Bonds

Why Kroll won’t use ESG scores in its bond ratings

Kroll Bond Rating Agency argues that environmental, social and governance scores based on subjective metrics that are not correlated to credit risk do not have a place in their credit ratings.

KBRA said the development, weighting, and ranking of the key factors in ESG scores are endeavors best left to investors rather than to rating agency credit analysts.

In its newly introduced “ESG Management” analysis, KBRA said it is now integrating relevant environmental, social and governance issues into its credit analysis “without having to veer into subjective selection, scoring, and weighting of ESG factors that are not meaningfully credit-relevant.”

“We don’t think it’s our place or any credit analysts’ place to decide which of those things are more important than another,” said William Cox, a Kroll senior managing director.

Kroll’s position and practice on ESG contrasts with the three largest players in municipal bond ratings.

“We don’t think it’s our place or any credit analysts’ place to decide which of those things are more important than another, except as they impact credit,” said William Cox, senior managing director at KBRA. “But asking a management team about how it identifies, plans for, and addresses ESG risks that are relevant to their specific situation is at the heart of what KBRA analysts do. We call that approach ESG risk management analysis.”

As an alternative to ESG scores, KBRA said it uses a two-step process to identify and integrate credit-relevant ESG considerations into its credit ratings analysis.

“First, we identify ESG factors with a direct impact on a given issuer or transaction,” Cox said.

KBRA defines direct impact as those factors that have a “clear, tangible effect on credit, are typically quantifiable, and the assessment of which is generally rooted in existing methodologies,” Cox said.

In the second step, KBRA seeks to understand a broader array of ESG-related risks or opportunities that may have more indirect or more future-oriented credit impact.

“In either case, KBRA performs its ESG factors analysis through the lens of risk management analysis, which includes assessment of an issuer’s ability to identify, plan for, and mitigate risks or to amplify opportunities,” according to KBRA.

KBRA said in its outreach to investors, the agency found that when it comes to ESG and credit risk, investors want more disclosure and transparency by issuers of relevant and material ESG-related factors, as well as deeper understanding of an issuer’s plans or a transaction’s features that take these factors into account.

“ESG issues that are most often relevant and top of mind for credit-focused investors are those related to climate change, cybersecurity, and the impact that stakeholder preferences may have on operating and financial strategies,” KBRA said.

Kroll said it is best accomplished through “fundamental, bottom-up credit-by-credit risk analysis, rather than through the collection of often irrelevant ESG data and/or the creation of ESG scores that are burdensome to analysts and issuers.

“In our view, ESG scores based on subjective metrics that are not correlated to credit risk have no place in the credit rating process,” the agency said.

Other rating agencies use scores that factor ESG into their methodologies in various ways.

Fitch Ratings rolled out ESG relevance scores in May of 2019 for municipal and infrastructure credits.

Fitch’s ESG relevance scores look for an overlap of credit risk and ESG risk, identifying them on a scale of one to five. One is ESG risk is irrelevant to the sector and to the issuer, while five would indicate that ESG risks are a key rating driver, generally with a negative impact on a rating. The approach has remained the same since it began in May 2019, but the impact can be seen on a more granular basis right now.

For global infrastructure, medium or high impact from ESG factors was at 5.5% as of December 30, 2020; for U.S. public finance tax-supported, the impact was 3.5%; and for U.S. public finance revenue-supported, the impact was 5.5%, according to Fitch.

S&P Global Ratings has been working on two tracks, looking at ESG impacts on credit quality and specific credit ratings.

The first is providing disclosures on the ratings impacts of ESG on companies or public finance entities relative to their peers, with the goal of making a connection between ESG and credit ratings more transparent because investors are asking for it.

The second is a product called the ESG evaluation that it is also based on sustainability using a qualitative analysis that produces a report to support a score from 1-100. The score isn’t a credit rating but is similarly a relative assessment of ESG factors across sectors and regions. The process is a time-consuming and qualitative process that relies on both environmental, social, and governance data points and meeting with the company or issuer.

Moody’s Investors Service uses its affiliate Vigeo Eiris to designate sustainable/ESG investments.

Moody’s ESG Solutions Group expanded to include investments in V.E. and Four Twenty Seven, a “leader” in climate risk analysis, the agency said in a release.

Market participants including rating agencies are focusing on ESG, climate change and green bonds, from the largest asset managers to third-party verifiers to issuers themselves. A universal language to define “green” and other ESG designations has been increasingly confusing investors and issuers alike while large asset managers have their own “black boxes” to define what they consider green or ESG and many firms are trying to make clearer those designations.

Third-party verifiers of green and impact bonds, including firms such as Kestrel and Sustainalytics, which provide green designations, continue to push issuers to adopt the designation. NASDAQ last year launched its own Sustainable Bond Network. Sources said there is value in using those second- or third-party designations, especially for smaller asset managers.

Build America Mutual also has a green designation for insuring bonds. Bloomberg is ascribing “green” designations on certain deals, as well.

Cox said in Kroll’s view, third-party verifiers are valuable and fitting for investors to use.

But when it comes to ratings, he and Kroll believe a score should be left out of the mix.

“When you think of the MTA, its central purpose is green. It moves people to city centers, removes cars from streets. They’ve had natural gas busses for years. They’re hardening the system to flood events,” Cox said. “Yet only some of the MTA’s bonds are green. Someone has made a distinct analysis that ‘this’ is even greener than ‘that.’ It’s appropriate for investors who are preferentially allocating capital, but it is subjective. One you get into that subjective landscape, we simply think it’s not the role of a credit analyst. We focus on ESG factors that can impact credit risk, risks that can be quantified, or that may be on the horizon because of stakeholder pressures.”

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