CRISTIANO ZAZZARA | S&P - The link between ESG factors and credit risk

The Link between ESG Factors and Credit Risk A Case Study on Energy Transition Risk

Cristiano Zazzara, Ph.D. Managing Director Risk Services S&P Global Market Intelligence cristiano.zazzara@spglobal.com

Sustainable Finance and Integrated Thinking – Today and Tomorrow Conference organized by MIB Trieste School of Management & Generali Trieste – October 16, 2018

TABLE OF CONTENTS Executive Summary  The Relevance of Environmental, Social and Governance (ESG) Factors  ESG Metrics That Matter  Market & Regulatory Trends  How is ESG Risk measured? A Review of ESG Ratings Vendors’ approaches  Interplay of Energy Transition Scenarios & Credit Risk  Caveats and Potential Implications for Investors

References

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Executive Summary  Environmental, Social and Governance (ESG) factors are becoming relevant in getting greater insights into company performance − In the past years, the number of companies reporting ESG information increased from fewer than 20 companies in the early 1990s to nearly 9,000 in 2016 − Investors interest in ESG data also grew rapidly. As of 2017, the UN Principles for Responsible Investment (PRI) - launched in 2006, and committed to incorporating ESG issues into their investment analysis and practices - had about 1,700 signatories with total Assets Under Management of about $68 trillion − Additionally, Regulation is currently driving Investment Managers, Banks, Insurers , and NonFirms to invest in new capabilities to complying with ESG requirements

 Interplay of Financial and ESG issues as a key additional dimension of risk − The intersection of Financial and ESG issues generates new risks over a longer risk horizon, which should be factored into company valuation frameworks from fundamental analysis − However, understanding, measuring, and pricing this new sources of risk presents challenges due to the wide breadth of ESG-related issues coupled with data limitations

New business and analytical tools are needed to understand how to create a sustainable business model in the long-run, and how to assess extra-financial risks impacting corporate and investment performances 3

WHAT IS ESG?

4

ESG is critical to long-term value creation for companies and investors Green Investing Does Not Require Financial Sacrifice: ‘In 90% of cases, environmentally efficient companies have lower costs of capital and superior stock market performance’ Oxford University Study Top Factors Driving Value Creation

Environmental Social Governance

• Greenhouse Gas (GHG) Emissions • Resource Consumption (Water, Energy, etc.)

• Stranded Asset Exposure

• Product Safety and Quality • Supply Chain Labor Standards • Human Capital Development

• Remuneration • Shareholder Rights • Board Composition and Policies

Implications for Companies and Investors

1

Reduce exposure to external

2

Increase franchise value

risks

with employees, customers and investors

3 4

Reduce or contain costs, e.g. resource consumption Comply with regulatory requirements

Source: S&P Global-TruCost Survey, GIST Advisory, Oxford University

5

Challenges due to lack of standards, data and analytical tools to assess ESG risks No Longer Niche: ‘More than a quarter of the $88 trillion assets under management globally are now invested according to Environmental, Social and Governance principles known as ESG.’ McKinsey

ESG Customers Investor

• Exclusionary screening • Sustainability-Themed Investing

Lender

• ESG-Linked and Asset-Based Lending • Track Loan Covenants

Customer Pain Points Data

Analytics  Forward-looking Models  Impact on Financial Metrics

• Risk Management (production, reputation) Supply Chain • Expense Management (resource Manager consumption)

Coverage CFO

• Financial Analysis of ESG Factors • Regulatory Compliance and Reporting

 Access to underlying data points  Asset-Level Data, e.g. factories

 Multi-asset class, sector, region  Coverage e.g. Small Cap Companies

Source: TruCost Survey, S&P Global ESG Task Force Research, McKinsey

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ESG METRICS

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Market Size – Investors Care about Sustainability Proportion of Global ESG Assets by Region, Total AUM USD $22.89 trillion 2016 $1,086 $516

Number of Signatories (RHS) and associated AUM (LHS, USD $ trillion) 80.0

1800

70.0

1600 1400

60.0

1200

50.0

1000 40.0 800 $8,723

30.0

$12,040

600

20.0

400

10.0

200

0.0

Europe 52.6%

United States 38.1%

Canada 4.7%

Australia/New Zealand 2.3%

Asia ex Japan 0.2%

Japan 2.1%

Source: 2016 Global Sustainability Investment Review (www.gsi-alliance.org/)

0

AO AUM ($ US trillion) Assets under management (US$ trillion) Number of AOs Number of Signatories Source: PRI, UN Principles for Responsible Investment (www.unpri.org/), April 2017.

