Investors of all kinds are increasingly looking at environmental, social and governance (ESG) factors to better inform their financial assessments of risk and opportunity.
Financial implications of ESG factors abound.
- Water stress has been linked to the closure of major business assets from mines in Chile to soft-drink bottling plants in northern India.
- The European Union aims to reach 27% renewable energy consumption by 2030—this and other targets are responsible for the closure of 13 gigawatts of fossil fuel-related power generation in 2015 alone—enough to power nearly one million homes.
- Malaysian palm oil producer IOI Group’s lost many of its largest clients when it failed to retain its sustainability certificates earlier this year. This has prompted Moody’s to review its credit rating for a possible downgrade.
“Given the breadth and depth of debt markets, credit rating agencies are a vital piece in the puzzle if we are to tackle the challenge of valuing natural capital effectively.”
Globally pension funds invest on average one third of their portfolios in bonds—for insurance funds this is closer to two thirds. Debt markets account for US$100-120 trillion in capital. The primary concern for bond investors is that borrowers repay their debts—on time and in full—allowing funds to pass on that income to their pension beneficiaries and policy holders. For these funds, credit rating agencies are an important and influential stakeholder as they provide independent opinions on the likelihood of a borrower defaulting on their debt. Given the breadth and depth of debt markets, credit rating agencies are a vital piece in the puzzle if we are to tackle the challenge of valuing natural capital effectively.
For this reason, the Principles for Responsible Investment (PRI)—supported by the UNEP Inquiry—has engaged a number of the world’s largest rating agencies to gain their ongoing commitment to ESG integration in credit ratings. To date, six rating agencies—including US firms S&P Global Ratings and Moody’s, China’s Dagong, Germany’s Scope Ratings, RAM Ratings in Malaysia and Liberum in Brazil—have signed PRI’s Statement on ESG in Credit Ratings. The Statement is supported by over 100 investors responsible for US$16.5 trillion that have committed to ongoing dialogue on ESG with credit rating agencies. This is effectively a pledge to collectively explore the links between ESG factors and issuer creditworthiness with an understanding that more stakeholders will take a more formal approach to ESG integration in future.
“We, the undersigned, recognise that environmental, social and governance factors can affect borrowers’ cash flows and the likelihood that they will default on their debt obligations […] we share a common vision to enhance systematic and transparent consideration of ESG factors in the assessment of creditworthiness.”
Excerpt from PRI Statement on ESG in credit ratings
Rating agencies evidently already consider a range of ESG issues in their ratings—primarily relating to governance and carbon regulations—as do investors. But we believe that analysts from rating agencies and investment organisations need to fully understand the potential impacts of environmental and social externalities in order to identify all potential risks to a business. Arguably, a closer consideration of governance factors could have forewarned investors on major economic shocks such as the subprime mortgage crisis, the European debt crisis and many of the aforementioned corporate blow-ups. Our initiative supports dialogue on the more complex issues beyond governance and carbon regulation, and ones which are only now starting to appear on the horizon, such as cybersecurity, boardroom diversity, diet related issues and biodiversity.
All things being equal, those borrowers that manage their exposure to ESG risks better than their peers should benefit from relatively higher credit ratings and a lower cost of capital. As banks and issuers in addition to investors and raters consider a broader set of risks, a range of positive social and environmental benefits will follow. Businesses which aren’t already doing so will place more focus on employee well-being and protecting human rights throughout their supply chain. Government issuers, particularly those in emerging markets, may reconsider environmental or social policies if these issues become material to their credit ratings and borrowing costs.
“The potential outcomes of this project are profound and far-reaching—better recognition of environmental and social risks, and more stable and resilient financial markets for all of us.”
PRI is grateful for the opportunity The Rockefeller Foundation has provided to bring this important initiative to life. The publication of the Statement on ESG starts off a movement towards more comprehensive consideration of ESG in credit ratings. The potential outcomes of this project are profound and far-reaching—better recognition of environmental and social risks, and more stable and resilient financial markets for all of us.
The United Nations-supported Principles for Responsible Investment (PRI) Initiative is an international network of investors working together to put the six Principles for Responsible Investment into practice. Its goal is to understand the implications of sustainability for investors and support signatories to incorporate these issues into their investment decision making and ownership practices. In implementing the Principles, signatories contribute to the development of a more sustainable global financial system. The Principles are voluntary and aspirational. They offer a menu of possible actions for incorporating ESG issues into investment practices across asset classes. Responsible investment is a process that must be tailored to fit each organisation’s investment strategy, approach and resources. The Principles are designed to be compatible with the investment styles of large, diversified, institutional investors that operate within a traditional fiduciary framework.