Fitch Ratings was awarded Environmental Finance's 2020 award for most transparent credit ratings agency. Andrew Steel, its global head of sustainable finance, explains how the firm has integrated ESG analysis into its ratings process – and what comes next
Environmental Finance: What is it that sets Fitch apart from other credit rating agencies when it comes to ESG and credit ratings.
Andrew Steel: There are a couple of things. The first is that, in determining our approach to assessing how ESG influences credit decisions, we sought to address the specific concerns that investors have raised around credit ratings and ESG – namely which ESG factors are relevant from a credit perspective, and then how material each relevant risk factor is to a credit decision being made for an individual entity or transaction. The templating system and the scoring process that we created are specifically designed to address that. It's not broad brush – it's about identifying the precise ESG issues that actually cause ratings to change.
The other thing that sets us apart is the way in which we went about this. We saw that the future would involve more and more integration of ESG factors in credit analysis, so we took the decision that, in turn, we should fully integrate ESG into our process and involve all our analysts in assessing these ESG factors. We've now trained more than 1,400 of our credit analysts on ESG and worked with them to extract ESG elements from our existing criteria to create sector-based scoring templates.
We have been able to create templates for industry sectors across all asset classes, including structured finance, which guide investors, issuers and our analysts on the areas of ESG risk that we consider to be most relevant. We're now at a point where we have 97 sector templates, covering over 10,750 entities and transactions, providing a rich dataset of over 150,000 individual scores – that's 90%-plus of our publicly rated entities, and we're constantly adding to this with a target of getting as close to 100% as possible.
EF: Why does transparency matter, and which aspects of it are key for fixed income investors?
AS: What we found was, when you look at these granular ESG risks, sector-by-sector, and apply them to individual entities, the impact can vary considerably. The E, S and G risks identified do not map neatly to the areas of traditional qualitative and quantitative analysis that fixed income investors typically undertake. Often when considering a particular ESG risk from a credit perspective, if it materialises, its impact can fall across several different areas of qualitative and quantitative analysis.
Even within a sector, the way in which an ESG factor impacts an individual entity is very strongly linked to that entity's business or financial profile. For example, if an automotive manufacturer breaches emissions rules, but has a dominant market position, low leverage and high net cash flow, the impact may only affect its profitability. On the other hand, if the automotive manufacturer were more highly leveraged, had a niche market position, and weaker cashflow, then the impact might materialise across both profitability, its overall debt structure and result in damage to market position. As we rolled-out our scoring across sectors, it became very clear that you need transparency down to an individual entity level to understand materiality of ESG factors when it comes to credit. Overall there can be huge variations in how ESG factors impact different entities' credit profiles, even within a sector.
EF: Investors are on a journey to incorporate ESG analysis into their investment processes. What do you think they want and need?
AS: Our main business at Fitch is credit ratings and analysis. The credit ratings that we produce are based on short- to medium-term forecasts, and we produce and maintain our ESG relevance scores concurrently with the credit ratings. Whilst investors appreciate the credit-focused nature of the scores, we often get asked for our views on the 10-, 15- or 20-year outlook for the impact of ESG on credit risk in a sector. For example, in the next 10 years, is the oil and gas sector most vulnerable from a credit ratings perspective, or is it more vulnerable over a longer timeframe? Similarly, for an automotive manufacturer, will electrification of vehicles impact credit profiles mainly after 2035, or is it likely to occur before then? These are the types of things that investors are looking for more perspective on.
Clearly investors would also like to see better and more consistent disclosure of ESG data in the market and, globally, a more standardised approach. I think investors are looking to the big credit rating agencies to not only try and help with standardisation, but also to provide scale and consistency of analysis. There's been some excellent work on disclosure done by the PRI and the TCFD, and also by some ESG service providers and stock exchanges. But it's really only a start to developing something which is clear and easy enough to be implemented, not only by very large companies, but also by smaller and medium-sized enterprises.
EF: Given investor needs around ESG, what plans does Fitch have to help address them?
AS: We have a number of initiatives at various stages of development. We're looking at complementing our ratings by providing greater granularity and analysis around the longer-term vulnerabilities of issuers to ESG risks over time – for example, looking at risks for different sectors, up to 2050, and thinking about the points where you would see the maximum levels of exposure from a credit risk timeframe, under particular scenarios.
Outside of the ratings, we're also looking at potential coverage of the green and sustainability bond market, including whether we can examine and assess the ESG characteristics of unlabeled bonds. Generally, we're looking at how we can broaden our analysis from a fixed income perspective; and I'm sure we'll have more to say about this over the coming months.