The UK’s Financial Conduct Authority (FCA) recently released a review of credit rating agencies. In it, they identify ESG as an emerging issue in credit rating methodologies. There is an acknowledgement that ESG factors can impact a firm’s financial credit rating. However, there is a lack of transparency and uniformity in rater methodologies. The FCA identifies the following areas for improvement:
- “Transparency of methodologies: We observed variations in how firms considered ESG factors in their published methodologies. Firms should be clear in the purpose of their published materials and articulate whether a methodology addresses ESG factors as analytical inputs or explanatory outputs. This would support transparency for users and align with firms’ disclosure obligations.
- Consistency of ESG factors: From reviewing files and discussing with firms, we identified inconsistency in how they were classifying and documenting ESG factors. For some CRAs, governance factors were sometimes treated as ESG factors, and at other times considered within broader credit risk analysis. Such inconsistency could reduce clarity for users of credit ratings when reviewing published rating action rationales.
- Application of ESG factors: Firms differed in how they were applying ESG factors during surveillance. A small number of firms’ methodologies included criteria for when to treat ESG factors as credit relevant, but others told us they relied more heavily on analytical judgement. To ensure consistent application, firms should consider how ESG factors are incorporated in their frameworks.
- Consideration of ESG factors: Most firms could describe at what stage ESG factors were considered within their surveillance process, for example before or during a rating committee. For some CRAs, we observed that internal documentation lacked clarity on the impact and materiality of environmental and social factors in determining a rating action. This may limit transparency for users in rating action rationales, where a specific ESG factor may be credit relevant.
- Ongoing monitoring of ESG risks: Our review of files and discussions indicated that firms had varying approaches to surveillance of ESG risks (such as near-term or long-term, materiality, impact). Where ESG risks are assessed to be potentially credit material but may emerge over longer time horizons, firms should consider the ability of their surveillance including people and processes, to effectively monitor such risks.”
This FCA publication addresses the same issue raised by anti-ESG AGs in their recent warning letter to ratings agencies in the U.S. However, where the anti-ESG crowd is arguing that the ESG genie should be put back into the bottle, the FCA takes a more reasonable approach. We’ve discussed the material financial impacts of ESG on this blog for some years now. Credit ratings agencies are catching up to the concept. ESG impacts companies, financial institutions, and governments in ways that cannot be siloed. The effects cannot be constrained to just “ESG ratings” or “ESG reporting.” As financial impacts materialize, traditional financial institutions are wrapping their heads around how to quantify ESG risk.
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