The S Factor: Putting sustainability into credit ratings

EURODEBTRATINGS1106_key1

The S Factor: Putting sustainability into credit ratings

EURODEBTRATINGS1106_key1
Environmental risks as a result of pollution, ecological degradation and resource scarcity are having an increasingly measurable effect on the valuation of corporate assets around the world. Successive improvements in the realm of credit risk analysis have contributed to our improved understanding of risk, materiality, and how to factor material issues into analyses more systematically. Today, given the scale of pollution, ecological degradation and resource scarcity globally, society is beginning to understand the extent to which social and ecological risks, from water scarcity to rising sea levels, may affect the bottom line. The recognition and measurement of these risks in credit ratings, however, remains inadequate.  This paper argues that a new wave of innovation is needed, one that fully integrates sustainability factors into credit ratings. It then goes on to define, test and evaluate two potential approaches that could be used to examine credit and environmental risk.
Based on Moody’s 2010 corporate credit scores, results show mixed evidence for the significance of Trucost data on changes to median credit scores or their ranking, but strong evidence for them moving ratings downward materially. Using Boomberg’s ESG Valuation tool, the results show material changes in terms of adjusting cost forecasts. In order for credit rating assessors (CRAs) to calculate the rating of a company, they would need to obtain more accurate pricing factors for adjusting cost forecasts. The test results are based on integrated oil and gas and mining companies but are suggestive of inadequacies of current ratings methodologies for other sectors with a high environmental cost profile, such as power, utilities, or food. Full report here.

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