Moody’s recent commentary on ESG risks in credit analysis supports one of our long-held views: that pricing environmental, social and governance risks is imperative in investing.
In our November 2014 issue of Spectrum, we wrote: “We believe that analysing ESG factors as part of an investment process enhances performance”. Although the interests of shareholders and creditors do not always converge, the inevitability that poor environmental, social and governance (ESG) practices will in time erode enterprise value should make the analysis of them relevant for shareholders and creditors alike. It follows that ESG risk analysis is an important part of our investment process.
In its report, “Moody’s Approach to Assessing ESG Risks in Ratings and Research”, the rating agency makes a similar argument: “ESG considerations are part of the holistic assessment of credit risk that we undertake for a rated entity. They are an important element in our assessment of an entity’s creditworthiness where they represent a material credit risk,” the paper states. “We capture ESG considerations in our long-term credit ratings when we believe they will affect the probability of default of a debt issuer or expected credit loss in the event of default.”
Just as we assign an ESG score to issuers, Moody’s does something similar: “ESG considerations are explicitly scored factors in some of our rating methodologies”.
Among ESG risks, we believe that poor governance is the most acute. This can lead to ineffective strategy, incompetent management and intensifying environmental and social risks – all of which can corrode the value of a business, no matter how attractive its assets currently are or how much market share it has at present. The market’s recognition of weak governance can spur sudden changes in valuations. We saw this in 2014 with the collapse of Phones 4U, and during the more recent episodes at Abengoa and Volkswagen.
Moody’s, too, recognises the importance of governance. “Governance factors for a bank or corporate typically consider the extent to which shareholders and creditors can have confidence in the proper systems of management accountability and incentives that are in place for a given issuer.” In fact, in the researcher’s US rating methodology, governance has a factor weighting of 30%, which is as high as the weighting for a company’s finances. But instances when ESG risks outweigh financial concerns are scarce: “ESG considerations are rarely the main driver of credit outcomes,” the paper states.
We have a slightly different view. Our analysts’ views on ESG risks impact our assessments of valuations, similar to operating and financial risks. If, for example, we take a long position in an instrument, we must be paid for the ESG risks facing the issuer. ESG risks may not often provide the key metrics in traditional credit analysis, but the cost of not assessing them can be great because companies with chronic ESG problems tend to underperform.
While ESG analysis can be a purely defensive measure undertaken to avoid blow-ups, it can also identify companies whose weak-but-improving ESG practices represent opportunities to generate alpha. Our current investment in AmericaMovil bonds is illustrative of this. Hermes EOS, our corporate engagement and stewardship team, is engaging the company to improve its governance through better disclosure of management compensation and the timely communication of proxy documents (including board nominees) ahead of annual general meetings. The company was receptive to these suggestions, and others, because they now understand more fully how important these matters are to all stakeholders. As investors, we believe that our clients will benefit from this engagement: if AmericaMovil’s governance improves, then the risk premia on its securities will diminish, leading to rising bond valuations.
The above information does not constitute a solicitation or offer to any person to buy or sell any related securities or financial instruments.
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