December 4, 2019 - As 2019 comes to a close, the rise of environmental, social and governance (ESG) significance in financial markets has been undeniable. In Europe, this trend is quite established, but over the last two years it has jumped the pond and there is now significant ESG interest by U.S. investors. In some cases, this may mean a drive to ESG-linked assets, but across the board there is burgeoning interest in how ESG factors impact credit ratings. (A trend which is also covered in November’s Loanly Planet.) In response, the LSTA is hosting a three-part webcast series on the topic with S&P, Moody’s and Fitch. The first in that series – S&P and ESG: Credit Ratings and Beyond – looked at how ESG is embedded in S&P’s credit ratings as well as their recently launched ESG Evaluation.

As noted in the webcast, the growth of investor interest in ESG is demonstrated by the increase in sustainable investment AUM which now stands globally at $31 trillion – a 34% increase since 2016 – and the exponential growth of investor signatories to the UN Principles of Responsible Investment. Signatories may integrate ESG into their decision-making differently, but they share a commitment to ESG as a tool in their investment decision-making.  From a credit perspective, we can anticipate that there will be a connection over time between ESG performance and financial performance in light of certain ESG-related realities such as, climate change and the advancement of related regulation, which are intuitively going to be driving financial performance. Furthermore, a management team’s preparedness for and proactive management of ESG risk factors is often typical of one that shows a high level of general risk awareness which tends to positively impact that company’s credit risk. Because credit ratings have always been focused on risk, in truth, financially relevant ESG factors have always been included in credit ratings. More recently, however, investors have asked for the connection between ESG factors and credit ratings to be made more apparent and direct. As a result, S&P has been separately calling out ESG considerations in recent credit ratings reports. As expected, the consideration is only of those ESG factors that are most material to credit quality, i.e. those that potentially have the ability to move credit ratings, watches or ratings transitions or to differentiate between two otherwise like companies that have different ratings. (For examples, please refer to the webcast replay).

The impact of ESG factors need not be negative, however. While it can be expected that some companies will underperform due to ESG factors, other that show a greater degree of preparedness than their peers can outperform. There are both ESG risks and opportunities which we can expect companies to monetize in the future. Unlike credit ratings, an ESG Evaluation captures both. It is a cross-sector relative analysis of an entity’s capacity to operate successfully in the future and is grounded in how ESG factors could affect stakeholders, leading to a material direct or indirect financial impact on the entity. It takes a holistic perspective and considers a broader set of stakeholders, not just debtholders, but equity holders, consumers, communities, employees, and supply chain. There are different reasons why a company would be interested in obtaining an ESG Evaluation. One may be to show improvement with respect to ESG preparedness over time, but it also could be used as the relevant metric in a sustainability linked loan. As reported in Loanly Planet, in July Masmovil, a Spanish telecom company, incorporated an ESG Evaluation in its revolving facility that ratchets down if its ESG Evaluation improves.  Masmovil is the first borrower to include a sustainability link in its leveraged loan.  For more information on sustainability linked loans, click here and refer to this recent Lexis Practice Advisor article. The second installment of the ESG and Credit Ratings series will be presented by Moody’s Investors Service on December 4th and the final installment will be presented by Fitch Ratings on January 14th.

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