“In 2017, more than one-quarter of AUM globally was invested according to the premise that ESG factors can materially affect a company’s performance and market value” – McKinsey (https://www.mckinsey.com/industries/private-equity-and-principal-investors/our-insights/from-why-to-why-not-sustainable-investing-as-the-newnormal) To change, turn on or off footer: Insert > Header & Footer > Enter / change text > Click Apply All.

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ESG Assets are growing in every Region  Europe is leading, but US and other regions are growing faster Europe vs. US: Growth rate 2014-2016 32.7%

35.0% 30.0% 25.0% 20.0% 15.0%

11.7%

10.0% 5.0% 0.0% Europe

REGION Europe United States Canada Australia/New Zealand Asia ex Japan Japan Total ESG AUMs

United States

ESG AUMs $10,775 $6,572 $729 $148 $45 $7

2014 % of Total ESG AUMs 59.0% 36.0% 4.0% 0.8% 0.2% 0.0%

ESG AUMs $12,040 $8,723 $1,086 $516 $52 $474

2016 % of Total ESG AUMs 52.6% 38.1% 4.7% 2.3% 0.2% 2.1%

$18,276

100.0%

$22,891

100.0%

Source: Global Sustainable Investment Alliance - GSIA (2016), “Global Investment Review”, http://www.gsi-alliance.org/wp-content/uploads/2017/03/GSIR_Review2016.F.pdf

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MARKET & REGULATORY TRENDS

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A view from Investors: Survey-based Evidence  Results represent feedback form those considering ESG info when making investment decisions 100.0% 90.0% 80.0% 70.0% 60.0% 50.0% 40.0% 30.0% 20.0% 10.0%

ESG information is material to investment performance

Of growing client/stakeholder demand

We see it as an We anticipate it to It is part of our We believe such policy to be effective investment product ethical responsibility become material in the near future strategy in bringing about change at firms Agreed

Europe

US

All

Europe

US

All

Europe

US

All

Europe

US

All

Europe

US

All

Europe

US

All

Europe

US

All

0.0%

Of formal client mandates

Disagreed

Source: Serafeim G., A. Amel-Zadem (2017), “Why and How Investors Use ESG Information: Evidence from a Global Survey”, forthcoming in Financial Analyst Journal.

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World Economic Forum Risks Rankings (Jan. 17, 2018) 

ESG Risks increasingly important −

The World Economic Forum Annual Global Risk rankings show the steady growth of ESG related concerns over time among global corporate leaders

−

In the 2018 survey, four of the five main risks cited were Environmental – Extreme weather events, Natural disasters, Failure of climate change mitigation - and Social - Water crises

−

This shows a dramatic change in corporate attitudes: a decade ago, the majority of the risks were perceived as economic or geopolitical Top 5 Global Risks in Terms of Impact – According to Corporate Executives

Source: World Economic Forum, “The Global Risks Report 2018”, 13th edition (https://www.weforum.org/reports/the-global-risks-report-2018).

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The EC Action Plan on ESG Accounting (Mar 2018)  Lack of comparability and standards in reporting ESG information −

The European Commission highlighted that financial accounting practices may not always be compatible with sustainable finance. Interestingly, the Commission raised concerns about the (negative) impact the new accounting standard IFRS 9 might have on long-term ESG investments √

The solution they propose comes from the European Financial Reporting Advisory Group (EFRAG), whose task is to ensure that European views are properly considered in the IASB standard-setting process and in related international debates

√

The Commission will set up a European Corporate Reporting Lab, modeled after the UK Financial Reporting Council’s Corporate Reporting Lab. This will promote innovation and development in corporate reporting practice, such as environmental accounting and the TCFD recommendations in particular. EFRAG has also been requested to assess the impact of IFRSs on sustainable investments

