and related mitigants. ¶Analytical components include criteria scores and subscores (including the key analytical elements to assess them). "Affecting" means leading to a different outcome for an analytical component or lower/higher headroom for an analytical component. †For structured finance transactions, social credit indicators express our view of the influence of social factors on any of the five key rating factors in our analytical framework before accounting for any benefit of legal or structural mitigants.|
|Governance Credit Indicators|
|G-1||Governance factors are, on a net basis*, a positive consideration in our credit rating analysis, affecting at least one analytical component¶†.|
|G-2||Governance factors are, on a net basis*, a neutral consideration in our credit rating analysis†.|
|G-3||Governance factors are, on a net basis*, a moderately negative consideration in our credit rating analysis, affecting at least one analytical component¶†.|
|G-4||Governance factors are, on a net basis*, a negative consideration in our credit rating analysis, affecting more than one analytical component¶ or one severely†.|
|G-5||Governance factors are, on a net basis*, a very negative consideration in our credit rating analysis, affecting several analytical components¶ or one very severely†.|
|*"On a net basis" means that we take a holistic view on exposure to governance factors and related mitigants. ¶Analytical components include criteria scores and subscores (including the key analytical elements to assess them). "Affecting" means leading to a different outcome for an analytical component or lower/higher headroom for an analytical component. †For structured finance transactions, governance credit indicators express our view of the influence of governance factors on any of the five key rating factors in our analytical framework before accounting for any benefit of legal or structural mitigants.|
ESG credit indicators relate to an entity's stand-alone analysis or, in the case of a parent company, the group credit profile. An entity's ESG credit indicator does not reflect the influence of ESG factors on the related parent or government owner (even if the rating on the latter could affect the entity rating). As such, the ESG credit indicator could diverge from that of its related parent or government. For instance, the environmental credit indicator of a renewable energy company that is a subsidiary of a larger oil and gas group could be E-1 if we conclude that environmental factors have a positive influence on its stand-alone credit profile (SACP), even if the environmental credit indicator of the parent or group could be E-4 to reflect the overall predominantly negative influence of environmental factors on our assessment of the group's industry risk. Similarly, a state-owned bank could have a G-2 governance credit indicator, pointing to an overall neutral influence of governance factors, even if we lowered the rating on the related sovereign due to governance deficiencies (even if the sovereign rating may cap the rating on the bank). Because the distinction is less evident for government-related entities (GREs) with an almost certain likelihood of extraordinary support under our criteria, we will not apply--at least initially--ESG credit indicators to such entities in our upcoming report cards. We are typically not applying ESG credit indicators to entities that do not have an SACP because we do not undertake a stand-alone analysis on such entities. In addition, we are not applying ESG credit indicators to entities rated 'SD' or 'D'.
Finally, we list below examples of the key ESG credit factors we currently assess, as stipulated in our ESG criteria. The ESG credit indicators will be accompanied by these factors to flag the actual areas of material influence we considered.
Corporates And Infrastructure
Primary author: Karl Nietvelt
We assess the impact of ESG factors through our corporate criteria. When material, they are most likely to influence scores such as industry risk, competitive advantage, scale, scope, diversity, profitability, cash flow/leverage, and comparable ratings analysis. For governance, we have an explicit management and governance (M&G) score in our corporate criteria, even though other areas--such as country risk and comparative rating analysis--can also reflect governance considerations.
In our view, environmental factors have a direct negative influence on 15 out of our 38 corporate and infrastructure industry risk criteria scores (see Table 5). We capture climate transition risks, physical risks, and waste and pollution or biodiversity risks in our credit rating analysis through our forward-looking qualitative assessments of secular change and substitution risks, as well as through profit margin and growth trends. For the oil and gas as well as unregulated power industries, we consider such risks as most pronounced and severely affecting such industry criteria subscores. According to the ESG credit indicator definition, such negative influence could imply a higher number of entities in these sectors getting an environmental credit indicator of E-4. That said, industry risk is just one of multiple components in our rating analysis. Consequently, environmental factors for a power generator with a high share of renewable generation assets could be an overall neutral consideration in our credit rating analysis because the negative influence on industry risk could be offset by positive environmental considerations in its competitive position score because of more advantageous (environmentally supported) regulations or contracted revenues. This could lead to an E-2 credit indicator for the entity rather than E-4.
