As the role of ESG ratings moves from “nice to have” to “must have” for investors, Craig Gosnell, senior director at Fitch Ratings, sought to clarify some of the issues at a recent ACT conference.
According to Gosnell, there has been a significant ramp-up of ESG issuances, with a prediction that by 2025 the market in such issuance will hit $5 trillion. These bonds and other financial products are designed be used to facilitate the reallocation of capital that will be required for companies to align their operations with ESG targets, such as net-zero agreements.
However, a key issue that needs to be tackled is that while there tends to be a high degree of correlation between credit ratings given by the major agencies (Fitch, S&P and Moody’s), there was less correlation among ESG ratings providers. “This is because ESG ratings are newer, there is no defined purpose or scale, and the inputs and the weightings that go into the ESG ratings can vary quite significantly,” he told the audience.
While ESG reporting is growing quickly, and is now very much “mainstream”, there is still a lack of an overarching definition for ESG. “It remains an acronym, there is still no consensus,” Gosnell said. “And data collection remains a challenge.”
Gosnell highlighted the different types of ESG-related ratings “as it is quite clear there is still some misunderstanding about what different scores, ratings and assessments provide”. These can be grouped together under the following headings:
On credit ratings with ESG relevance scores, he said: “About four years ago, investors started to ask us to help them understand how E, S and G is influencing credit ratings on a systematic basis. So, Fitch integrated the relevance of ESG into its credit ratings at the start of 2019, and we maintain this for every company and entity we rate globally. But it is not how green or brown a company is… it is the level of influence E, S or G has had on its credit rating.”
On ESG risk ratings, he told the audience: “This looks from the outside in. As climate and society changes, what risks does that have on the stock value or enterprise value of a company? These ratings do not necessarily measure impact or performance of a company’s ESG strategy, and this is where some misunderstand can come, as there are high polluting sectors which carry strong ESG risk ratings.”
The third group, SPOs, is designed to focus on debt instruments and sustainability frameworks, analysing ESG key performance indicators (KPIs) and use of proceeds among other factors. The analyses aim to identify the alignment of an issuance or framework with all core components of an issuer’s relevant principles. “These opinions will look at a certain ringfenced area rather than the company itself,” Gosnell said.
The combination of the first three led Fitch to look at ESG impact ratings from “the inside out”. These ratings measure an entity or transaction’s impact and performance on environmental and social matters while assessing the effectiveness and quality of the governance, demonstrating and communicating this to key stakeholders. “As companies align to the Paris Agreement [on climate change], their destination on how to get there, we will assess how they are progressing on that journey,” Gosnell said. “But we are not inside the tent, we have to be independent.”
1. Green – use of proceeds exclusively used to fund projects that have a positive environmental impact
2. Social – use of proceeds exclusively to fund projects with positive social impacts
3. Sustainability – use of proceeds used to finance a mix of green and social projects
4. Sustainability-linked – performance-based instrument in which the financial or structural characteristics (the coupon rate) are adjusted based on the achievement of pre-determined sustainability performance targets
(Source: Fitch)
Philip Smith is editor of The Treasurer