PRI warns over ESG integration in credit

ESG factors still not being addressed consistently and systematically

The fixed income market must make ‘fundamental institutional changes’ to embed ESG into credit risk, according to the PRI’s bonds lead.

Carmen Nuzzo, head of fixed income at the UN-backed Principles for Responsible Investment (PRI), said while issues such as climate change, resource depletion and board gender diversity are earning a firmer place on the agenda of fixed income investors and credit rating agencies (CRAs), ESG factors in credit risk analysis is still not being addressed consistently and systematically by all fixed income market participants.

“Since many fixed income investors buy bonds for capital preservation, it is critical that – where material – these factors are systematically included in bond valuations.

“This is particularly pressing for insurers and pension funds, which own large quantities of fixed income securities for asset/liability management and have a fiduciary duty to their policy holders and beneficiaries,” Nuzzo said.

Since the launch of its ESG in Credit Risk and Ratings Initiative in 2016, the PRI has been working with investors and CRAs to identify gaps in ESG credit risk analysis.

It has found that while credit rating scores, and assessments measure how well issuers perform on ESG factors relative to their peers, there was still confusion about the underlying meaning of these ratings.

“While [these scores] can help investors make more informed decisions, they don’t necessarily capture the implications of ESG factors on issuers’ balance sheets and hence their relative risk of default,” Nuzzo added.

According to Nuzzo, investors expect more clarity from CRAs to understand what is already factored in their rating opinions and avoid double counting.

The investor-CRA dialogue has also highlighted that ESG dynamics in fixed income differ from considerations in equity markets.

“For example, the potential materiality of ESG factors varies depending on the financial strength of the entity that issues a fixed income instrument, as well as the type of issuer, its sector and the maturity and structure of a bond.

“These considerations cannot be separated from other factors, such as inflation developments, prospective central bank policy interest rate changes, liquidity conditions and foreign exchange movements,” Nuzzo commented.

While there have been positive developments in the industry, with many investors and CRAs intensifying their focus on analytical tools and resources as well as launching dedicated ESG web pages and boosting their transparency efforts, the PRI believes incorporating ESG integration more systematically in credit risk analysis will require fundamental institutional changes.

This may include examining how credit analysts should be incentivised and equipped with the resources required to broaden their analysis beyond traditional financial variables, according to Nuzzo.

“It also raises questions around the role of senior management in promoting the systematic and transparent integration of ESG factors in credit risk analysis. And what role should regulators play, if any? Finally, how can investors and CRAs help to reinforce the need for enhanced data disclosure by issuers?” Nuzzo commented.