More and more clients ask us when and how ESG will impact their activity and the way they interact with their banks. This post is the second of three to be published in our attempt to summarize the impact of ESG regulations for the companies.
3. How does ESG scoring work?
So far, ESG factors have mostly indirectly influenced credit ratings. ESG compliance is limited primarily to pricing, with a margin ratchet linked to performance towards certain key performance indicators (KPIs), or an ESG score determined by an external ESG rating agent. Borrowers obtain a premium or discount to the margin based on performance against the agreed KPI or score. The following exhibit lists a sample of common ESG indicators from which ESG ratings tend to be drawn.
Source: Elyse Douglas, Tracy Van Holt and Tensie Whelan, “Responsible Investing: Guide to ESG Data Providers and Relevant Trends,” Journal of Environmental Investing, 8, No. 1 (2017)
Ratchet discounts are still fractional and typically set at a maximum of 15 basis points, but as investors pay closer attention to ESG concerns, these could become more financially material over time. The majority of deals so far in 2021 measure ESG margin ratchets against KPIs, with the number of KPIs typically ranging from one to three. KPIs for carbon footprint, water consumption and governance are seemingly widely included.
A key challenge the market is facing, however, is whether one format for testing criteria will become the market convention – and if it does, on what basis the targets will be set. As ESG ratings have become more relevant, confusion and scepticism about the reliability of ESG ratings have emerged as key concerns. The main issues are that (a) most of the rating agencies basically use self-reported data to construct their metrics and (b) there are no generally accepted guidelines as to how to compile, normalize, weight, and process ESG data. An individual company can carry vastly divergent ratings from different agencies simultaneously, due to differences in methodology, subjective interpretation, or an individual agency’s agenda.
This current lack of standardization is responsible for the significant variation between ESG scores across the competing rating agencies. There is evidence of three major biases in ESG ratings:
- Higher scores are attributed to larger firms. More highly capitalized companies systematically show higher ESG ratings, with an average value of 64 (rating scale 0-100) for mega-cap firms and 46 for micro-cap firms.
- Companies in countries with more disclosure regulation also show higher scores, with an average value of 66 for Europe (most regulated) and 50 for North America (less regulated).
- The oversimplification of industry weighting and company alignment lead to biased ratings that do not properly account for company-specific risks. For instance, the utility industry shows a 61.3 average ESG score, the highest value among all the sectors, while the lowest is 48 for the healthcare sector.
For the time being, ESG factors have not been a direct component of issuers’ final credit ratings. The way rating agencies have integrated ESG themes into their rating methodologies thus far has kept these as isolated concepts not impacting directly the rating. Rather, ESG issues are considered in relation to the impact they have on corporates and their financial risk profiles. At the same time, fundamental credit factors such as financial flexibility, the strength of free cash flow generation and robust liquidity can limit or offset ESG risks, at least from a rating perspective. In short, rating agencies’ ESG analysis has so far complemented their overall credit rating analysis.
4. How will ESG affect Financial Institutions?
Basel III and CRD4, on the banking regulators’ side, currently do not explicitly integrate the ESG dimension, so it does not yet influence the cost of capital. But certain authorities, such as the ECB or the DNB (De Nederlandsche Bank) have a greater willingness to incorporate this into the regulation and market practices and make them compulsory. The regulatory framework still is work-in-progress, but it is fast-moving. The EU taxonomy creates a dictionary common to banks and companies for reporting under ESG, in their annual reports starting 2022.
Moreover, the ECB has recently published a Guide on their expectations in terms of including climate-related and environmental risks in risk management systems. They are also making increasing use of stress tests / sensitivity analysis exercises. In addition, the EBA published a discussion paper to present its views on management of ESG risks by institutions as well as the incorporation of ESG risks in the prudential supervision.
These transitioning requirements for banks will involve having to progress through various stages and will have an organisation-wide impact. Transformations will be expected in (i) the organisation and structure of FIs, (ii) processes and ways of working on products and services offered, (iii) heavier and deeper reporting on risks to shareholders and various controlling authorities and (iv) improvements in IT systems, tools and data technologies to allow for the increasing reporting demands.
Inevitably, banks will have to report on their client ESG impact, which brings us to the next question: how will ESG regulation affect companies?