Over the past two years, Moody’s Investors Service, S&P Global Ratings and Fitch Ratings have become more serious about integrating environmental, social and governance (ESG) risk factors into credit ratings. Each has signed onto the PRI's ESG In Credit Risk and Ratings initiative1 and developed centralized ESG teams within their organizations, and each is now routinely inquiring about ESG risks with bond issuers. Importantly, all of the agencies have become more transparent about their approaches, including publishing work on how and when ESG factors are material to credit risk.
The agencies’ progress to date is a positive development for capital formation in the municipal bond market. Their focus on transparency and materiality provides investors with better information to assess how ESG factors may influence credit fundamentals. Additionally, we believe the agencies’ heightened focus will likely encourage states, cities and other local governments to be more proactive in planning for ESG risks.
Consistent with our belief that stakeholder engagement provides a deeper understanding of current issues in the municipal market, we spoke with these three-largest bond rating agencies in June 2019 about this increased focus on ESG. The conversations yielded the insights that follow.
Centralized Teams Drive ESG Efforts
The three agencies each oversee their ESG integration strategy via centralized teams. These groups overlap or work with members of the agencies’ public finance rating groups. The size and function of the dedicated ESG teams vary by agency but their purpose is shared: to provide thought leadership on ESG issues, create frameworks for evaluating ESG risk and to support analysts in integrating those risks into credit opinions. Notably, the bond raters’ European offices and employees have been leaders on the ESG front. According to the agencies, a centralized structure has been an effective way to leverage global and cross-sector knowledge and to drive best practices down toward individual rating groups.
Transparency is a Priority
As investor interest in ESG risks has grown, these agencies have become more transparent about how these risks are incorporated into rating criteria. In late 2017, all three released guidance on how ESG risks are factored into ratings.2 Since then, each has published public finance sector-oriented documents discussing how various ESG risks are factored into their credit assessments.
Approaches are Driven by Materiality
Materiality remains the touchstone of bond rating methodologies, and the agencies have published a significant volume of thematic research on various ESG issues over the past few years. For example, Moody’s published a materiality heat map detailing the importance of certain environmental risks in key sectors, including public finance. To directly tackle the subject of materiality on an issuer-by-issuer basis, Fitch Ratings has recently started publishing ESG Relevance Scores for its rated public finance entities. These scores detail how certain predetermined ESG elements impact an issuer. Additionally, one of the rating agencies is considering including a standard ESG section in all of its credit assessments.
Climate Change Remains a Challenge
Even with these developments, we see opportunity for rating agencies to improve their assessments of climate change vulnerability. Currently, these agencies’ examination of climate risks are typically focused on management practices and are informed by the issuers’ long-term planning documents and discussions with management. While these qualitative assessments of governance and disaster preparedness provide useful information, quantitative metrics are also important and can help communicate the relative magnitude and materiality of climate risk.
In our January 2018 publication Rating Agencies and Municipal Climate Risk, we highlighted certain areas where the agencies could enhance their approaches toward integrating climate change vulnerability into their credit analysis process. While some thematic research and individual publications have cited various climate change metrics, the rating agencies still have not consistently employed or communicated the use of these quantitative assessments.
Heightened ESG Focus a Positive for the Market
At Breckinridge, we view ESG factors as important risk inputs to investment research. Since 2011, we have employed proprietary sector sustainability frameworks to identify material ESG risks that could adversely affect the credit quality of the municipal issuers in which we invest. Over the years, we’ve continued to refine our ESG research and develop new capabilities, which have included the integration of critical climate change metrics to assess vulnerability to factors like sea level rise, hurricanes and extreme heat, among others.
We also work to galvanize the broader investment community toward adoption of ESG. We are encouraged by the heightened focus of bond rating agencies on ESG. They are highly influential in the municipal market, and heavily impact the pricing of municipal debt. To the extent these agencies continue to sharpen their focus on ESG factors, credit ratings should more accurately depict all relevant risks and may encourage issuers to place a greater emphasis on mitigating ESG risks.
 The Principles for Responsible Investment (PRI) initiative “aims to enhance the transparent and systematic integration of ESG factors in credit risk analysis.” Breckinridge Capital Advisors is also a signatory to this initiative. See https://www.unpri.org/credit-ratings/statement-on-esg-in-credit-risk-and-ratings-also-available-in-chinese-/77.article.
 “How Does S&P Global Ratings Incorporate Environmental, Social And Governance Risks into its Rating Analysis,” S&P Global Ratings, November 21, 2017; “Moody’s Approach to Assessing ESG in Credit Analysis,” Moody’s Investors Service, October 25, 2017; “Fitch Ratings Approach to Capturing Environmental, Social and Governance Risk in Credit Ratings,” Fitch Ratings, November 7, 2017.
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