Table 5 outlines our opinion as to the different degrees to which environmental considerations have affected the qualitative subscores of our industry assessment for corporate and infrastructure ratings.
Social factors are principally influencing entity-specific components of our analysis rather than differentiating industry scores. We believe this is because the influence of social risks becomes more important when assessing an entity's specific exposure to and management of social risks, as it often relates to its own staff, communities, and customer base. The one exception is the mining industry, which has exposure to community opposition and safety risks that moderately negatively influence our industry subscores, notably growth and profit trends.
The limited impact of social factors on our industry scores is also due to the heterogeneous nature of some of our industry risk scores. For instance, the "transportation cyclical" industry combines both shipping, with its low health and safety exposure, and airlines, which have high such exposure. As a result, the average impact of social factors on our "transport cyclical" industry score is limited. However, the final social credit indicator for airlines will likely be weaker than S-2, as the credit ratings on all airlines are negatively affected by the pandemic and safety considerations more generally (whether through profitability, cash-flow performance, or other entity-specific business drivers).
Governance credit indicators are strongly linked to our management and governance (M&G) criteria score. (See "Methodology: Management And Governance Credit Factors For Corporate Entities," published Nov. 13, 2012, for more details.) We may assign a strong M&G score to reflect, among other factors, our positive assessment of management's ability to anticipate, monitor, and rapidly adapt to changing operating or financial conditions and successfully execute its strategy. Such positive credit influence translates into a governance credit indicator of G-1. A satisfactory M&G score would generally reflect a neutral view of governance factors on creditworthiness and would therefore correlate to a G-2 credit indicator, whereas a weak M&G score under our criteria would generally reflect that governance factors are a very negative consideration on creditworthiness, therefore correlating to a G-5 credit indicator.
For entities with a fair M&G score, we differentiate governance credit indicators further--from G-2 to G-4, depending on how the underlying management and governance subfactors have been assessed. The most important governance considerations in our M&G criteria relate to governance subfactors such as board effectiveness; entrepreneurial or controlling ownership; management culture; regulatory, tax, and legal infractions; internal controls; communication of messages; and financial reporting and transparency. However, we also consider the following management subfactors as governance-related: the strategic planning process, consistency of strategy with capabilities, execution of strategy, and risk management standards and tolerances. If we view particular weaknesses in any of these M&G subfactors, this would generally reflect either a moderately negative or negative view of the impact of governance on creditworthiness and would therefore correlate to a G-3 or G-4 credit indicator, depending on the severity. Conversely, we likely view governance as an overall neutral credit consideration, correlating to a G-2 credit indicator, if the fair M&G assessment did not identify any material weakness among these M&G subfactors.
In addition, in almost all instances, entities controlled by a financial sponsor or private equity firm that have been assigned a fair M&G score, will generally be seen as reflecting a moderately negative view of the impact of governance on creditworthiness therefore correlating to a G-3 credit indicator. This is because we believe that the company's highly leveraged or aggressive financial risk profile points to corporate decision-making that prioritizes the interests of the controlling owners, given its focus on maximizing shareholder returns and often finite holding periods.
|Governance Credit Indicators Are Largely Derived From Our Management And Governance Criteria*|
|Strong||A strong M&G assessment tends to correlate to a G-1.|
|Satisfactory||A satisfactory M&G assessment typically results in a G-2.|
|Fair||A fair M&G assessment could result in 1) G-2, when there are no material weaknesses in the M&G subscores*; 2) G-3, if there is a moderate weakness in the M&G subscores*; or 3) G-4 if there is a more severe weakness in one or more M&G subscores* (including when an SACP of 'a-' or higher was negatively affected).|
|Weak||A G-5 corresponds to a weak M&G assessment.|
|*The most important governance-related subfactors in our M&G criteria are board effectiveness; entrepreneurial or controlling ownership; management culture; regulatory, tax, or legal infractions; internal controls; communication of messages and financial reporting and transparency; strategic planning process; consistency of strategy with capabilities; and execution of strategy and risk management standards and tolerances.|
Finally, governance factors might affect other analytical components of our rating analysis. This could result in some deviation from the above-outlined correlation to our M&G scores (the exception being a G-5, which we only apply when the M&G assessment is weak). An area of governance-related exposure in our rating analysis relates to the potential high institutional, political, or transparency risks for countries with high or very high country risk or rule-of-law-related regulatory/operating risks in certain countries that feature negatively in our competitive position assessment. Governance weaknesses may also be captured in our comparable rating analysis.
