Taking a fixed-income perspective on ESG ratings

Environmental Finance: Sustainable Fitch has recently announced the launch of its ESG Ratings products. What approach have you taken with the new product? 

Andrew Steel: After we integrated the transparent display of ESG risks into Fitch’s credit ratings, we saw a rise in the number of asset managers and owners asking us for detailed ESG ratings which went beyond financial materiality to include analysis on ESG performance, impact and outcomes. This gap in the fixed income market led us to build a framework for ESG analysis which captures these risks for both entities and individual debt instruments. 

Andrew SteelWe started from the fundamentals, by building an analysis framework from the bottom-up that provides asset owners with a modular, granular data set and commentary with a lot of emphasis on activities and outcomes, as well as aspirations. While the ESG Ratings will positively factor in science-based targets, they also recognise the impact of the business’s current activities. To get a proper cross-comparison of entity ESG performance between sectors, it is crucial not to under-emphasise current activities, or use ‘best in sector’ scoring where significant activity impact differentials exist.

By the end of this year, we anticipate that we will have covered around 900 entities and nearly 2,000 labelled and sustainability-linked bonds. 

EF: What interaction have you had with issuers on the ratings? 

AS: For every entity that we cover, we share the report we produce for commentary and feedback. The level of interaction from issuers was much higher than we anticipated: over 50% actively engaged with us on the reports that we’re producing. I think that’s because of the quality and the granularity in those reports.

Beneath the overall E, S and G factors, there are a large number of sub-factors, supported by a number of data sets. For instance, if an investor is interested in something as specific as environmental supply chain management, they can see a separate score and commentary for that, and compare it with other entities we rate. Our ESG Ratings provide a very high level of granularity. 

EF: The ratings are particularly aimed at fixed income investors. How has that guided the approach you’ve taken? 

AS: The detail and granularity we provide in our entity-level ESG Ratings means they can be used equally by debt or equity investors, allowing investors to pick and choose the aspects that are relevant to them. Our bottom-up approach in building the ESG Ratings also allows for easy aligment with different frameworks, whether the Sustainable Development Goals, ICMA principles, EU Green Bond Taxonomy or any other requested taxonomy.  

But for fixed income investors, it’s very much about the instrument-level ESG Ratings. There are two things that differentiate them. The first is that we cover all types of labelled or sustainability-linked debt instruments, not just bonds. The second is that we can also provide an ESG instrument rating for an issuer’s conventional bonds. This takes account of how they are aligned with its entity-level ESG framework and ESG policies, long-term aspirations and targets. That allows an investor to gain insight into whether, for example, a conventional bond from a telecoms company might better fit its ESG portfolio than a green bond from an oil company. 

EF: Separately to your ESG ratings, you also produce ‘climate vulnerability scores’ looking at longer-term climate risk. How do these work? 

AS: We have embedded our ESG Relevance Scores into Fitch’s credit ratings to provide a view on the financial materiality of ESG risk issues on a value-neutral basis. Lots of companies, however, are very good at managing near-term environmental and social risks to ensure there’s no financial impact. However, when you start to look longer-term, the changes to sector risk profiles may change significantly, depending on what type of climate scenario emerges, and influence how companies need to prepare for future risks. 

For our Climate Vulnerability Scores, we picked a 2°C scenario and looked at what actions will be needed for countries, industry sectors, and manufacturing processes to become net zero. An entity that may be effectively managing its environmental risk today might face a longer-term scenario where it becomes exposed to legislative changes that might shut part of its business down or dramatically change its cost profile. 

We can then use this information to start to connect credit impact with ESG performance. The short-term, value-neutral, financial materiality of ESG risks is displayed in Fitch’s credit ratings; the potential long-term credit risk from climate change is shown in the Climate Vulnerability Score; and the ESG Ratings show if and how the company is recognising and dealing with these longer-term risks. The granularity enables investors to either agree with or make their own alternative assumptions about which scenarios are likely to transpire.  

EF: What are the next steps for the ESG ratings product?

AS: We’re also building coverage of the leveraged finance market, working with a significant number of European and US managers. We’re aiming to have that completed by the end of the year. Once we’ve completed ESG ratings for the labelled bond universe, we’re looking at extending coverage to some of the conventional bond indices. Ultimately, over the long term, we aim to cover the entire bond universe, but we’ll be guided by the immediate requirements of investors.    

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