This article examines why Environmental, Social and Governance (ESG) issues have come to the fore in the financial services industry, how we are beginning to think about and analyse these factors in credit risk scenarios, and what the outlook is for ESG in the near and medium term.
For the purposes of evaluating ESG factors, The European Banking Authority (EBA) recently introduced a useful definition, that is “Environmental, social or governance matters that may have a positive or negative impact on the financial performance or solvency of an entity, sovereign or individual.”
The Rise of ESG
In recent times, ESG seems to have taken on a life of its own. However, credit professionals have always known that these aspects of risk form part of any good credit analysis, and we've looked at them many times before. For example, the environmental liabilities that might accrue to any polluting business would be part of any credit analysis. As would the risk associated with the lien over an asset that may require potentially expensive environmental reparation in the event of a foreclosure with the bank, for example, becoming owners of the asset.
The quality of management and governance have long formed part of any assessment of credit risk. Some social factors might have been included, but with rather less emphasis in the past than on environment and governance factors. So, what exactly has changed to bring ESG so much to the fore, and for these factors to become particularly important right now?
ESG Factors in the Spotlight
It appears that there are a number of key drivers placing an increased focus on ESG. Firstly, society as a whole has become increasingly aware of, and interested in, these aspects of economic activity. Secondly, there is an overarching regulatory focus on ESG topics. Thirdly, there is an increasingly realization amongst the risk and investing communities that perhaps the rather narrow view that we have held of ESG risks in the past did not fully capture the risks and potential opportunities. Finally, the direct opportunities and risks that these ESG factors could have for businesses need to be more explicitly factored into a full risk assessment.
The investing community, perhaps a little ahead of the credit risk world, have for a while now, sought to incorporate a consideration of these externalized costs of a business into any investment analysis. These are the ESG costs faced by society in general rather than purely by the business itself as a result of any business activities - perhaps the most obvious ones being pollution and climate change.
Tackling Climate Change
The World Economic Forum identifies climate change as the single most important risk to the global economy. This reflects the warning from the Stern Report that the externality of climate change is one of the greatest failures of the market economy. These externalized costs are now being increasingly internalized, i.e. becoming a cost to the business through reputational damage, or for pollution that can be specifically attributed for example, through litigation, carbon pricing and more general impacts.
The on-going health and viability of a business may well be intimately bound up with its direct engagement with ESG factors and how well it manages these over the longer term. Of course, not all companies are exposed to the same risks, and so, the impact of ESG factors and the level of relevance and vulnerability to them can vary depending on the exact nature of the business activities of the firm. ESG relevance and ESG vulnerability scores, such as those developed by Fitch, can articulate the level of influence that ESG has on credit ratings based on credible downside ESG scenarios for both sectors and individual businesses within a sector.
A Brief History of Sustainability
At intergovernmental level, there have been a number of treaties and agreements to try and manage climate change. The United Nations Framework Convention on Climate Change was an early international agreement. The Kyoto Protocol and the Paris Climate Agreement are other key frameworks. The Paris Climate Agreement at COP21, building on the Kyoto agreement, was the first legally binding intergovernmental agreement on climate change, which asked all nations to reduce emissions and targeted amongst other things, a maximum level of global warming at 1.5 degrees centigrade, a commitment to falling greenhouse emissions, and to balance emissions and removal of greenhouse gases by the end of the century. Recently, we've had the latest edition of COP, COP26 in Glasgow, and COP27 in Egypt next year will seek to build upon the targets and commitments from COP26.
Conducting an ESG Analysis
Let's take a closer look at the dynamics of ESG and how some of these factors may impact credit risk. Some of the key factors in the Environmental space associated with credit risk, may include climate change and water pollution. For Social, we can look at resource management and workers' rights, including pay and conditions, and equal opportunities. In the Governance sphere, we may consider Board independence, diversity, corruption, shareholder rights and the appropriate role of the non-executives on various governance committees. An ESG analysis recognizes that a focus on economic growth alone is not enough, and that economic growth is only possible with sustainability through environmental protection and long-run social progress as a pre-requisite.
This brings us onto the idea of triple bottom line accounting, which along with the usual profit element must account for ESG factors, the planet and people. In the planet/environmental sphere, The World Economic Forum has estimated that more than half of the world's economic output, some $44 trillion of economic value creation annually, is moderately or highly dependent on nature. Therefore, nature lost through environmental impacts represents a significant risk to corporate and financial stability. So, not only do we have to protect the planet, but also pay attention to the social dynamic.
The Bigger Picture - ESG and Credit
The risks and opportunities that a business faces as a result of these ESG factors is measured via transmission channels. A transmission channel is a causal chain by which ESG factors may impact an entity, business for example, or society more widely, either directly or indirectly.
