With trillions of dollars pouring into sustainable investment — rising 55 percent over four years to $35.3 trillion last year — it is more critical than ever that investors are able to analyze the environmental, social and governance (ESG) aspects of potential investments. More institutional investors are integrating ESG considerations into their asset allocations and risk management practices. Some build new investment strategies around them.
Responding to this wave of interest, Ceres Company Network member Moody’s Investors Service recently launched a scoring framework to assess the ESG risks facing debt issuers and transactions. Moody’s updated ESG methodology explains how its analysts assign issuer profile scores to indicate a debt issuer’s exposure to ESG risks and how those scores impact credit ratings.
Ceres Senior Manager Siobhan Collins spoke with Moody’s Senior Vice President Swami Venkataraman, who is also manager of ESG analytics and integration, about the new ESG scoring framework. Their conversation builds from a workshop they led at the Ceres 2021 conference about scoring and the consideration of ESG risk factors.
Exhibit 1: Four key components of Moody’s analysis of ESG considerations
Exhibit 2: Our ESG classification captures credit-relevant risk categories
Siobhan Collins: How does Moody’s incorporate ESG considerations into its credit ratings?
Swami Venkataraman: Our core approach to integrating ESG considerations into our ratings for enterprises remains unchanged. We seek to incorporate all material credit considerations, including ESG issues, into our ratings and to take the most forward-looking perspective that visibility into these risks permits.
Our analysis of ESG considerations is composed of four pillars [shown in Exhibit 1 above]: First: an ESG classification that identifies E, S and G components that we view as most likely to have credit implications across sectors [shown in Exhibit 2 above]. Second: heat maps that rank sectors based on their exposure to E and S considerations. Third: ESG issuer profile scores , which assess an entity’s exposure to risk categories in the ESG classification and are used as inputs to credit ratings. And fourth: the integration of ESG considerations into our credit ratings and research. We incorporate ESG issues into our ratings in a variety of ways, either directly or indirectly through scorecard factors, models, metrics or, more generically, as other considerations outside the scorecard or model. Credit impact score (CIS) is an output of the rating process that indicates the extent, if any, to which ESG factors impact the rating of an issuer or transaction.
Collins: Does Moody’s weight all ESG considerations equally?
Venkataraman: No, we do not. In order to be transparent about which ESG considerations we consider to be important, we have published both an environmental risk heat map and a social risk heat map that identify the ESG risk categories that are credit material to each sector. The heat map is based on the analytical judgment of Moody’s analysts globally and is the second of the four pillars that constitute our approach to ESG [shown in Exhibit 1].
The objective of our ESG analysis is not to capture all considerations that may be labelled green, sustainable or ethical, but rather to identify those that have a material impact on credit quality. This distinction is important. Individual companies encounter a multitude of ESG-related risks and opportunities, many of which will have little tangible impact on operating or financial performance. We recognize that materiality is a fluid concept. Besides varying by sector, it will also vary across companies within the same sector or even for a given company over time. We periodically revise our heat maps to reflect our changing views of materiality.
Collins: How is Moody’s defining materiality for its new ESG scores?
Venkataraman: Our issuer profile scores take the analysis from the sectoral level of the heat map down to the issuer level. The E and S sector heat map category scores illustrate the inherent exposure of individual sectors to E and S risk categories, using a four-point scoring scale to denote very high risk, high risk, moderate risk and low risk. The E or S issuer profile score of an issuer or transaction is our opinion of its exposure to that specific risk, focusing on the credit-relevant considerations outlined in our classifications and mitigating or strengthening actions related to those specific exposures. The G issuer profile score of an issuer or transaction is our opinion of its relative governance strength. E, S and G issuer profile scores are expressed on a five-point scale, from E-1, S-1 or G-1 (positive) to E-5, S-5 or G-5 (very highly negative) [as shown in Exhibit 3].
Our credit impact scores (CIS) follow a similar five-point scale as the IPS and indicates the impact of an issuer’s ESG profile (as illustrated by its E, S and G profile scores) on its credit rating. These CIS scoring levels indicate the extent, if any, to which the credit rating of an issuer or transaction is different than it would have been in the absence of exposure to the risks related to the issuer’s ESG characteristics. A score of CIS-4 (highly negative) or CIS-5 (very highly negative) means we think the credit rating is lower than it would have been in the absence of ESG risk exposures. A score of CIS-3 indicates that ESG risks have a limited impact on the current rating with the potential for greater negative impact over time. A score of CIS-1 means that we think the rating is higher than it would have been in the absence of ESG benefits.
Collins: How do these new scores integrate and measure long-term material risks? What are the time horizons Moody’s is factoring in?
Venkataraman: Our credit ratings and ESG scores are not limited to any time horizon, such as three to five years. We incorporate a long-term perspective of environmental and social risks into our issuer profile scores. When it comes to credit ratings, our ability to forecast the magnitude and timing of the financial impact of trends that will only unfold far into the future is necessarily limited. As the time frame for a source of risk lengthens, the less certain we can be of its impact on an issuer’s cash-flow-generating ability, and the less clarity we have regarding the importance of that risk in relation to others. It is this uncertainty that limits the credit impact of long-term risks, rather than any defined time horizon for our analysis. For example, longer time frames give an issuer more time to adapt by lowering costs, adopting new technologies, or realigning its business model, budgetary spending or balance sheet to changed circumstances. These characteristics are not unique to ESG considerations. Credit analysis often involves an evaluation of risks with inherent uncertainty or poor visibility.
Collins: The race to net zero is on and we’re soon headed into COP26. How will the recent plethora of net-zero commitments be reflected in the ESG scores?
Venkataraman: The rise in net-zero targets among corporates and governments — coupled with the increasing focus on disclosure around the risks of climate change — is likely to raise credit risk, as well as reduce the availability and increase the cost of capital for carbon-intensive activities. As a result, we expect pressure to inexorably rise for major producers and users of hydrocarbons to adjust business strategies and implement credible transition plans. We expect the impact to be more significant than current patchwork policy implementation, gradual changes in disclosure requirements or moves by investment funds to reduce their fossil-fuel holdings. However, the full implications of such initiatives will only become clear over time.