A company’s ESG conduct has no direct relationship whatsoever to its credit rating, according to a study from the Institute for Energy Economics and Financial Analysis (IEEFA).
Hazel Ilango, a Singapore-based energy finance analyst for debt markets at the IEEFA, carried out an analysis of more than 700 companies who received credit ratings from the big three credit rating agencies – Fitch Ratings, Moody’s Investors and S&P Global Ratings.
She found that while all three agencies have taken important steps to integrate ESG into their assessments of an entity’s creditworthiness as illustrated by their development of ESG credit scores, this did not go far enough and it was difficult to establish any link between ESG scores and credit ratings.
“Based on IEEFA’s analysis of 721 companies as of September 2022, we find that there is no direct relationship between their ESG credit scores and credit ratings,” Ilango said. “While the three agencies all provide detailed ESG credit scores to bond investors, it is difficult to establish a straightforward link between their ESG scores and credit ratings.”
Ilango noted the three rating agencies were missing a trick and not just because investors are increasingly sensitive to a company’s ESG profile. Even investors who are blasé about a company’s ESG credentials could still find themselves exposed to abrupt ratings downgrades stemming from climate change over the long term.
In her study, Ilango cited the examples of Chinese state-owned enterprise China Huaneng Group, which has an A credit rating from the three major rating agencies, and Danish offshore wind power company Orsted, which has a triple-B rating from S&P and Fitch, even though Huaneng is reliant upon fossil fuels and vulnerable to high stranded asset risks.
Ilango noted the principal challenge is a mismatch between ESG factors and the credit ratings time horizon. Credit rating agencies would typically factor in the impact of a carbon emissions tax, for example, but would not factor in the potential cost of an extreme weather event because of the uncertainty of its timing.
In response, Ilango proposed an overhaul of ratings assessments to take into consideration long-term ESG risks. She also suggested rating agencies possibly introduce dual ratings, one based on conventional credit assessments and another that factors in ESG factors.
This story first appeared on our sister publication, ESG Clarity.