The Emergence of ESG as a Significant Risk Factor

Recent reports of Australian investors "facing tough questions" over their failure to back climate change resolutions in 2019 highlights increased scrutiny surrounding corporations’ policies on climate change, especially amidst the devastating wildfires that swept through the country earlier this year. The same questions are now being asked globally of borrowers by lenders and investors about their environmental, social and governance (ESG) policies.

As we previously noted in a blog post, the increased focus on ESG concerns may expose once private policies to the light of public view and impact corporate strategy, leading investors to become increasingly sensitive and savvy to the impact ESG can have on performance. Now, credit rating agencies (CRAs) are taking note, making ESG part of their diligence review.

CRAs Take Note of ESG

Any CRA will tell you that they measure creditworthiness and the ability to perform based on factors that currently exist, as well as foreseeable future events. So, anything that’s a concern for a CRA is a concern today. ESG policies and strategies have arrived as a risk factor.

A Fitch report released last month highlighted how ESG factors are playing a greater role in banks’ underwriting decisions. 182 global banks participated in its Q3 2019 ESG survey, which revealed that this shift is mainly being seen at large and medium-sized banks, and is being driven predominantly by company policy and regulation, followed by reputation and litigation risks. Fitch noted that "banks’ monitoring of ESG risk generally results in greater due diligence rather than outright deal rejection." However, this elevated due diligence may benefit lenders by creating a more comprehensive risk profile for prospective borrowers.

Investors Want ESG Disclosures

Separately, the Loan Syndications and Trading Association (LSTA) has created two initiatives due to investor demand for greater transparency on ESG risk.

The first initiative was the release of an ESG Diligence Questionnaire. Developed in collaboration with various investment managers, the questionnaire is "designed to be completed by a borrower during the due diligence phase of the loan origination process." The idea is that responses will be "posted to the relevant public side data room for review by prospective lenders."

Questions include:

  • Do you have a formal ESG policy?
  • How is ESG performance being tracked?
  • What ESG-related business issues have you identified for your company’s business?

While participation is voluntary, the hope is that the questionnaire will facilitate information sharing, allowing lenders and investors to make more informed investment decisions that incorporate ESG considerations.

Under the second initiative, the LSTA examined more deeply how ESG factors influence credit ratings, by interviewing S&P, Moody’s and Fitch. The LSTA found that CRAs’ attention to ESG factors was not new and that they have been categorized as "material risks" when warranted, but the risks have not always been expressly labeled. CRAs will now need to respond to investor interest in seeing the direct link between ESG factors and credit ratings. S&P has been shedding light on the connection by including ESG criteria in its recent credit ratings reports, and Fitch has taken similar steps by introducing ESG "Relevance Scores" to show how ESG impacts credit ratings. Indeed, about a quarter of Fitch’s rated RMBS transactions were found to have "elevated" ESG factors.

Looking Ahead

The next challenge will be to predict if and how these factors affect loan performance. Bernstein Research recently examined the link between companies’ sustainability ratings and stock performance, and found a positive correlation in the European market where there is a strong ESG presence, but noted a "murkier relationship" in the United States where ESG is still emerging.

While this link is still unclear, what is becoming apparent is that banks are becoming more mindful of ESG risks when lending, and asset managers are seeking greater transparency from investors on how ESG factors influenced their investment decisions. This is perhaps indicative of a more risk-averse sentiment among lenders and investors, and mirrors the Federal Reserve’s findings in its recent survey that banks are reporting a "reduced tolerance for risk." But now that ESG factors are being more clearly identified, investors may be able to use these data points to gain insight into future performance.

With the climate crisis now widely regarded as one of the most significant issues facing us today, ESG considerations are now more relevant than ever for both sound management and investing. The CRAs’ consideration of ESG-related risk exposure reflects that urgency. If The Day After Tomorrow is already here, at least investors and lenders will know the impact on their portfolios.

Emily Hatchett, a paralegal in the Insolvency, Creditors' Rights and Financial Products Group, assisted with this post.

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