 Global Impact “The Commission will promote discussions on this Action Plan in existing fora, such as the Financial Stability Board, the G20, the G7, the United Nations and the International Organisation of Securities and Exchanges Commission (IOSCO)”

−

This sentence is very important, because it provides support to the global relevance of ESG issues: these regional regulatory actions will definitely have an impact beyond Europe

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EU HLEG Report & EC Action Plan on ESG (Jan-Mar 2018) 

ESG: From Awareness to Policy −

Awareness of sustainability has seen a marked acceleration since 2015 – the year the Paris Agreement and the Sustainable Development Goals were adopted

−

On January 31, the EU High Level Expert Group on Sustainable Finance (HLEG) published its final recommendations to the European Commission (EC) in its Financing a Sustainable European Economy report •

−

On March 8, the European Commission (EC) published its Action Plan: Financing for Sustainable Growth in response to the recommendations of the HLEG •

−

The Plan consists of 10 action items , but we note this is not formal legislation yet

Tackling short-termism is a key theme in both the HLEG Report and EC Action Plan •

−

These recommendations from HLEG will cement ESG (Sustainability) into the financial landscape

Climate change and ESG issues are by nature long-term, and can only be addressed with longer-term thinking, hence the desire to address short-termism across finance in general

Existing supervision could be updated to include ESG elements (explicit reference to BASEL III, MiFID II, AIFMD, UCITS, SOLVENCY II, etc…) – The mandates of EBA, ESMA and EIOPA could be reviewed to include ESG-related objectives •

The HLEG report and the EC Action Plan also gave specific guidance to other segments of the financial services industry, including: Credit Rating Agencies and Index Providers 14

Market Trends – Impediments to ESG integration  According to a recent report from HSBC, a number of key challenges remain: – Lack of comparability and standards in reporting ESG information • Patchy across sectors and geographies • ESG disclosure is too infrequent to be useful – Costly to gather and analyze ESG information • ESG data is collected, managed and dispersed by multiple providers • Lack of reliability of data/lack of audit and assurance – Disagreements on materiality • Lack of quantifiable ESG information

Source: HSBC Global, “ESG Sector Playbook”, November 2016.

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CRITICAL REVIEW OF ESG RATINGS VENDORS

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SCOPE OF OUR ANALYSIS • Selection Criteria: – In-scope: ESG Ratings of Companies (entity-level focus) – Coverage of E, S and G: Specialized vendors on one of these dimensions not included (such as Carbon trackers, etc…)

– Vendors with a productized ESG offering: Firms that offer only customized ESG analyses or ESG advisory services not included (such as Asset Managers and Investment Banks offering ESG advisory services) – Analysis based on publicly available Information (websites, research reports, etc...). All online sources are reported and available to Task Force Members – Focus on for-profit organizations: Offerings from Governmental Organizations (GOs) and Non-GOs not included – Out-of-scope: ESG Ratings of (Investment) Funds (Mutual and ETF) and Securities (such as green bonds), ESG Indices • Our sample includes 18 ESG Rating Vendors, representative of a segment of ESG data & analytics produced by third-party information providers (as of April 2018)

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OUR LIST OF ESG RATINGS VENDORS The following Table identifies the 18 ESG Ratings Vendors under examination (ISS was included due to its recent acquisition of Oekom).

No. 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18

ESG Ratings Vendors MSCI ESG Company Ratings Bloomberg ESG Disclosure Score Thomson Reuters FTSE ESG Ratings Sustainalytics ESG Company Reports - Solaron RobecoSAM Corporate Sustainability Assessment Oekom - ISS Governance Score Arabesque S-Ray RepRisk Truevalue Labs Covalence Vigeo Eiris HIP Investor Ratings Inrate Sustainability Ratings EcoDesk EcoVadis Supplier Sustainability Ratings 18

OVERVIEW OF THE 18 ESG RATINGS VENDORS (1) VENDORS 1. MSCI ESG Company Ratings

Product/Description

2. Bloomberg ESG Disclosure Score

The MSCI ESG Ratings The Bloomberg ESG measure information on Score measures the degree of firms’ Environmental, Social, transparency on ESG and Governance issues. factors.

