Company ratings by ESG rating agencies

BACKGROUND

For many decades, the evaluation of companies by rating agencies has been of central importance for investment or credit decisions. By means of a relatively easy-to-understand rating classification, a condensed statement is made about the financial condition (e.g. from the analysis of the annual financial statements, the short-term income statement and the planning calculations) of a company (creditworthiness), which is supplemented by qualitative information (e.g. market position, management). In essence, this rating is an estimate of the probability of default of the assessed company, i.e. the risk of insolvency. For banks and investors, this rating results in important decisions regarding the further treatment of a loan/bond, e.g. with regard to pricing, loan/bond conditions or the accounting treatment of the receivable.

Due to this importance, rating services are regulated for the financial system. This is not yet the case for sustainability ratings. In February 2022, the European Securities and Markets Authority (ESMA) carried out a text analysis of the press publications of rating agencies [1], which showed that the sustainability information on the companies and the underlying ESG (environment, social, governance) factors very often vary in the rating reports, even in sectors that are heavily influenced by ESG factors. As a result, ESMA has asked the relevant market participants for an assessment of the ESG ratings market in Europe by the beginning of June 2022(Targeted consultation on the functioning of the ESG Ratings Market in the European Union and on the consideration of ESG factors in credit ratings).

CURRENT MARKET SITUATION

Most of the current rating products do not provide absolute statements on the ESG behavior of a company. The lack of standardization means that UniCredit's TCFD (Task Force on Climate-related Financial Disclosures) Report 2020, for example, shows the rating results of 12 rating agencies, which were provided with a classification of the result by the bank. However, due to the lack of transparency of the rating agencies, the comments of the companies concerned are sometimes based on assumptions with regard to the criteria used. The similarity to recognized credit rating processes can give the impression of comparable quality and reliability, but this is not the case.

The German Federal Financial Supervisory Authority (BaFin) sees sustainability risks as factors of the known risk types in its information sheet (information sheet on dealing with sustainability risks). A separate risk type "sustainability risks" is rejected; "a distinction would hardly be possible". Sustainability risks can have a significant impact on all known risk types and contribute as a factor to the materiality of these risk types. Credit risk is cited as an example if a company's business model can be significantly impaired by political decisions on ESG issues.

This results in the current situation that, although there are many providers of ESG ratings and the assessments are reflected in ESG certificates, their content cannot be objectively verified and understood and therefore ultimately only represents the expression of a subjective assessment based on largely individually defined criteria. The aim should be an integrated risk classification, i.e. the expansion of the classic credit rating to include sustainability factors relevant to creditworthiness. However, this would require a complete restructuring of traditional ratings: instead of (essentially) looking at a company's past and deriving (essentially) short-term future developments, the strategy, business model and thus the company's value would have to be assessed under the medium and long-term changing ESG factors. This would correspond to high-quality external reporting of financial information with a view to sustainability issues.

OUTLOOK

The EU Commission's proposal to revise sustainability reporting (Corporate Sustainability Reporting Directive, CSRD, COM (2021) 189 final) and the standards developed for this purpose (European Sustainability Reporting Standards, ESRS) by EFRAG (European Financial Reporting Advisory Group) attempt to incorporate this approach into corporate reporting. This is done, for example, by requiring the use of climate scenarios, as already proposed by the Taskforce on Climate-related financial disclosures (TCFD). As part of the ESRS standards, companies will in future have to make their own assessment of how they want to deal with the changing framework conditions and thus strengthen their resilience. Third parties could then attempt to objectify this judgment.

However, whether these assessments can be used to derive a similarly transparent and comprehensible statement about a company's probability of insolvency as is the case with traditional financial ratings remains questionable to say the least. The rating assessments of ESG criteria could only have an impact on "long-term ratings" anyway. The Institute of German Public Auditors (IdW) also points out that there is currently not much generally available ESG data, "which means that market participants can hardly assess ESG ratings from third parties themselves".

Today's rating assessments are based on generally accepted (national or international) accounting and reporting standards that have been developed over many years. Comparable recommendations for sustainability issues have already been advanced in some areas (e.g. by the Global Reporting Initiative, GRI), but their application is currently voluntary. It is to be hoped that the regulators will agree on binding standards for sustainability reporting as soon as possible in order to create the basis for meaningful and comparable ESG ratings. Regulating the rating market could also help to eliminate current shortcomings (keyword: greenwashing) and enable largely objective investment decisions with regard to sustainability aspects.

Sources

[1] ESMA TRV Risk Analysis (2022): Text mining ESG disclosures in rating agency press releases. www.esma.europa.eu/sites/default/files/library/esma80-195-1352_cra_esg_disclosures.pdf