Disentangling Credit Ratings and ESG Ratings

Disentangling Credit Ratings and ESG Ratings

Dr Rory Sullivan and Dr Ian Woods

Credit ratings are widely used by fixed income investors to shape their investment decisions. These ratings - produced by credit rating agencies such as Moodys, S&P and Fitch – assess the credit risk of an issuer or of one of its debt instruments. Credit rating agencies are regulated and need to meet specified requirements in relation to the rigour of their assessment methodologies and in relation to the information they provide on these methodologies.

In recent years, investors have started to pay much greater attention to environmental, social and governance (ESG) factors in their investment research and decision-making processes. Some credit agencies have responded by producing ESG scores or ratings that sit alongside their credit ratings, and others have started to provide commentaries detailing current or potential specific ESG information that can affect issuers’ risk of default over the long term. Beyond the credit rating agencies, many ESG data providers now provide ESG scores and assessments for fixed income issuers (e.g. companies, governments, municipalities).

In practice, investors have struggled to unpick the relationship between credit and ESG ratings. Even basic questions such as whether ratings align or conflict or whether and how credit ratings incorporate ESG ratings remain fiendishly difficult to unpack.

In 2022, the Principles for Responsible Investment (PRI) commissioned Chronos Sustainability to systematically analyse and compare credit ratings and ESG ratings, to map out the commonalities and the differences between these ratings. In 2023, the results of this research were published on the PRI’s website. The outputs include:

·       A table providing a summary of the key features of credit ratings and ESG ratings, covering aspects such as: how the different types of rating ratings assess materiality, their coverage, their treatment of subsidiaries or other entities, the level of disclosure (transparency) of methodologies and of assessment result, the types of data used, and stakeholders’ ability to deconstruct and reconstruct ratings.

·       A spreadsheet comparing the key features of six main credit rating agencies (CRAs) and ten ESG information providers. The features compared include the type, number and geographic coverage of the issuers and issuances, the materiality criteria used to weigh and assess the ESG factors considered, the methodologies used to develop the ESG ratings and the scoring systems applied to the data.

·       A spreadsheet comparing the credit ratings and the ESG ratings for approximately 120 corporate entities, across a range of sectors. The spreadsheet includes examples of when entities with high/low credit quality also have high/low ESG ratings, and of when the signals from the credit rating and ESG ratings are mixed.

Both credit ratings and ESG ratings are important. This project – which is part of the PRI’s wider Credit Risk and Ratings Initiative – is another step forward in building understanding of the overlaps and the differences between these two types of ratings.

 

 

 

 

UpdateAmanda Williams