3. Thomson Reuters 4. FTSE ESG Ratings

The Thomson Reuters Corporate Responsibility Ratings (TRCRR) measures a company’s ESG performance as well as its E, S, and G score.

5. Sustainalytics ESG Reports

6. Solaron

The Rating system Sustainalytics covers E, S and G issues.

Provides ESG Company ESG FTSE Russell’s ESG Reports provide research and analysis Ratings are also used to qualitative analysis and custom reporting construct the ESGand quantitative related FTSE4Good ratings Index Series.

Factors

Overview

Information

ESG Ratings, research, ESG Ratings, research, ESG Ratings, research, ESG Ratings, research, ESG Ratings, data & analytics data & analytics research & analytics data & analytics data & analytics

ESG Provided

Rating Type Industry Specific

Coverage

• The ratings are based The FTSE Russell’ ESG • on data from the Ratings are based on The rating accounts ASSET4 database, 300+ indicators, where for more than 70 which is managed by each company’s rating is general and industry• Thomson Reuters and built upon an average of specific weighted • contains over 250 key 125 indicators.

• performance indicators on ESG

MSCI rates firms on 209 Bloomberg score firms exposure and on 120 metrics using a management metrics, proprietary model. covering 37 key ESG Data are collected from issues, using a public sources and via proprietary model. a proprietary survey

Companies Cost

Access Distribution

Scale of AAA to CCC

50+ indicators 400 ESG and industry specific criteria 35 Risk themes 3000+ news feeds History since 2007 ESG Research & Ratings

The ratings range from The ratings range from 0 Scales of 1–5 (abs) and Scale of 0–100 (low– Letter rating and 0high) 100 score 0 (low) to 100 (high) (low) to 100 (high) 1-100 (relative by sect)

YES

YES

YES

YES

YES

YES

6,500 (unique) listed firms

10,000 listed firms

5,000 listed firms

4,100 listed firms

8,400 listed firms

4,800 companies

Fee-based: Undisclosed

around $24,000 per year

$600 per year (Ratings only) Dedicated online platform

Fee-based: Undisclosed

Fee-based: Undisclosed

Fee-based: undisclosed

Online platform

Bloomberg terminal

Online platform

Online platform

Online platform

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OVERVIEW OF THE 18 ESG RATINGS VENDORS (2) VENDORS

Product/Description

7. RobecoSAM

8. Oekom

The RobecoSAM Corporate Sustainability Assessment (CSA) addresses ESG issues.

Provides ratings, research, trends and risk analysis

9. ISS Governance Score

10. Arabesque S-Ray

11. RepRisk

12. TruValue Labs

The RepRisk TruValue Labs uses Arabesque S-Ray Company Report rate artificial intelligence Provides company E&S monitors the firms based upon to deliver timely, and G scores, research sustainability of their exposure to ESG objective ESG ratins and data analysis corporations via scores risks. with an outside-in and filters perspective.

Factors

Overview

Information

ESG Ratings, data & analytics

Research & Ratings

Scores, data and research

ESG Ratings, data & analytics

Rating Type

Scale from 0 (low) to 100 (high)

Letter grade scale

Numeric decile

0 (low) -100 (high)

Ratings from AAA to D

0 (low) -100 (high)

YES

YES

YES

YES

YES

YES

3,400 listed firms

5,500 listed firms

5.600 listed firms

7,000 listed firms

85,524 listed firms

8,500 listed firms

$24,000 per year

Fee-based: undisclosed

Fee-based: undisclosed

ESG Provided

Industry Specific

Coverage

Companies Cost

Access Distribution

• 100 sector selected social and environmental indicators Alignment with • UNSDG and PRI Industry peer benchmarking

Via Bloomberg Terminal ORBIT online database

E&S QualityScore uses 380 factors and disclosure standards for a E&S risk score Governance Quality Score uses 200 factors to score performance

Metrics are based on 27 main ESG issues - ESG Metrics based that guides the risk (across sub-scores) on SASB’s Materiality screening and - News signals from over Map standards identification 50,000 sources across - Historical data for 5 process, plus 36 15 languages years specific ESG “hot - Historical data for 10 topics” and themes. years Historical data for 10 years

The scores come from • 80–120 industryspecific questions gathered in the CSA. The CSA measures • companies’ performance on • sustainability issues that directly affect financial outcomes.