Primary author: Emmanuel Volland
We assess ESG factors for banks through our applicable criteria, including our Banking Industry Country Risk Assessment (BICRA) and bank criteria. Although these factors can influence our assessment of any analytical component (criteria scores) described in these methodologies, they are most likely to influence (when material) criteria scores such as the economic resilience and institutional framework of our BICRA methodology (when at system or country level) and business position or risk position (when at the entity level).
In our view, environmental factors currently have a very limited influence on our credit rating analysis of banks, and therefore we expect that most banks would have an environmental credit indicator that correlates to E-2. However, we recognize that climate is likely to become a more important credit consideration for banks given the evidence that climate change and the energy transition are becoming a greater focus for policymakers. If this were to materially affect our credit rating analysis (through some analytical components), it is likely that we would view the impact of environmental factors weighing more negatively on creditworthiness and that correspondingly the environmental credit indicator of some banks would transition to weaker categories (E-3, E-4, and E-5).
We believe that the most relevant environmental factors for banks are climate transition and physical risks. When material, the influence of these factors is more likely to be captured under the economic risk score of our BICRA analysis (when it is system- or country-specific) or under our scoring of business position or risk position (when it is entity-specific).
Overall, there is a high correlation between the geographical location of a bank's assets and the materiality of some environmental factors. Some countries are regularly adversely affected by natural disasters, such as hurricanes and earthquakes, that cause significant damage to critical infrastructures and disrupt economic activity. Due to these geographic concentrations, the customers of banks operating in these countries are likely subject to heightened physical risks that ultimately affect their creditworthiness and could lead to weaker credit-quality metrics. This negative environmental consideration, if material enough, is reflected in a weaker economic resilience score under our BICRA analysis, weighing on domestic banks' anchor. This impact could result in environmental credit indicators of E-3, E-4, or E-5, depending on the severity of these risks and the influence they have in our credit rating analysis.
The exposure to environmental factors is also evident at the individual bank level. Climate transition risks would be higher for banks displaying a high exposure to economic sectors most exposed to climate change. For instance, a bank with a high concentration of customers in the oil and gas sector is more vulnerable to shifts in policies and to climate change, even if this risk is not material at country or sector level. We therefore expect some correlation between our environmental credit indicators of banks and the climate-exposed sectors or entities they lend to.
The influence of social factors is most likely to be bank-specific instead of country-specific. Overall, we see social factors as a neutral consideration in our credit rating analysis for a majority of banks.
The positive influence of social factors could stem from the specific function that some banks play in the economy. For example, some government-owned banks have a public mission that can directly be linked to social considerations. This could be the case when their role is to improve financial inclusion or finance specific sectors of the economy, including social housing. This feature is not a reason in itself for a bank to be viewed as having its creditworthiness positively affected by social factors and an S-1 credit indicator outcome. The latter would more likely apply to some GRE banks if we believe their social mission means they benefit from a greater likelihood of extraordinary government support (as assessed through their GRE-related role and link under our GRE criteria).
Social factors could also have a negative influence in our bank analysis. For example, we view banks with a high proportion of lending to subprime customers as more exposed to social factors, as they usually face heightened compliance, reputational, and regulatory risks. These risks can be more or less pronounced depending on the country in which they operate. For instance, we believe that these risks are more pronounced in the U.S. than in emerging markets. We would apply a social credit indicator of S-3, S-4, or S-5 if one or more analytical component (for instance, the risk position) is negatively influenced by this element, depending on its severity.
We assess the influence of governance factors at system and entity levels through our BICRA and bank criteria. Unlike corporates and insurance, our bank methodology does not have an explicit M&G score. Banks are subject to a higher level of regulation and supervision than most other economic sectors, meaning that the quality of their governance tends to be overall stronger. This will be reflected in governance credit indicators that are expected to be, on average, stronger than for corporate entities.
We analyze the quality of governance at the system level in our BICRA analysis when assessing the institutional framework. This assessment is based on the analysis of the following three factors: banking regulation and supervision, regulatory track record, and governance and transparency. The initial assessment is based on the first two subfactors, but it can be worsened by one category if we've scored governance and transparency as weak. Therefore, our governance credit indicators would be partly driven by the assessment of this subfactor, even if other governance-related analytical components could also have an influence (positive or negative). Most banks that would be expected to have a governance credit indicator of G-3, G-4, or G-5 would likely be based in some emerging markets for which we have a negative view for governance and transparency in our BICRA analysis.
