Monday, 10 July 2017

Credit Rating Agencies’ Entrance into the Sustainable Finance Market: More Concerns Raised

On the 22nd May here in Financial Regulation Matters, a recent article produced by this author and published in the International Business Law Journal was previewed regarding the leading credit rating agencies’ entrance into the sustainable finance market, with particular reference to their adoption of ‘Environmental, Social, and Governance’ (ESG) concerns into their rating portfolios. These concerns, which are aligned to the ‘Principles for Responsible Investment’ (PRI) initiative, are increasingly of pressing concern to investors and, as such, the rating agencies have responded by tentatively agreeing to factor these important principles into their rating methodologies. However, a report conducted recently by the PRI has concluded that there are ‘disconnects’ between investors and rating agencies, with particular reference to how both parties are factoring in these ECG concerns into their business. So, in this post, we shall focus upon this report and its findings and emphasise, yet again, that there must be an increased vigilance into the rating agencies’ adoption of these important principles.

The report, which is the first of three on the PRI’s ‘initiative to enhance the systemic and transparent consideration of ESG issues in the assessment of the creditworthiness of borrowers in fixed income markets’, aims to be an introductory analysis into this important and new sector of finance. The report begins my making clear that there is tangible evidence that both investors and CRAs are making progress with regards to recognising ESG issues by way of increased resources being deployed, but that the two parties are at very different stages in the process. For the PRI, the main concern at this moment in time lies in the divergence between the CRAs’ understanding of the confines of ESG concerns, and the investors’ understanding, which is encapsulated in the PRI’s question of ‘how can investors and CRAs address the issue of timeframes for long-term ESG risks?’. In simplified terms, the issue at hand concerns the divergence regarding time-horizons, as ‘there may be a disconnect for buy-and-hold investors since a credit rating agency’s long-term rating “may not be forward-looking enough”, and for more frequent traders, “it could be too long-term”’.

It is fair to note that the PRI is hopeful but not particularly impressed by the rate of development, with one connected onlooker noting that ‘the dial is definitely beginning to move in the right direction, but we are not at a stage yet where ESG factors are systematically included in credit risk analysis… ESG integration is still perceived as a “nice to have” rather than a “must have”’, which is a sentiment echoed by the PRI with its rebuke of investors’ incorporation of ESG in that ‘it can be advisory in nature and the responsibility often falls on ESG analysts alone to raise red flags’. Furthermore, and in support of the generalised criticisms of the rating agencies – which have seen them fined time and time again – the PRI declare that ‘CRAs acknowledge that they need to be more explicit and transparent about other ESG factors’ other than just the ‘governance’ criteria.

Whilst the PRI is remaining cautiously optimistic about the entrance of the CRAs into this particular field, others are not so convinced. Apart from the article produced by this author, others have been clear that the rating agencies’ incorporation of these principles is simply not up to standard, whilst a senior member of Hermes recently stated that although ESG factors are extremely important in determining creditworthiness, ‘credit ratings do not sufficiently reflect ESG risks’. This understanding casts further doubt on both the effectiveness of the rating agencies’ output, and moreover the need to have rating agencies at all – it seems that Professor Partnoy’s assertion that rating agencies’ outputs are of ‘scant informational value’ grows truer by the day.

The calls for rating agencies to do more in this field began to pick up pace last year, and rating agencies have responded in king by pledging their support for the ideal of incorporating ESG into their analyses more. However, what the PRI are experiencing is something that was entirely predictable simply because the leading rating agencies have inherent issues which permeate every element of their practice. Rating agencies do not make their money through being transparent and timely with the release of their information, so to expect them to do so is a clear indication of the actual v desired dichotomy that is consistently preached here in Financial Regulation Matters. Whilst the PRI are not wrong for encouraging the CRAs to incorporate such factors, it is important that they are clear in their understanding of who it is they are actually dealing with. Ultimately, investors will have much more impetus to incorporate ESG factors into their decision making as it potentially protects them from losing their investments – rating agencies have no such concern. In fact, in a rather crude understanding, the impetus for rating agencies has not changed since before the financial crisis, which is arguably why their behaviour has not changed either – they make their money by allowing products to come to market. This understanding alone, if accepted, is the key reason for why the entrance of the leading rating agencies into this ever-growing and important area of finance needs to be viewed with extreme vigilance, because the underlying sentiments of the parties involved are simply not aligned. Rating agencies can be useful in this endeavour, but they must be consistently and thoroughly monitored in order to protect against the iniquities of the industry taking hold of this societally-important endeavour.

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