Online platform

- 200 ESG metrics

ESG Ratings, data & ESG Ratings, data & analytics analytics

Between $5 and $50K Reports from $450 to per year $3,500 Online platform

Online platform

Fee-based: undisclosed Online platform

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OVERVIEW OF THE 18 ESG RATINGS VENDORS (3) VENDORS 13. Covalence

Product/Description

14. Vigeo Eiris

15. HIP Investor Ratings

Vigeo Eiris rates ESG ratings and rakings individual companies developed from Scores and ranks using the Vigeo Eiris company disclosures companies using a Rating, which reflects a and publically available quantitative based composite score across information ratings methodology six domains that reflect ESG issues.

16. Inrate Sustainability Ratings

17. EcoDesk

Sustainability rating agency with a focus on the Swiss market and companies in MSCI Wolrd/MSCI EM Indicies • ESG Impact Ratings • ESG Real Estate

Supply Chain sustainability platform

18. EcoVadis Supplier Sustainability Ratings

Collaborative platform of sustainability ratings for supply chains

Factors •

Overview

ESG Provided

•

• • • •

6 domains 38 sustainability drivers 41 sector subframeworks 330 indicators

• 3 Pillars of Research 5 Impact Pillars • (E) Earth (+)Company Reporting • • (S): Wealth, Health (-) Controversy Analysis • (+/-)Production Impact and Equality • (G): Trust • 180 + Indicators • 4-6 metrics per • Best-In-Class pillar.

Approach

• 230 indicators 275,000 data • points

175 global supply chains 21 CSR indicators • 150 categories • 120 countries

Information

Research and Ratings

Ratings and Research

Ratings & Information

Rating Type

Not disclosed

0-100 (low-high)

0-100

A+ to D-

N/A

0-100

YES

YES

NO

YES

YES

YES

3,500 Primarily Public

6,500

3,000

Fee based: Undisclosed

Fee based: Undisclosed

Fee based: Undisclosed

Fee based: Undisclosed

Free for suppliers Enterprise undisclosed

By Size: $500p.a $3000+ p.a

Online platform

Online Platform

HIP Ratings Portal, HIP Scorecards, data feed

Online Platform

Cloud, SaaS, Web

Platform & Scorecards

Industry Specific

Coverage

•

Company performance defined by 7 dimensions 50 ESG criteria aligned with GRI & UN framework Sector based rankings

Companies Cost

3,400 Primarily Public

Ratings and Research Supply Chain Ratings Supply Chain Ratings

-

12,000 organisations 100 countries

-

175 global supply chains 40,000 trading partners

Access Distribution

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KEY FINDINGS: METHODOLOGIES, INFO AND COST  Most tool providers use their own unique methodology to create their ratings, thus the ratings are not easily comparable across different tools – We’ve reviewed the underlying methodologies for each rating

• Some vendors are merging to provide full ESG Ratings – March 15, 2018: ISS (Governance Ratings) acquired Oekom (Environmental and Social Ratings)  ISS is a large data and analytical provider in the Governance space (more than $120 mln in Revenues)

 Most ESG Ratings platforms do not provide any financial information

 All of these ESG Ratings are fee-based tools, with an average cost of around $50K (however, the cost range is wide) − Not all the vendors provide the cost of their ESG ratings offering 22

KEY FINDINGS: ESG RATINGS INTERDEPENDENCY  ESG Ratings Vendors use data and analytics from other organizations, creating some methodological and commercial interdependency in their offerings: – Sustainalytics is the ESG Ratings provider of Morningstar Sustainability Rating for funds – RobecoSAM is the ESG Ratings provider of S&P Dow Jones Sustainability Indices – RobecoSAM relies on RepRisk real-time ESG score for its own ratings – Thomson Reuters relies on TrueValue Labs for real-time ESG scores on its Eikon platform – RobecoSAM relies on Bloomberg to distribute its ESG Ratings – Bloomberg redistributes ISS, Sustainalytics and RobecoSAM Ratings on its terminals