However, some banks in mature markets could also have weak governance credit indicators. At the individual bank level, we analyze the quality of the governance through our scoring of the business position. Indeed, management and corporate strategy is one of the three subfactors. Typically, good governance does not have a material positive influence on our bank ratings, as it is expected for these entities (and embedded in our rating construct through the high level of some bank anchors) given that they are highly regulated and supervised.
Primary author: Antonio Farina
We assess ESG factors through our applicable criteria, including our covered bonds criteria. Although these factors can influence our assessment of any analytical component described in these methodologies, they are most likely to influence (when material) our collateral support analysis and the issuer credit rating (ICR) on the issuing entity. ESG factors can influence ratings, outlooks, and credit enhancement required for the assigned rating. Environmental and social factors typically affect the quality of the assets in the cover pool and the results of our collateral analysis. Governance factors, on the other hand, usually affect the uplift that we assign to a covered bond program above the ICR of the issuing entity. The ICR may be affected by financial and nonfinancial factors including ESG considerations. We are typically not applying ESG credit indicators to entities--such as certain mortgage banks--that do not have an stand-alone credit profile (SACP), because we do not undertake a stand-alone analysis on such entities. Where the issuer is not rated but belongs to a group with a rated parent and we determine the ICR using our "Group Rating Methodology," published July 1, 2019, we would typically consider the ESG factors relevant to the parent company as starting point for the influence of ESG factors in our covered bond rating analysis.
In our view, environmental factors currently have a very limited influence on our credit rating analysis of covered bonds, and therefore we expect that most programs would be assigned an environmental credit indicator of E-2.
Cover pools could be positively exposed to environmental credit factors via mortgage loans granted to increase the underlying property's energy efficiency. However, we generally would only consider the inclusion of these loans in the cover pool as positive in our credit rating analysis if higher updated property valuations decrease the estimated loss severity and, ultimately, the credit enhancement required for the rating. On the other hand, we would consider the exposure of the mortgaged properties to climate change and natural disaster risk as a negative factor if it leads to a greater credit enhancement to achieve the same rating uplift.
Climate change will likely become a more important credit consideration for banks given climate change and the energy transition are becoming a greater focus for policymakers. If this materially affected our credit rating analysis for banks, it is likely that we would view the impact of environmental factors as more negative for covered bond creditworthiness and that consequently the environmental credit indicator for some programs would transition to a weaker category.
We believe that the most relevant environmental factors for banks and covered bonds are climate transition and physical risks.
We believe that the most relevant social factor for covered bonds is social capital. Social benefits include guarantees provided by government-related entities to support underbanked borrowers, such as "Nationale Hypotheek Garantie" loans in the Netherlands, and loans to social housing providers. We also view the funding of hospitals, educational buildings, and other essential community facilities as a potential supportive social credit factor if it positively influences an entity's creditworthiness.
Covered bonds' exposure to social risk largely stems from measures that regulators may impose to treat customers fairly, which may include provisions to decrease interest payments or delay property foreclosures.
Governance is an important component of our analytical framework for assessing the rating uplift that we can assign to a covered bond program above the ICR of the issuing entity. We look at several factors, including the originator's underwriting and servicing policies, the quality of the data provided, and the availability of liquidity and overcollateralization provisions, which would allow us to assign the maximum collateral-based uplift. We would, for example, identify the lack of liquidity provisions in a legal framework as a governance factor if it negatively affects either the ratings on the program or the number of unused notches – the number of notches the issuer rating can be lowered without resulting in a downgrade of the covered bonds. Some of those issues are systemic and affect all the covered bond programs in a given country, such as liquidity provisions in the relevant legal framework, while others are program specific, such as overcollateralization provisions at the program level.
Primary author: Dennis Sugrue
We assess ESG factors through our insurance rating methodology. Although these factors can influence our assessment of any analytical component (criteria scores) described in these methodologies, they are more likely to be reflected under components such as competitive position, capital and earnings, risk exposure, and governance (when material at the entity level) and in the insurance industry and country risk assessment (IICRA; when material at the country level).
