Andrew Steel on the five ESG themes to watch out for in credit during 2021

Ahead of the Sustainable Investment Forum Europe 2021, Andrew Steel from Fitch Ratings talks to Climate Action about the five ESG themes to watch out for in credit during 2021. He discusses the innovations in ESG finance and how far the social risks exacerbated by COVID will influence policy and economies.

Will more data disclosure lead to greater ESG scrutiny?

Good quality, comparable data is essential for high quality analysis and decision making, and during 2021 we expect that better data will encourage financial institutions to further enhance their ESG due diligence.  This focus on ESG will further tilt the financing landscape for issuers, in turn encouraging more data disclosure and availability.

During 2020 we saw a significant increase in ESG reporting requirements and recommendations globally.  The increase in both mandatory and voluntary disclosure requirements, standards and guidelines, we believe, is set to create a deluge of ESG data in the coming years. Europe and Asia are likely to experience this first, and given coordination of efforts across the EU we feel that is where the effects will be felt soonest.

Non-disclosed and blended data is also becoming increasingly sophisticated, such as the use of geospatial data to monitor physical climate risks, which again will have far reaching consequences for sectors such as insurance, agriculture and public finance to name but a few.

But this increase in information is not without drawbacks.  The sheer volume of reporting demands and diversity is starting to become an increasing challenge for companies. Whilst in 2021 we expect further consolidation and coordination of leading standard setters, which will support harmonization over time, disclosure is likely to remain difficult and complicated because of the different needs of the stakeholders involved.

On a positive note we expect better data quality and availability to enable further refinement of financial institutions’ ESG policies, allowing much more scrutiny of difficult to assess areas such as supply chain labour practices. The potential for bank and investor policies to tilt the financing landscape for issuers is a trend we identified in 2020, and we expect to see this continue and if anything accelerate throughout 2021.

This trend for more and better data will also support policy and regulatory initiatives at a government and central bank level.  Financial supervisory authorities have talked for some time about mandating bank climate-change stress tests, the first of which are set to be implemented during the course of 2021.

If one of the trends is an increased level of ESG data and disclosure, then how is that likely to impact credit and funding decisions?

Well our second trend that we have identified for 2021 looks at precisely that issue.  In essence we expect innovation will widen access to ESG financing for different sectors and asset classes, and with it it will draw more attention to ESG credit risks.

The market for ESG instruments has increased rapidly, with cumulative green bond issuance reaching USD 1tn in 2020. In fact ESG bond issuance made history during September 2020 as supply in some of the bond market’s core sectors outstripped conventional bond issuance for the first time.

However, all is not likely to be plain sailing in 2021.  These markets have largely been developed off the back of voluntary or industry-led principles, which can be open to interpretation and some of the labelling that has occurred lacks clarity and consistency. 

Regulatory initiatives underway, such as the development of sustainable taxonomies and regulatory green bond standards, will help to formalise ESG market issuance and tackle issues like “green-washing”.  But, in doing so it is also likely to limit the scope of eligible issuance opportunities, and we think this will lead to further innovations in areas such as sustainability linked bonds.

We expect innovations around sustainability-linked instruments to be an enabler that will continue to widen access to ESG funding across a variety of sectors.  This trend already started in 2020 and was evident in sectors such as transport, chemicals and food & beverages in terms of the loan market, and early indications are that Q1 2021 SLB issuance is at record levels.  We see this continuing to accelerate and broaden in scope during 2021 and expect to see more sustainability linked bonds from entities that have perhaps historically been less able to tap traditional green markets. 

We also expect to see ESG labels adapting further to cater to the currently underserved asset classes, such as high yield bonds and certain structured finance transactions.

Do you expect more details to emerge on the array of net zero pledges made in 2020?

We expect companies and governments to start providing more extensive detail around their plans on how to achieve net-zero pledges.  Hopefully this will make the likely economic impacts much clearer to the market.

Economies accounting for more than two-thirds of world GDP have now made pledges to reach net-zero emissions. However, the economic and credit consequences depend on energy strategies undertaken to achieve net-zero, as well as factors such as technological progress and the role of carbon offsetting in many industries.