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KEY FINDINGS: ISSUES WITH ESG RATINGS  Our review of ESG Ratings shows a series of key challenges: – Quality of Information: • In many cases, the information used for selecting ESG factors comes from the companies themselves, which complicates the ability to verify, compare, and standardize this information – Lack of comparability and standards in reporting ESG information • Lack of quantifiable ESG information, qualitative info prevalent in ratings assessment. Disagreements on Materiality • Low agreements across ESG Ratings, in line with recent academic research (Chatterji et al, 2014) • ESG disclosure is usually on an annual basis, too infrequent to be useful – however, new vendors are providing near real-time ESG ratings based on Artificial Intelligence and publicly available info – Costly to gather and analyze ESG information • ESG data is collected, managed and dispersed by multiple providers 24

THE EVOLUTION OF ESG RATINGS MODELS  The Link between ESG ratings and “Financial Materiality” will be key for improving the informativeness of ESG data for market participants  Recent research shows that a very large number of ESG data points used by specialized vendors to rate companies are not material. According to: − Russell Investments (2018), less than 25% of the data items in the traditional ESG score are considered material − Harvard Business School (2017), firms with strong ratings on material ESG topics outperform firms with poor ratings over a longer horizons, both in terms of stock return (alpha) and financial performance (ROI, ROA, and ROE)  SASB (Sustainability Accounting Standards Board) in the US is very active on this front, with the goal of identifying financially material ESG metrics for industry sectors (https://www.sasb.org/)  More research is needed on this front, since the risk horizon for ESG assessments is longer than that of traditional financial analysis The Next Generation of ESG Risk Models should be able to differentiate factors that may affect financial and credit risk performance of a company, and/or the trading performance of its securities 25

ENERGY TRANSITION SCENARIOS & CREDIT RISK

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A CASE STUDY ON FIRMS IN HIGH-EMITTING SECTORS 

S&P Global Market Intelligence’s Risk Services and Trucost teams recently carried out an analysis for a project on “Energy Transition & Credit Risk” sponsored by the European Commission.



The empirical analysis explored the impact of energy transition risk scenarios on the credit risk of nine firms in the Utilities, Steel, and Cement sectors.

Interplay of Energy Transition & Credit Risk

FORWARD-LOOKING CREDIT RISK ASSESSMENT OF CLIMATE-RELATED IMPACTS (via a Scenario Analysis Approach) A

B

ENERGY TRANSITION RISK SCENARIOS • Transition to a low-carbon economy • 2-degree scenarios to reduce greenhouse gas (GHG) emissions to limit climate change in the long term (until 2050)

C

CARBON EARNINGS AT RISK

SCENARIO-IMPLIED CREDIT SCORE/PROBABILITY OF DEFAULT (PD)

• Financial impact on countries, sectors, and companies (Revenues, Costs, EBITDA) • Estimation of financial exposure to future carbon costs, based on current carbon taxes, emissions, trading schemes, and fuel taxes

• Credit risk materiality of energy transition risk at the entity-level • Scenario analysis using S&P Global Market Intelligence’s suite of Credit Analytics models, based on projected long-term financial metrics

Provided by Trucost

Provided by Risk Services

• Measurement of a “carbon price risk premium”, defined as the gap between current and future carbon prices; this premium reflects the additional financial cost per tonne of emissions from likely increased carbon pricing regulations in the future

• PD Model Fundamentals or CreditModelTM • Scorecards for specific sectors/asset classes (e.g., Specialized Lending, etc.)

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MAIN TAKEAWAYS FROM OUR ANALYSIS  Inaction by companies has consistently negative credit consequences under transition scenarios

Credit score: difference btw Frozen and other adaptive capacities

Figure 1 – Average notch difference in statistical credit scores (CreditModel) between Frozen and other Adaptive capacities 1.6 1.4 1.2 1 0.8 0.6 0.4 0.2 0 -0.2

Worsening credit quality

Improving credit quality 2016

2020

2025

2030

2040

ACT Utilities

LCT Utilities

ACT Cement

LCT Cement

ACT Steel

LCT Steel

2050

Source: S&P Global Market Intelligence (2018), “Connecting the Dots: Energy Transition Scenarios and Credit Quality”, report submitted to the European Commission.

