CorporateTreasurer

Increasing transparency around the credit implications of ESG risks and opportunities

By Content Lab | Jan 18, 2022

Greater transparency around how ESG considerations are integrated into credit ratings, coupled with new technologies to produce market-leading research on the credit implications of ESG factors, were among key drivers behind Moody’s Investors Service winning CorporateTreasurer’s 2021 Credit Rating Agency award.

Research studies, industry polls and anecdotal evidence all point to the same conclusion about sustainability: it is an increasingly integral part of business decisions and expectations.

For a credit rating agency such as Moody’s Investors Service, this requires a commitment to increasing transparency when considering material environmental, social and governance (ESG) factors, and climate change issues, within credit analysis.

Not only has the firm introduced innovative ways of showing how ESG considerations are factored into credit analysis, it leverages cutting-edge technology via natural language processing (NLP) techniques to produce market-leading research on the credit implications of ESG risks and opportunities.

Greater transparency

Moody’s is committed to increasing transparency around its systematic incorporation of material ESG considerations and climate change into its credit analysis. The firm’s credit analysis incorporates all issues that can materially impact credit quality, including ESG and climate risks and opportunities. It also aims to take the most forward-looking perspective that visibility into risks and mitigants permits. To provide greater transparency about how Moody’s systematically incorporates ESG considerations into credit ratings, it has updated its ESG methodology to include an ESG classification that describes how Moody’s defines and categorises E, S and G considerations that are material to credit quality. Moody’s has also published Environmental and Social risk “heat maps” that identify the financial materiality of these E and S risk categories to each of over 80 sectors for which Moody’s maintains ratings.

In addition, the methodology introduces ESG scores at the issuer level that further explain the integration of ESG into credit analysis.

ESG Issuer Profile Scores – which are an input into the credit rating process – are an opinion of the extent to which a given issuer or transaction is exposed to E, S and G factors. They also assess any mitigants against these ESG risks, as well as any potential benefits the issuer faces from its exposure to E, S or G factors.

ESG Credit Impact Scores – which are an output of the rating process – explain the impact of ESG considerations on the rating of an issuer or transaction. Credit Impact Scores are based on Moody’s qualitative assessment of the impact of ESG considerations in the context of the issuer’s other credit drivers that are material to a given rating.

Moody's started rolling out ESG Issuer Profile Scores and Credit Impact Scores in January 2021, and has now assigned scores to over 1,700 debt issuers globally, including sovereigns, regional & local governments, companies, financial institutions and multilateral development banks.

In addition, Moody’s credit rating announcements and Credit Opinions contain explanations about whether and how E, S or G factors have been material to a rating action outcome or rating level.

Measuring carbon transition risk

Moody’s has also developed a carbon transition assessment (CTA) framework to provide a consistent and verifiable means of analysing carbon transition risk for rated non-financial companies in sectors such as oil & gas, utilities and autos, that have been identified as having High or Very High exposure to carbon transition risk in the environmental heat map.

CTAs (which are not credit ratings) allow Moody’s to rank-order issuers’ exposure to carbon transition risk across sectors, following a standard, transparent approach based on the most relevant and material characteristics for credit analysis.

The framework contains four key components relevant to an issuer's ability to successfully manage a shift to a lower-carbon economy:

  • The current business profile
  • Medium-term technology, market and policy exposure
  • Medium-term response activities
  • Longer-term resilience

Taking the tech lead

Technology has further fuelled Moody’s efforts to conduct research on the extent to which ESG considerations are factored into credit analysis.

In 2021, Moody’s published two reports looking back at how often ESG factors were cited in public and private-sector rating actions. Instead of relying on analysts to manually review thousands of rating actions, Moody’s leveraged cutting-edge NLP technology to identify ESG risks in published rating action press releases.

This resulted in a robust dataset of rating actions that cited ESG as material credit considerations, yielding far more accurate results than manual keyword searches.

Counting the effect of Covid

By using NLP to review over 8,700 private-sector credit rating action announcements published in 2020, Moody’s found that the frequency of ESG considerations cited had increased notably. Several key trends were clear:

  • ESG risks were cited as material credit considerations in 85% of private-sector credit rating actions in 2020, up from 32% in 2019, largely driven by the pandemic
  • A higher frequency of citations across all three ESG categories – 71% for social risk factors, 53% for governance issues and 13% for environmental issues
  • Carbon transition risk was the most frequently cited environmental consideration in the rating actions
  • Social considerations were mentioned most often in rating actions involving sectors with high exposure to social risks and those most affected by COVID-19
  • Governance issues partly reflected expanded corporate risk management measures taken to mitigate the pandemic’s impact

An evolving ESG landscape

Spurred by heightened interest among investors and decision-makers around ESG risks, the integration of ESG into credit ratings is an ongoing initiative for Moody’s. The firm will continue to roll out its ESG Issuer Profile Scores, Credit Impact Scores and Carbon Transition Assessments for more sectors going forward.

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