While environmental, social, and governance (ESG) considerations have historically garnered more attention in equity investments than debt investments, credit rating agencies are increasingly turning their focus to sustainability issues.

These agencies measure the financial strength of entities based on the ability to meet debt obligations without defaulting or making late payments. The higher an entity’s risk of default is, the higher the interest payment investors require to compensate for the risk they take.

The role that credit rating agencies play is critical to the proper functioning of global debt markets. Their increasing focus on ESG issues to determine credit ratings could impact the entire financial system.

Introducing Relevance Scores

In January 2019, Fitch Ratings revealed that it would produce relevance scores to explain how environmental, social, and governance factors influence its rating decisions. Shortly after, Standard & Poor’s announced that it would include an ESG considerations section in its credit rating reports. In April of this year, Moody’s acquired a majority stake in ESG research firm Vigeo Eiris. Moody’s announced this acquisition amidst the expansion of its ESG teams and ESG reporting efforts across asset classes.

These developments follow a concerted effort by the United Nations Principles for Responsible Investment (PRI) to encourage credit agencies and investors to better emphasize sustainability. Since 2016, PRI worked with credit agencies and called for increased transparency on how ESG factors are reflected in corporate credit ratings. This year, PRI hailed the progress made by the three major ratings agencies as a “race to the top.” PRI expects credit agencies and investors to continue to engage with debt issuers to improve awareness, disclosure, and transparency.

Bond managers’ investment choices carry huge importance.

Pricing Bonds

Ultimately, improving the link between credit ratings and ESG principles may mean that companies with higher scores will be able to borrow at lower rates of interest. This would assist with the European Union’s wider effort to encourage greater investment capital toward sustainable activities to help meet the goals of the Paris Agreement.

Asset management firm Hermes indicates that there is already a strong relationship between corporate bonds’ pricing and their ESG scores. Companies with lower ESG scores have higher rates of interest. Some studies argue that governance issues may be a better predictor of credit ratings than environmental and social considerations, according to a report last year from the World Bank and the Government Pension Investment Fund of Japan. The report cites one Barclays study of US corporate bonds in which high ESG scores overall resulted in “a small but steady performance advantage,” but with “the effect . . . strongest for a positive tilt towards the G factor.” Additionally, “issuers with high G scores experienced lower incidence of downgrades by credit rating agencies.”

Though “[p]oor environmental or social management may lead to lower credit ratings and higher cost of debt,” the World Bank report points out that “[t]he materiality of E and S factors vary considerably across sectors and industries.” Meanwhile, “[w]ell-managed companies tend to be more aligned with bondholder interests, and corporate transparency keeps bondholders better informed of exposure and management of risk.” The report also points out that fixed income investors generally consider governance to be the most important ESG factor.

However, credit rating agencies have not yet succeeded in fully reflecting ESG factors in their credit rating decisions. For now, investors must conduct their own ESG analyses on issuers to properly price individual corporate bonds.

Seeing Positive Impact

Unlike equities, debt investors usually do not have voting power at annual general meetings (AGMs), which is a key opportunity to influence corporate decision-making. Nevertheless, bond managers’ investment choices are important as debt constitutes a significant portion of corporate financing. For instance, in the US, corporate debt typically dwarfs equity by a ratio of over 2 to 1. In fact, the World Bank argues that bond holders may potentially carry more influence than shareholders overall. This is because debt investors have leverage over companies when bonds reach maturity and the organization must look for fresh financing terms.

Nonprofit ShareAction has called for bond investors to use this leverage to pressure companies to combat climate change and proactively engage with high-carbon emitters. “Bond investors have come a long way very quickly on the sustainability dimension,” said Wolfgang Kuhn, author of a 2019 ShareAction report on bond investors and climate change. “What is left is to realize the power they have to create a positive impact and muster the courage to use it.”

While the fixed income industry appears to be moving in this direction, it is still in its early days. For instance, Standard & Poor’s has pledged to incorporate an ESG section on its “high-profile issuers” by the end of 2019. It plans to eventually consider ESG factors for all the issuers it rates.

There could soon be regulatory teeth behind this transition, as the European Securities and Markets Authority is set to publish guidance later this year over the use of sustainability factors by credit agencies.