We believe that the most relevant environmental factor for insurers is physical risk, particularly for non-life re/insurers. Our assessment of a re/insurer's risk exposure considers material risks that could make an insurer's capital and earnings significantly more volatile. Concentrations in natural catastrophe exposure, and as a result physical risk, have been a source of significant capital and earnings volatility for many non-life re/insurers over the years, and we typically reflect these concentrations with a risk exposure assessment of moderately high or high. For companies with a risk exposure assessment that is primarily driven by potential volatility from physical risks, we are likely to apply an E-3 or worse environmental credit indicator, depending on the severity of these risks and the negative impact they have on our analysis. In addition, in some markets we have observed that the impact of natural disaster risk manifests at an industry level through its impact on profitability across the non-life sector in that country. For insurers in these markets, such as Japan, physical risk exposure is captured in our IICRA and likely to result in an E-3 or worse environmental credit indicator for non-life insurers in those markets.
At the same time, in our view, environmental factors are currently having a limited influence in our credit rating analysis of insurers more generally, and therefore we expect that most insurers would have an E-2 credit indicator applied. Climate is likely to become a more important credit factor for insurers given the evidence that it is changing and policymakers' efforts to reduce greenhouse gas emissions. If so, this could eventually affect our rating analysis and ultimately result in a lower environmental credit indicator.
The influence of social factors for insurers is most likely to be company-specific instead of country-specific. Social factors are a neutral consideration in our credit rating analysis for the majority of insurers.
The positive influence of social factors could stem from the specific function that some insurers play in the economy. Some insurers (including some that we are likely to consider a GRE under our criteria) provide a benefit to the economy that can directly be linked to social considerations. This could be the case, for example, when a GRE's role is to improve financial inclusion or provide coverage for certain risks that the private market would otherwise not insure at an affordable price for citizens. We also observe the positive influence of social factors in insurers with activities that generate measurable externalities that have an impact beyond just their client base. These characteristics in themselves are not a reason for an insurer to be viewed as having its creditworthiness as being positively affected by social factors and an S-1 credit indicator outcome. Indeed, the latter would only be considered if we assess that this specific role is a positive consideration in our credit rating analysis. This would be the case for some GRE insurers if we believe their social mission means they benefit from greater government support (as assessed through their GRE-related role or link under our GRE criteria) or for private insurers with social activities that provide benefits to their competitive positions through higher customer retention, improved brand awareness, or stronger earnings.
Our assessment of the quality of an insurer's governance (and its related factors) is done both at a system and entity levels through our IICRA and governance assessments, respectively. Insurers, like banks, are subject to a much higher level of regulation and supervision than most other economic sectors, meaning that the quality of their governance tends to be stronger overall. This will be reflected in governance credit indicators that are expected to be, on average, stronger for insurers than for corporate entities.
Our governance criteria factor in our insurance rating methodology assesses an insurer's risk culture and how it is governed; its relationship with shareholders, creditors, and other stakeholders; and how its internal procedures, policies, and practices can create or mitigate risk. Typically, good governance does not have a material positive influence on our insurance ratings, as it is expected for entities that are highly regulated and supervised. For insurers where we identify shortcomings in or severe risks posed by the governance structure, we typically expect to apply governance credit indicators of G-3 or worse.
We assess the quality of governance at system level in our IICRA analysis when scoring both the institutional framework under our industry risk assessment and country risk. If our industry risk analysis suggests that the institutional framework is not supportive of profitability, we would expect the governance credit indicators for insurers in that market to typically have a governance credit indicator applied of G-3 or worse. In addition, there are instances when country risk is assessed as high or very high due to concerns about the potential for significant institutional or political risks or weak transparency that cannot be sufficiently mitigated by prudential regulation. Accordingly, we expect insurers in these markets to typically have governance credit indicator applied of G-3 or worse.
U.S. Public Finance
Primary author: Nora Wittstruck
We assess the impact of ESG factors through U.S. public finance (USPF) sector-specific criteria. When material, they are most likely to influence our credit rating analysis of a government or not-for-profit enterprise's economy, market position or service area characteristics, budgetary performance and flexibility, and our debt and liabilities criteria components.
Management teams and the governance that they adhere to in terms of policies and practices, taking a forward-looking view of managing risks through comprehensive risk management strategies, and the transparency of information they provide to stakeholders, are all particularly relevant and can be distinguishing factors within our credit rating analysis for U.S. public finance issuers.
