Credit rating agencies face call for action from sustainable investors

Credit rating agencies could do more to incorporate environmental and social information into their analysis, says Archie Beeching, a senior manager in the investment practices group at the United Nations-supported Principles for Responsible Investment. He spoke with Bloomberg Briefs Sustainable Finance Editor Emily Chasan about the a PRI credit ratings project started in May, backed by 100 investors and six credit rating agencies, including S&P Global Ratings and Moody’s. Comments have been edited and condensed.  This article appeared first in Bloomberg Brief | Sustainable Finance. 

Q: Why did PRI want to start getting involved in working with credit rating agencies?

A: At PRI, we now have around 1,500 investor signatories, and if you look at their assets, about 600 of those organizations have a significant amount of fixed income in their portfolios. It’s about 10 percent of their assets. These investors have signed a commitment to incorporate ESG into their investment analysis because they see [ESG issues] as risk factors that might affect their returns. Fixed income is a very important asset, particularly for pension funds and people who need a safe haven or reliable source of income. The risk in fixed income is all about getting your interest paid and your principal back when the bond matures. Investors are concerned about material risks in their portfolio that would affect that.

Q: How do you think credit rating agencies are currently incorporating ESG information, and how might that change?

A: We’ve been engaging the big three credit rating agencies for years. Last year we had a meeting and there was a clear signal from investors that they wanted more. There’s a need for better understanding by credit rating agencies about what they need to produce for investors, and also a bit more transparency on what they are doing and processes they use, how they consider ESG in a systematic way. We published this statement earlier this year in May. It’s aspirational, but really it’s saying PRI will foster this dialog between investors and rating agencies.

Poorly governed companies don’t tend to be particularly credit worthy. Climate risk is front and center for a lot of investors at the moment given what happened in Paris last year, and emerging issues around supply chain risk, water scarcity, and employee relations. Governance issues come up in credit ratings, but environmental and social issues hardly do. There needs to be some understanding. A lot of climate issues are yet to be regulated, but post COP 21, I think we’ll see more of that. It’s early days for investors still. Few investors could claim to be very advanced. We wanted to start this project now so that investors and rating agencies can learn together.

Q: Are there any times credit rating agencies have been taken by surprise on ESG issues and learned from this?

A: Credit rating agencies have been taken to task over the last 10 years in the subprime mortgage crisis and the sovereign debt crisis. A lot of people would say the rating agencies called those issues too late. If you look at the governance scores on debt in Greece and Italy, you could see that there were problems. Not paying attention could lead to risk being misunderstood by the market. It’s not to say if they looked at ESG they would have done a better job, but ESG is a forward-looking method for discovering financial risk and has the ability to create better understanding.

Q: After the financial crisis, the ratings agencies made a lot of changes themselves to their own governance and policies. Do you think that made them more aware of ESG issues?

A: It’s very easy to argue now from an investor perspective, they should also be asking questions about their climate risk, water policy or exposure to human rights issues.

It’s partly that investors and rating agencies are using quite different terminology. Where investors might talk about climate-related risk, a rating agency is probably thinking about litigation risk, cost of capital or regulatory risk. We hope to create more transparency for both sides in this project.

Q: What’s at stake for investors here? What changes do you hope to see?

A: The ideal outcome over the next two years —  the life of the initial project —  is to see more resourcing among the ratings agencies internally. We’d like to see some dedicated ESG resources and more ESG thematic research. We’ve already seen some more of that over the years from S&P and Moody’s. We’d also expect to see some discussion of ESG issues in the ratings summary. So we can see whether these issues have been taken into account when they are material, and what bearing it’s had. We’re looking at the ESG credit worthiness of assets generally and their exposure to ESG issues.

Virtually every pension fund and insurance company in the world has a sizable exposure to debt. They invest in bonds because they are safe and they hope to rely on a steady income for them. If they’ve signed up to Principles of Responsible Investing and are looking at ESG when they invest, then they should want their rating agencies to do so as well. There’s nothing in it for the agencies if they are going against the market.

Request a demo.