“The heat map was very much designed for investors and issuers to visualise Fitch’s ESG Relevance Scores, to see how relevant specific ESG issues are to credit ratings for a particular sector,” says Mervyn Tang, Senior Director, Global Head of ESG Research, Sustainable Finance, Fitch (Hong Kong) Limited. He explains that an individual can select the threshold of entities that have a particular score, from 1% to 50%, allowing them to gain an accurate picture of whether an ESG issue only affected particular issuers or applies more widely across the sector.
Take pharmaceuticals and the ‘Exposure to Social Impact’ category, says Tang. More than 50% of the sector scores a ‘4’ in that category, indicating that it is relevant to the credit ratings in combination with other factors. This is due to drug pricing and affordability being a contentious issue in a number of countries, leading to regulatory and social pressures on prices for many companies in the sector.
This contrasts with the ‘Labour Relations & Practices’ category for the mining sector, where more than 1% but less than 10% of issuers score a ‘4’. “This is due to labour strikes affecting only specific issuers in the sector, rather than being a more widespread problem across the sector,” he explains.
Alongside the heat map, Fitch also published in January 2020 an ESG Sector Template Compendium. Tang explains that this can work alongside the map and allows treasurers to see what issues are specific to their sector under a broader ESG general risk category, and which part of the credit rating criteria is impacted by those ESG issues. “For example, under the category ‘GHG Emissions and Air Quality’, the aerospace industry is specifically affected by emissions from their products and potential changes to emissions standards, and that could impact our assessment of their Technology, Strategic Position and Profitability in our credit rating criteria for the sector.”
Not all ESG issues affect credit
When talking about ESG, people often think about it in terms of subjective value judgements: ‘this is a good or bad ESG company’ says Tang. But that isn’t what the heat map studies. Instead, it looks at how ESG issues end up affecting credit ratings “So, if that poor performance on an ESG issue is not leading, or likely to lead to a policy, customer or financial market reaction that affects the credit profile of that company, it’s not going to currently affect the credit rating,” he explains, adding that this is why it is important for treasurers to distinguish credit-relevant ESG issues from other ESG issues in their thought processes.
When it comes to the markets that the map found to be most affected by ESG issues, Tang notes that emerging markets (EMs) generally have had more impact on ESG issues affecting credit ratings than developed markets (DMs) – particularly on the governance side. “That’s not really that surprising, given the governance standards in EMs would typically be lower,” he says.
What is surprising for him however, is the greater impact from social issues for developed markets. He believes that it is in part due to a lot of the social issues that materialise, such as the affordability of drugs for the pharmaceutical sector, or obesity issues for beverages. These issues command a much more rapid response in terms of policy action in DMs, which in turn can lead to an impact on credit ratings for companies if they have little time to manage those regulatory changes. “In EMs, you don’t tend to have such a rapid link for those social issues into policy impact for companies,” he adds.
Consequences for ‘bad’ ESG performers
“We are seeing companies starting to be affected by ESG as banks and asset managers pay more attention to ESG in their lending and investment decisions, and policymakers become more active,” says Tang. According to 182 global banks that responded to a Fitch survey, 64% said that they incorporate ESG considerations in their risk organisation ‘always’ or ‘most of the time’. Meanwhile, 16% of respondent banks said that they perform climate scenario analysis and/or climate stress testing.
Banks are placing more scrutiny on some ESG sectors seen as ‘bad’, he says, such as metals and mining, gaming and chemicals, and some are prohibiting financing to ‘no-go” areas such as coal, weapon manufacturers and companies that are perceived or judged to have human rights violations.
In July 2019, the private prison company, CoreCivic, had its Fitch Rating Outlook revised from Stable to Negative as a result of US and international banks halting the provision of financial services to private prison operators.
But a lack of rewards for ‘good’
In contrast, says Tang, instruments like sustainable bonds and loans (such as green bonds) are intended to reward ‘good’ ESG sectors. “We’ve seen more and more companies issue green bonds, and we actually talk to a lot of treasurers who are thinking about green bonds.” The challenge with these at the moment though, he says, is that there isn’t clear evidence of a financing advantage yet, or at least not one that is significant enough to move the financials of a company or have a positive impact on a credit rating.
Tang believes that this is in part due to green bonds not having government-backed financial incentive, and is instead setting up the infrastructure for the green finance market to expand. “All this talk about the EU taxonomy and the EU Sustainable Finance Action Plan is starting to build that infrastructure for green finance together. But we don’t expect that to have a positive impact on credit ratings unless governments also provide financial incentives,” he says.
According to the ESG Credit Trends 2020 report, “Fitch expects the influence of ESG on financing decisions to grow over time as social and regulatory pressures push more banks and investors to take ESG considerations into account.” As a result, for treasurers of companies that are looking to borrow money, they may find it more costly to do so if they are perceived to perform poorly on ESG, says Tang. Companies have some ability to manage their performance on certain ESG issues, he says, but some that operate in ‘bad’ ESG sectors will have limited room to manoeuvre. The relevance of credit ratings to ESG issues does however depend on the broader credit profile, he adds.
For example, a company already facing financing challenges will be more vulnerable to banks and asset managers pulling funding for ESG reasons. There, says Tang, treasurers should not consider ESG as a standalone issue.