Environmental credit factors can have an acute and negative influence on our credit rating analysis by affecting an entity's economy or service area location. Climate transition risk and physical risks are generally the most influential environmental credit factors to our credit rating analysis as these risks can disrupt revenue collected within a specific boundary that supports operations and debt service payments. In addition, utilities may need to substantially invest in infrastructure or modify operations to accommodate net-zero policy initiatives, which could require additional leverage and that leads to lower debt service coverage. Furthermore, rated entities with significant coastal exposure may have more difficulty completely offsetting the exposure to physical risks, considered within the economic and market position components in our credit rating analysis. If an entity is exposed to a low probability but high-impact event, we may apply an E-3 credit indicator because operations could be significantly disrupted. We may also apply E-3 if an entity's location is exposed to more frequent and severe hurricanes, wildfires, and other weather events, as well as chronic risks like sea level rise and flooding.
While physical risks in the U.S. can have a very negative impact on our analysis of rated entities, we view the support provided by the Federal Emergency Management Agency (FEMA) as an important mitigant. Because of the general availability of FEMA funding for USPF issuers, we may rarely apply an environmental credit indicator of E-5 (the highest impact on the scale) in this sector. Instead, we will typically apply E-3 or E-4 depending on the severity or number of components we view as being affected by the risks. We could apply E-2 when entities have implemented additional related mitigants like climate action plans, insurance, and comprehensive capital planning strategies to harden infrastructure to protect assets and the economic base from the effects of climate change. In addition, we may apply E-2 when an entity's large physical boundary allows an entity to absorb the risks or when climate transition and physical risks are more material to a smaller, local area or specific asset location.
Social capital is fundamental to our credit rating analysis across USPF and we analyze it by evaluating specific information within the entity's credit profile and relative to other rated entities. Assessing an entity's specific exposure to and management of social capital risks, often relates to characteristics of residents or how specific trends affect an enterprise's customer base. The area where governments draw economic activity and that creates demand for not-for-profit enterprises is largely driven by demographic trends. We evaluate demographic trends in our credit rating analysis and typically compare them to the broader U.S. Demographic information can underscore economic expansion, demand for utility connections, passenger air traffic, demand for health care procedures and elective surgeries, and enrollment growth for charter schools and public and private elementary schools and higher education institutions. As a result, when demographic trends are generally consistent with the U.S. in terms of population, income, and affordability of services or tax structure, we would likely apply an S-2 credit indicator, indicating growth is manageable and similar to the nation. When these trends fall below the U.S. or regional statistics and lead to pressure in a rated entity's credit rating analysis, we may apply S-3 or S-4. Whether we apply S-3 or S-4 would typically be based on the entity's the economy or market position and whether these trends have also hindered revenue-raising flexibility to increase property taxes or user fees like utility rates or tuition charges to support services and infrastructure costs that can lead to budgetary imbalances.
While we view the flexibility to adjust revenue positively, we also consider the affordability of services relative to the underlying wealth and income within the region or service area. We may apply a social credit indicator of S-3 to reflect affordability issues such as high housing, tax, or user fees related to the costs of doing business, or living in a particular area leading to population out-migration, business relocation, or hindering future revenue increases because costs are already high relative to the area's demographics.
Governance is an integral aspect in our credit rating analysis and is primarily reflected in our financial and operational management assessments for governments and not-for-profit enterprises. Typically, we view governance factors for rated entities in USPF as neutral within our credit rating analysis (and therefore apply a G-2 credit indicator) given the expertise and sophistication of the policies and practices most management teams use. Generally, our assessments reflect management teams that are adept at handling emerging risks, as governments and not-for-profit enterprises have typically been on the front lines of responding to physical risks, protecting communities and customers from health and safety events, and ensuring vulnerable populations have access to services.
For state and local governments, the government and institutional frameworks are important in understanding how different layers of government can influence the operations of another. For example, we may view positively a state statutory framework that supports a local government in fiscal distress. However, states may also have the operational flexibility to reduce payments to local governments in times of budgetary pressure, leading to greater uncertainty in a local government's financial resources. Because the structure between governments may have both a positive and negative influence on our credit rating analysis, we would usually apply a G-2 credit indicator to reflect an overall neutral view of the relationship.
Furthermore, we observe limited variability in our assessment of state government frameworks. The generally clear and active fiscal policy frameworks that allow states the autonomy to manage their operations under the federalist system results in a fairly cohesive and neutral view of governance in our credit rating analysis (leading to the application of a G-2 credit indicator in most cases). In addition, we believe states' operational flexibility can offset risks when the federal government sequesters funding or implements federal mandates without a corresponding revenue source to fill the potential budget gap related to required expenditures.
