DBRS Morningstar's Takeaways From Its 2022 Credit Outlook Series: Understanding the Impact of ESG on Credit Profiles

As part of its takeaways series, DBRS Morningstar is publishing several write-ups about pertinent topics discussed during its 2022 Credit Outlook series. In the session titled “Understanding the Impact of ESG on Credit Profiles” Andrew Lin, Managing Director, Infrastructure, at DBRS Morningstar compared how the company's credit analysts assess financial risks from environmental, social, and governance (ESG) factors when rating corporate issuers with the approach of equity research analysts or sustainability analysts.

With the growth of ESG investing and the awareness of these issues in the financial markets, the difference between a company’s sustainability record and the financial risks from ESG is often confused, said Lin.

“ESG credit risk factors are quite different from the sustainability side of ESG,” said Lin. “While ESG sustainability factors focus on how a company affects the world—or a society—at large, ESG credit risk factors are more inward looking. It's more about how the world or society affects the company."

For example, when discussing climate change as a sustainability issue, the focus is on the company’s carbon footprint and emissions. But as an ESG credit risk issue, the focus is on how the company is financially affected by more volatile weather or rising sea levels as a result of climate change.

“Those who have read up on the sustainability side of ESG will recognize these same words because they are pretty much the same themes and the same topics. But we interpret those words and topics differently from a credit risk factor point of view,” Lin said.

While credit analysts and equity research analysts look at ESG in similar ways with both asking how ESG factors financially affect a company, Lin said equity analysts can look at a wide variety of large and small factors contributing to overall value. Credit analysts on the other hand typically look at the probability of a company honouring its debt obligations, including whether the company could comfortably repay its debt and if it could stay solvent over time. Further, the time frame for credit analysts tends to be shorter than for fundamental equity analysts, he said. For example, a long-term capital expenditure can be beneficial from an equity value viewpoint, but can be negative to credit analysts in the short-term point if it is debt funded.

Lin said ESG credit risk factors are assessed in the same manner as all other credit factors financially affecting the company, but noted the presence of an ESG credit risk does not necessarily mean it is material enough to have a financial impact on the credit rating if it is relatively small or fully mitigated. “In general, ESG sustainability factors have little material impact on a company’s credit profile as they are typically non-financial in nature.”

However, Lin said ESG sustainability factors can “sometimes” be a credit risk factor. He said this could happen if a company’s failure to meet sustainability targets results in legal, regulatory, or other penalties and if those penalties have a material financial impact. “If both of those boxes are checked, then those ESG sustainability factors can actually have an impact as credit risk factors.”

On the flipside, if a company meets sustainability targets that also result in savings and, if these savings are financially material, then such action could also be a credit risk factor.

DBRS Morningstar has developed a methodology that maps some 17 ESG factors ranging from emissions, effluents, and waste to the social impact of products and services, and bribery, corruption, and political risks. DBRS Morningstar’s Corporate Finance analytical group considers up to 15 of the 17 factors in its rating analysis, the Financial Institutions Group considers 12, the Governments group considers 10, and the Structured Finance team considers eight of them.

These factors are contained in the methodology titled “DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings,” published in February 2021. This methodology presents the standards that explain the ESG risk factors that may affect DBRS Morningstar’s assigned and/or monitored credit ratings across all global sectors and asset classes.

Written by Scott Anderson

Notes:
For more information on this credit or this industry, visit www.dbrsmorningstar.com or contact us at info@dbrsmorningstar.com.

DBRS Limited
DBRS Tower, 181 University Avenue, Suite 700
Toronto, ON M5H 3M7 Canada
Tel. +1 416 593-5577