Wayne Dass | ESG and Caribbean credit ratings

There is growing expert consensus that the physical effects of climate change are contributing to more frequent and extreme weather events, including floods and droughts. The COVID-19 pandemic showed us how wide and varying countries’ responsiveness can be to health and safety risks.

Governance matters including those tied to a board’s composition, skills sets and the existence of an ethical decision-making framework are emerging as major drivers of high long-term value and resilience in corporations.

These are all examples of ESG factors – environmental, social and governance – the impact of which has been increasing in recent years in many spheres of activities, including in the finance and investment fields.

Indeed, ESG has become an important and growing trend in shareholder activism worldwide. In the credit ratings world, it is well-established that material ESG credit factors can influence an entity’s creditworthiness, that is, its capacity and willingness to meet its debt obligations in full and on time.

A distinction is made here between ESG factors and ESG credit factors, in that not all ESG factors will necessarily have a direct and material enough bearing on creditworthiness. ESG credit factors are those ESG factors that will do so.

One can easily envisage how ESG credit factors can lead to a change in a rated entity’s revenue, operating costs, profitability and liquidity, ultimately impacting on its credit ratings.

As examples: in the environmental space, a financial institution’s rating can come under pressure if the rating agency is of the view that the FI will suffer from material loan losses from the impact of recent floods on its loan portfolio; in the social area, an entity found guilty of severe health and safety violations and subject to hefty fines can suffer financial and reputational damage with concomitant loss of business leading to an erosion of its creditworthiness; and in the governance realm, increasing political uncertainty and inaction to major economic and fiscal challenges facing a country – weak leadership and governance – can lead to external financing risks, which can result in a weakening in the sovereign’s ability to meet large upcoming external debt repayments, resulting in a lowering of its credit ratings.

Emerging trends

It is still relatively early days yet for a full incorporation of ESG into credit ratings but certain basics and trends are emerging.

There is understandably a high level of uncertainty associated with the projected impact – timing and likelihood – of some credit factors, for example extreme weather events, especially as it relates to how these influence long-term financial forecasts.

The impact of ESG credit factors on credit ratings can vary by industry, geography and entity; and can change over time as new information becomes available or policy changes introduce new costs.

High creditworthiness does not necessarily translate into strong ESG attributes and vice versa. An eco-friendly entity like a windfarm could have weak credit metrics in relation to its outstanding debt and therefore a high probability of default.

And ESG does not only pose risks but can also introduce opportunities. An entity faced with high negative impact from ESG credit factors can realise a boost to its credit ratings if it demonstrates that its ESG risk mitigation plan fully covers any potential negative fallout, for example, through insurance.

Historically, rating agencies have always included some aspects of ESG considerations in their credit risk analysis, particularly in the environmental and governance spaces. However, a considerably more formal and comprehensive approach is now being adopted that brings social credit factors into play and deepens the analysis of environmental and governance factors.

Amended methodology

Caribbean Information and Credit Ratings Services Limited, CariCRIS, Is currently in the process of amending its rating methodologies to include in a formal way relevant ESG considerations. For sovereign ratings, the key environmental issues to be considered include management of the effects of climate change, water resources and pollution, biodiversity, energy resources, air pollution, natural disasters and natural resources.

Major social factors comprise of human rights including social stability and living standards, education and human capital, health levels, employment levels, trust in society and institutions, crime and safety.

The governance issues consist of, inter alia, institutional strength, corruption, rule of law, regulatory effectiveness and quality, accounting standards, freedom of the press and political and civil liberties.

For corporate entities, the major environmental factors that will be considered include climate change vulnerability, use of renewable energy, use of clean technology and green building initiatives, toxic emissions and waste disposal, and carbon emissions. Social considerations here comprise labour management, health and safety, human capital development and supply chain labour standards. Governance issues comprise board governance – board member credentials, succession planning, board diversity, voting rights and transparency – as well as ownership profile, management track record and performance, business ethics and tax transparency.

The emphasis in the early stage of CariCRIS’s ESG rollout would be to gather and collate meaningful data that would inform the credit metrics and benchmarks. We intend to engage in meaningful dialogue with our clients and prospects to understand their plan to manage climate change risks and other ESG credit factors.

Our view is that updating our rating criteria and methodologies to include ESG considerations will result in rating opinions that more accurately reflect the economic and business realities faced by sovereigns and corporate entities in the Caribbean, in the face of growing impacts from extreme weather events and other ESG-related credit factors.

This should, in turn, enable investors and other stakeholders to make more informed financial decisions.

Wayne Dass is CEO of CariCRIS Limited.wdass@caricris.com