We believe ESG issues have a significant bearing on risk. Poor corporate and regulatory governance are recognised contributors in most corporate failures. In addition, dangerous environmental and social practices can lead to significant financial cost, as well as reputational and brand damage.
In our experience, companies and governments that manage ESG risks poorly typically manage other risks poorly. This has a flow on effect, which filters through to most aspects of the business.
Assessment and monitoring
Analysts identify ESG risks during their bottom-up credit research. We analyse ESG risks through our own risk framework, which also takes into account Stranding Risk1, arriving at a customised ESG ranking. Analysts consider these issues alongside their own research with reference to a variety of other external sources.
By analysing and assessing ESG issues within a company, we can identify sources of unrecognised financial risk. We are able to identify companies with a higher default risk than the balance sheet implies. This gives us greater insight than that offered by a rating from a traditional credit agency.
A key output of the credit research process is the internal credit rating (ICR). The ICR is a forward looking measure of default risk over a 1-3 year time frame. Our ICR is on the same scale as ratings assigned by major ratings agencies, but can be materially different for individual issuers.
Our key engagement is with banks and counterparties to understand their ESG risks and their approach to managing those risks. For example, we are interested in understanding climate change and other environmental risks relating to a bank's loan book and financing, and aspects of their lending policies.
A challenge for responsible credit investors has been effective ESG engagement with issuers. This is in part due to the contractual nature of bond investments and the fact that a majority of securities are purchased on secondary markets. We do, however, actively incorporate ESG questions into our regular investor updates with issuers. Our brokers are aware of our ESG focus and also facilitate ESG discussions where possible. We continue to build on this program of engagement.
1 Stranded Risk relates to the risk of assets losing value or turning into liabilities before the end of their expected economic life (e.g. fossil fuels remaining in the ground due to the emergence of renewable energy sources).
"ESG issues are fundamental to infrastructure companies, given they have significant service obligations and moral accountability to the communities in which they operate."
ESG Profile - Influence on Internal Credit Ratings and Default Experience
Over the last two years we have reported on the influence ESG factors have on our internal credit rating when compared to the credit rating agencies and how we believe this helps us reduce incidence of defaults. As part of our annual reporting we will be updating these statistics.
The first chart shows how our internal credit rating differs from the credit rating agencies. The second shows how issuers with high ESG risk are more likely to be the group that has received lower ratings.
The final chart shows our default experience versus what would have been experienced by a fund weighted as per the credit rating agencies' ratings.
Aggregate internal credit rating (ICR) vs S&P or Moody's
Aggregate internal credit rating (ICR) vs S&P or Moody's split by ESG Risk
Global Credit Income Fund (GCIF) - Defaults vs Ratings Agencies
We recognise that climate change impacts investment risk across our fixed income portfolios. They affect different industries in different ways, with some sectors/geographies being more heavily impacted than others.
Our over-arching approach is to consider how climate change – and, importantly, society's response to it – is likely to impact the business model and corporate strategy of issuers. We incorporate both internal and external data sources to help inform our ESG risk assessments.
We take into account how such ESG factors will likely impact the financial performance of each company going forward. Subsequently, we determine the overall credit risk for a company, including its risk of asset stranding. This is incorporated into our internal credit ratings and translates to an acceptable yield level to compensate for that issuer's risk across the maturity curve.