When we view the appointed or elected boards that govern an entity as operating in a weak risk management culture, or when governments have created long-term financial pressure by not adhering to a legal and control framework that ensures good oversight of pension and other post-employment benefits for instance, we would reflect these risks in the credit rating analysis and application of the governance credit indicator. The severity of the situation and its impact on the credit rating analysis would be reflected in either a moderately negative (G-3) or negative (G-4) credit indicator. Finally, while cyber security issues cut across all sectors in the economy, governments and not-for-profit enterprises are regular targets resulting from the essential infrastructure and personal information they maintain. Should a cyber attack lead to our view that risk management, culture, and oversight may be inadequate, we would likely apply a G-3 or G-4 credit indicator.
For more information on how we incorporate ESG credit factors into our credit rating analysis, please see "Through the ESG Lens 3.0: The Intersection of ESG Credit Factors and U.S. Public Finance Credit Factors," published March 2, 2022.
Primary author: Matthew Mitchell
ESG credit indicators for structured finance transactions express our view of the influence of ESG factors in our analysis of any of the five key rating factors in our analytical framework, before accounting for any benefit of legal or structural mitigants which get factored into our issue credit ratings (see chart 3). Accordingly, ESG credit indicators are applied at the transaction level in structured finance, not to each individual tranche.
Consistent with our ESG criteria, our issue credit ratings on structured finance transactions incorporate an analysis of ESG factors when, in our opinion, they could materially influence creditworthiness and therefore affect the timely payment of interest or ultimate repayment of principal by the legal final maturity date. Under our structured finance analytical framework, our issue credit ratings assigned to individual tranches in transactions reflect the analysis of five key rating factors and structural credit risk mitigants (see chart 3 below). In our view, material exposure to ESG factors could either positively or negatively influence our credit rating analysis for any of the five key rating factors.
However, the legal and structural mechanics that characterize structured finance transactions may also mitigate the risks posed by ESG factors. As such, our issue credit ratings may not be affected even where we identify material exposures to these factors. For example, common transaction features such as credit enhancement, deleveraging, eligible collateral requirements, concentration limits, replacement and performance triggers, insurance policies, and isolation of assets from an originator's bankruptcy may mitigate any negative influence of ESG factors in our credit rating analysis. Time tranching of structured finance instruments (i.e. the short tenor of the rated securities) could also mitigate the potential impact on creditworthiness of relatively longer-term risks, including ESG-related risks.
Note that, even if ESG factors are material to our analysis of the five key rating factors, they may not ultimately impact our issue credit ratings assigned to individual tranches. For example, even if ESG factors have a very negative influence (e.g. in cases in which the credit indicators are E-5/S-5/G-5) when analyzing the credit quality of the securitized assets, a tranche could still be rated 'AAA (sf)' so long as we believe those risks are appropriately mitigated.
We may also assign issue credit ratings to various tranches in the same transaction that may have large differences in creditworthiness. We generally believe the capital structure of a transaction can mitigate the influence of ESG factors in our credit rating analysis, rather than change a transaction's exposure to them. Therefore, as noted above, our ESG credit indicators are applied at the transaction level in structured finance, not to each individual tranche.
For structured finance transactions where the credit ratings on underlying obligors or support providers are the primary driver of our credit rating analysis, such as collateralized loan obligations or weak-linked transactions such as repackaged securities or asset-backed commercial paper conduits, we do not expect to publish separate ESG credit indicators for each transaction. This is because the influence of ESG factors in our credit rating analysis primarily depends on the influence of ESG factors on the underlying credit rating dependencies. However, we may disclose entity-specific, weighted average, or distributions of ESG credit indicators for the underlying rating dependencies, where applicable.
Across structured finance, physical risks are an environmental factor that could influence our credit rating analysis because they can disrupt collections, impact the credit quality of obligors, or materially reduce collateral values. Physical risk is typically more pronounced for concentrated pools of immovable assets, such as for certain commercial mortgage-backed securities, where a local area or specific asset location could be affected. On the other hand, residential mortgage-backed securities (RMBS) are typically more diversified by obligor and geography, so environmental factors may have a neutral influence in our credit rating analysis (E-2). Across structured finance asset classes, we would typically only view physical risks as having a very negative influence in our analysis (E-5) if there is very high visibility and certainty (i.e., our ability to assess the likelihood or impact), such as following a high-impact event that affects a material share of the collateral thereby impacting the credit quality of the securitized assets.