How all of these factors interact means that the global energy mix in 2050 could potentially vary widely under different scenarios and, with it, macroeconomic consequences such as changes in commodity prices.  

Costs of capital for new solar and wind capacity continue to fall in many regions with increasing economies of scale, expansion of competitive auctions and policy support.  This is a trend likely to continue in 2021, but the longer-term outcome is by no means certain.  Whilst a very big change from business as usual is required to achieve a rapid decarbonisation scenario, things need to go substantially beyond that if the net zero pledges are to be achieved.

China is set to play a significant role over the next few decades and will start up its domestic emission trading scheme in 2021.  We believe this will rapidly become the world’s largest scheme, and is a key aspect to watch during the course of this year.

Whilst we expect many strategies will start to become clearer in 2021, as policies are announced and implemented, this potentially only represents the tip of the iceberg in terms of the actions that will need to follow. 

Our ESG vulnerability scores, published in October 2020, for global utilities, and February 2021 for oil, gas and natural resources entities, look at how credit risks build over time in a scenario that sees global warming limited to 2 degrees by 2050.  The reports we published provide an interesting insight into the variances in credit risk that could occur across countries, regions, sectors and sub-sectors, as the world tries to transition to a low carbon future.

So you have more data, increased innovation and access to ESG funding, but what does that mean in terms of risk?  Will the social risks exacerbated by COVID continue to influence policy and economies?

We expect new ESG risks to emerge and existing risks to be exacerbated as economies settle into a new normal following the onset of the pandemic.  Particularly in terms of social risks. 

The pandemic has widened inequality, with poorer segments of society less able and equipped for homeworking and also less able to respond to the hurdles posed by government directed changes such as lockdowns. We expect this trend to deepen in 2021 and to see this shift in perceptions of economic fairness further shaping government policy agendas, a trend we also highlighted in 2020.

Other societal divides have also started to become evident, such as the disproportionate job losses faced by women, and the impact on self-employed workers. We expect the future actions that companies take will receive much closer scrutiny in the face of these divides.  A company’s “social license to operate”, particularly if it has received support or incentives during the pandemic will be foremost in both customers, suppliers and funders minds. 

Banks are perhaps a good example here. Covid-19 rescue package loans will be a source of potential reputation risk as it seems inevitable that recoveries will be problematic.  Governments and society are likely to pay close attention to recovery tactics for loans that many entities will find difficult to service or repay given the heavy economic burden induced by the pandemic.

Do you think the importance of sustainability in strategic and management decisions will increase?

We expect ESG issues to increasingly influence strategic and management decisions as sustainability becomes further embedded into governance. Fitch’s ESG Relevance Scores have consistently shown that governance factors are the most relevant and material of ESG risk factors to credit ratings.

The growing interest in sustainability is sparking debate on how corporate governance frameworks should be reformed to foster long-term responsible corporate behaviour, such as clarification of directors’ duties and related remuneration systems.

The EU Commission launched a consultation on sustainable governance in October 2020 and has identified it as one of the core priorities in its Renewed Sustainable Finance Strategy. Developed countries in other regions are also starting to focus on how ESG elements should be considered in corporate governance, such as the revision planned in Japan for Spring 2021.

Over the last few years we have seen an increasing level of support for Environmental and Social proposals from shareholders at AGM’s, as investors and debt holders have stepped up engagement and active ownership. We think that combined with a greater focus on sustainability by company boards, ESG issues will start to have more influence on management decisions with potential consequences for credit profiles.

As 2020 demonstrated things don’t always pan out how we expect, but our dedicated research and analytics capabilities at Fitch are here to support investors by providing insightful and independent opinions as markets develop and change.

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Andrew Steel will be speaking at the Sustainable Investment Forum Europe in April, bringing together asset owners and managers, ratings agencies, banks, UN and Government policymakers, investors, development banks, think tanks, and NGOs committed to driving forward the sustainable finance agenda. Register your place for free here.