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A good ESG rating can determine whether a company is financially stable or an investment is safe. For that reason, it is vital to know what exactly ESG ratings are and how they relate to traditional credit risk ratings. 

This was the goal of a new edition of The Garrigues Sustainable Dialogs, entitled What ESG ratings are and their relation to credit ratings. The talk, moderated by Gonzalo García-Fuertes, partner in Garrigues’ Corporate/Commercial Department, was with two experts in the subject: María Martín de Vidales, analyst at Morningstar Sustainalytics, and Marcos Álvarez, analyst at DBRS Morningstar. 

During the talk, the speakers went into depth on the importance of ESG ratings in assessing a company’s performance and how they measure a company’s impact on the environment, its commitment to fair employment practices and ethical and transparent corporate management. Moreover, although they are not related and the analysis is quite different, they also explained how ESG ratings can be used by investors and lenders as a factor to be considered, indirectly, in their credit risk assessments.

María Martín de Vidales noted that the two ratings can be complementary and Marcos Álvarez remarked that, although the key mission of credit ratings is still to analyze the risk of default on a financial obligation, “in recent years, components of ESG analysis have been gradually incorporated in order to see, for example, how they might influence the likelihood of an issuer defaulting on an obligation.” 

The importance of methodology

For this reason, applied methodology is key. “We try to be as transparent as possible so that companies know how these ESG ratings are built,” noted Martín de Vidales. To which she added that it is necessary “to make the sustainability environment more transparent.” In the case of Morningstar Sustainalytics, she explained that its methodology “is based on creating a final rating that reflects the material sustainability risk for the company that has not been able to be managed efficiently.”

This expert highlighted that the methodology includes an annual review of the criteria that are applied to each of the subindustries that they analyze: “Every year we analyze in great detail all the factors that we take into account for each of the more than 140 subindustries that we have. And, on top of that, the ratings are also updated annually, mainly because most of the information that we incorporate comes from the sustainability report, which is released to the public once a year.”

For his part, Álvarez explained that the various credit agencies have developed methodologies and check lists, and that, although it will never be their mission to look at an issuer’s sustainability, there has been more transparency toward the market on how agencies view different types of ESG factors in credit ratings. 

And what do they assess?

As for what exactly sustainability ratings assess, MaríaMartín de Vidales noted that the first and most important thing is for the company to have a good sustainability report: “It should be complete and talk about all the issues that will be material for the company.” In this regard, she asserted that “it is important for the company to be as transparent as possible when it comes to the efforts that are already being made in the organization, because it’s not really a question of lack of effort or a lack of implementation of different measures, but rather purely an issue of communicating with the outside world.” And she concluded that “if it has a good sustainability report, the company has already made a lot of headway.” 

To what extent can it affect the credit rating?

The experts agreed that sustainability can have a relevant impact on credit ratings. Marcos Álvarez recalled that his credit analyses already included certain ESG aspects in the past: “What has happened over the past 3 to 5 years is that it has become more transparent.” And he confirmed that, in some cases, he has changed credit ratings due to issues related to ESG factors. In this regard, he explained that it depends a lot on the industry or jurisdiction in which the issuer operates: “An oil company is not the same as a bank or a university. Some can have greater or lesser exposure to ESG risks than others. In the finance sector, for example, what we see the most are governance problems, i.e. corporate governance, that translate into fines from regulators or into an issuer’s loss of credibility in certain markets due to those fines.” These types of issues have sometimes led them to take action on the credit rating. In other areas, like in the case of insurance companies, they consider, for example, environmental issues or climate risk, but in these cases they are issues that “have a relevant, but not significant impact on the credit rating.” 

Cost of transitioning to sustainability

Another relevant issue addressed was the cost that transitioning to sustainability can entail for companies. “The cost of transitioning for an oil company is not the same as for a bank,” noted Álvarez. “In our annual review process, for a number of years now, we include specific questions on how much the transition costs and what the transition requirements are from now to 2030 or 2050.” He acknowledged that “many of these issues are hard to measure,” but they also assess what level of sophistication the issuer has in terms of how it sees the transition risks: “You note a degree of maturity and you can consider it as a positive factor.” 

Future developments in ESG ratings

María Martín de Vidales set out her vision of the future in this field: “Our aspiration is for both metrics, i.e. credit and those measuring ESG factors, to be considered in the same way. We believe that there is market momentum, although there is still a long way to go.” She also underscored the importance of comparability of ESG ratings, something which will pose quite a challenge looking forward.

Marcos Álvarez, for his part, highlighted that “ESG factors will be integrated into credits ratings more and more, with an increase in transparency, in how such information is disclosed to the market, and more emphasis on the analysis of certain ESG factors and on how they impact credit risk.” In his opinion, these issues “will continue to grow in importance due both to market demand and to regulatory pressure worldwide.” On this regulatory expansion, both experts agreed.