ESG in Credit Analysis
What is “ESG in Credit Analysis”?
Environmental, social, and governance (ESG) factors are commonly incorporated into credit analysis to assess the capacity of the borrower to repay debt. Analysts identify and track ESG factors that impact a company’s financial performance in order to assess its ability to service debt. The rationale is that improper ESG risk management will negatively affect financial performance and increase the likelihood of default. Fixed income instruments issued by such companies will be priced at a discount to those issued by companies that manage their ESG risks responsibly.
Key Learning Points
- The analysis of ESG factors affecting the issuer is done as part of the assessment of the issuer’s capacity to repay its debt.
- ESG factors that impact the price and yield of fixed income securities include those specific to the issuer as well as those that influence the whole industry.
- ESG factors may pose both risks and opportunities for companies that issue fixed income securities, but those relating to downside risks are particularly relevant in the credit space.
- The capacity to repay debt, as well as considerations of collateral, covenants, the character of the management as well as features of the fixed income security determine the size of credit valuation adjustment needed to value the security.
Credit analysts and credit rating agencies generally assess debt issuers’ operating performance using a range of traditional analysis methods such as profitability, liquidity, and solvency ratios. ESG factors are increasingly important because companies that fail to address ESG risks often find themselves facing fines for environmental damage or the inability to comply with new environmental regulations. They may also suffer from reputational risks if they fail to manage health & safety issues that their employees or those working for their suppliers face.
ESG risks are therefore considered to be part of the assessment of an issuer’s so-called “capacity”, which is the ability to service and repay debt. Considering such factors allows the analyst to better understand the business and its ability to withstand shocks. Other factors also taken into account are the characteristics of any debt covenants, collateral, and the overall character or quality of the company management.
In addition, credit analysts need to consider not just what all the different ESG risks are and which ones are particularly material to the business. They also need to understand the specifics of the financial instrument, typically a corporate bond, that they are assessing and trying to value. Some debt instruments have a relatively short time period to maturity, so long-term risks faced by the issuer are unlikely to be relevant to the valuation of such short maturity instruments.
As a result, borrowers that face significant climate transition risks see their debt instruments trade on high yield as the market requires a higher rate of return to compensate investors for the risks that stem from such ESG considerations.
To value fixed income security that is subject to credit risk, an analyst could first value it on the assumption of no default. With the help of credit risk modeling, the credit risk is then reflected in an adjustment to the risk-free value referred to as credit valuation adjustment, which is deducted from the risk-free value of the bond. ESG considerations would be reflected in that adjustment too.
Given the below information, we have been asked to calculate the fair value of the bond, taking the ESG factors into account.
The calculated bond value of $105.20 assumes no credit risk but additional credit valuation adjustments are required which are detailed below:
It has been established that two credit valuation adjustments were needed to reflect the risk of default, capturing a range of operational and financial risks the business faces, including ESG risks. As a result, the final value of the bond would be $100.20.
Consideration of ESG factors has become an integral part of credit analysis because those factors can significantly influence the business in question and thus impact its ability to repay its obligations to creditors. Analysts identify and assess material ESG risk factors in order to evaluate how well the company in question is managing them. If the identified risks are being inadequately addressed by the company, the valuation of the company’s fixed income instruments and the yield they offer to investors would need to reflect those risks.