Note: - ACT: Ambitious Climate Transition, 2-degree scenario - LCT: Limited Climate Transition, 2.7-degree scenario 28

MAIN TAKEAWAYS FROM OUR ANALYSIS  More firms are estimated to improve their credit quality under the various scenarios - In some cases, a company’s ability to grasp transition opportunities and a strategic alignment with energy transition drivers appears to be capable of outweighing the effects of transition risks, and result in improving credit quality  Impacts on credit scores (and related PDs) are not material for several firms

Largest change in credit score

Figure 1 – Range of changes in statistical credit scores (CreditModel) from 2016 baseline 2.5 2 1.5 1 0.5 0 -0.5 -1 -1.5 -2 -2.5

Worsening credit quality

Utilities

Cement

Steel Improving credit quality

A

B

C

D

E

F

G

H

I

Company Maximum increase in credit score

Maximum reduction in credit score

Source: S&P Global Market Intelligence (2018), “Connecting the Dots: Energy Transition Scenarios and Credit Quality”, report submitted to the European Commission.

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CAVEATS AND POTENTIAL IMPLICATIONS FOR INVESTORS  Our results should be considered illustrative and exploratory rather than definitive - In the context of Scenario Analysis, it is important to remember that:  Scenarios represent plausible future pathways under uncertainty  Scenarios are not associated with probabilities, nor do they represent a collectively exhaustive set of potential outcomes - Need to cover a wider range of industries facing climate-related risks and opportunities, directly or indirectly  Further work needs to be done by investors/lenders to embed scenario analysis in credit and investment analysis as a key exercise in managing forward-looking climate risks  These preliminary results suggest that there is potential value to investors/lenders in engaging with companies that seek more proactive management of transitions risks

Climate change-related scenarios generate not only downside credit risk, but also credit risk opportunities for companies (and, therefore, potential Alpha for investors)

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References 

Chatterji A., D. Rodolphe D., Levine D., Touboul S. (2014), “Do Ratings of Firms Converge? Implications for Managers, Investors and Strategy Researchers”, Vol. 37, Issue 8, Strategic Management Journal.



European Commission (2018), “Action Plan: Financing Sustainable Growth”, March, https://ec.europa.eu.



European Commission (2018), “Final Report of the High-Level Expert Group on Sustainable Finance”, January, https://ec.europa.eu.,



Global Sustainable Investment Alliance - GSIA (2016), “Global Investment Review”, April, http://www.gsialliance.org/wp-content/uploads/2017/03/GSIR_Review2016.F.pdf.



HSBC Global (2016), “ESG Sector Playbook”, November.



Khan M., Serafeim G., Yoon A. (2016), “Corporate Sustainability: First Evidence on Materiality”, Vol. 91, No. 6, Accounting Review.



Oliver Wyman (2018), “Extending Our Horizons: Assessing credit risk and opportunity in a changing climate: Outputs of a working group of 16 banks piloting the TCFD Recommendations - Part 1: Transition –related risks & opportunities”, April, www.oliverwyman.com.



PRI - Principle for Responsible Investment (2018), “Shifting Perceptions: ESG, Credit Risk and Ratings - Part 2: Exploring the disconnects”, June, www.unpri.org.



PRI - Principle for Responsible Investment (2017), “Shifting Perceptions: ESG, Credit Risk and Ratings - Part 1: The State of Play”, July, www.unpri.org.



Russell Investments (2018), “Materiality matters: Targeting the ESG issues that can impact performance”, March, https://russellinvestments.com/uk/insights/articles/materiality-matters.



Serafeim G., A. Amel-Zadem (2017), “Why and How Investors Use ESG Information: Evidence from a Global Survey”, forthcoming in Financial Analyst Journal,



S&P Global Market Intelligence (2018), “Connecting the Dots: Energy Transition Scenarios and Credit Quality”, report submitted to the European Commission.

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