Some asset classes where there are significant pressures to reduce greenhouse gas emissions may be exposed to climate transition risk. For example, auto asset-backed securities (ABS) transactions primarily comprising vehicles with internal combustion engines (ICE) could experience lower recoveries or residual value losses given numerous jurisdictions have announced plans to phase out ICE engines, and several have introduced fees for driving certain classes of these vehicles in city centers. We would generally view this as a moderately negative influence in our analysis (E-3) but could adjust if there are concentrations of vehicle models with relatively high emissions that we believe could be more affected by future policy changes which we would incorporate in our analysis of the credit quality of the securitized assets and our legal and regulatory risk analysis.
For unsecured consumer asset classes, including credit cards, personal loans, and student loans, environmental factors typically have a neutral influence on our credit rating analysis (E-2), given that the receivables are not secured by collateral which could be exposed to physical or climate transition risk, and there is significant diversification by obligor and geography.
Social capital can be an influential social factor in structured finance transactions as conduct risk can present a direct social exposure for lenders and servicers, particularly as regulators are increasingly focused on ensuring fair treatment of borrowers, predominately retail ones. We generally view social factors to have a neutral influence (S-2) in our analysis for pools comprising prime borrowers with lower interest rates, such as prime auto ABS. We believe that exposure to social factors is higher for borrowers where affordability considerations, higher interest rates, and servicing policies and procedures could increase legal and regulatory risks, particularly for nonprime borrowers. Social factors may also have a larger influence in our analysis in asset classes with strict regulatory requirements and where enforcement of security could experience delays, such as in RMBS, given that housing is a basic need.
Health and safety factors are more likely to influence our analysis when there is a concentrated exposure by obligor, industry, or geography, or where the collateral backing the securitized assets could be affected by health and safety risks. For example, sectors reliant on social gathering, such as lodging, may have relatively higher exposure to a pandemic, while vehicle safety and potential recalls could affect secondhand values.
Structured finance issuers are typically established as bankruptcy-remote, special-purpose entities (SPE) where each transaction party's roles and responsibilities and the allocation of cash flows are well defined, and transactions are structured to isolate the assets from the seller. This makes the transaction documentation, outlining the management and operation of the structure, a key component of our analysis of the governance framework for structured finance transactions. Other governance considerations in structured finance transactions may cover key transaction parties including the originator, servicer, and transaction counterparties.
Given the prescriptive nature for how SPEs are operated, we generally view governance factors as having a neutral influence in our credit rating analysis (G-2). However, some transaction structural features such as revolving collateral pools or prefunding may have a negative influence since the assets' risk profile could change over time and expose investors to the risk of looser underwriting standards or potential adverse selection. The documented requirements for making amendments to a transaction, such as selecting alternative interest rates, or replacing a transaction party following a deterioration in their creditworthiness or nonperformance, may also be reflected in our governance credit indicator.
Governance considerations at the originator or servicer could also influence our analysis, such as our view of their risk management and internal control frameworks, and any third-party oversight. New originators or products with relatively short operating histories may have a negative influence in our credit rating analysis of structured finance transactions given limited reporting available.
This report does not constitute a rating action.
|Primary Credit Analysts:||Gregg Lemos-Stein, CFA, New York + 212438 1809;|
|Emmanuel F Volland, Paris + 33 14 420 6696;|
|Lapo Guadagnuolo, London + 44 20 7176 3507;|
|Matthew S Mitchell, CFA, Paris +33 (0)6 17 23 72 88;|
|Karl Nietvelt, Paris + 33 14 420 6751;|
|Dennis P Sugrue, London + 44 20 7176 7056;|
|Nora G Wittstruck, New York + (212) 438-8589;|
|Secondary Contacts:||Antonio Farina, Milan + 34 91 788 7226;|
|Nicole Delz Lynch, New York + 1 (212) 438 7846;|
|Pierre Georges, Paris + 33 14 420 6735;|
|Xavier Jean, Singapore + 65 6239 6346;|
|Luis Manuel Martinez, Mexico City + 52 55 5081 4462;|
|Diego H Ocampo, Buenos Aires (54) 114-891-2116;|
|Rian M Pressman, CFA, New York + 1 (212) 438 2574;|
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