How Does ESG Alter Credit Risk? India Ratings Wants To Spot The Link

ESG relevance disclosures will become part of the ratings action commentaries by the firm from Jan. 1, 2022.

<div class="paragraphs"><p>Indian 50 rupee, left, and 2,000 rupee banknotes in an arranged photograph. [Photographer: Brent Lewin/Bloomberg]</p></div>
Indian 50 rupee, left, and 2,000 rupee banknotes in an arranged photograph. [Photographer: Brent Lewin/Bloomberg]

Starting the New Year's day, India Ratings and Research Pvt. will start integrating commentary on how certain environmental, social and governance issues impact the credit ratings of companies.

It announced the launch of ESG Relevance Disclosure, which would now be part of its rating action commentaries from Jan. 1. The move comes as ESG is increasingly becoming a defining factor for the flow of capital across the world.

"We are trying to see what is the intersection of the ESG risks with the credit risk over the rating horizon of five years," Rakesh Valecha, senior director and head of the core analytical group at India Ratings, told BloombergQuint. "Our aim is to see if there are any ESG factors that are, either on their own or in conjunction with other rating drivers, impacting credit ratings. And, if there are, to highlight (it) and bring forth in our disclosures.”

India Ratings' analysis will be drawn from 14 factors—five environmental, five social and four for governance—based on a framework devised by the Sustainability Accounting Standards Board. The credit rater will then classify these in three broad categories to show whether any of the factors are minimally, moderately or highly relevant to the credit rating decision.

How It Differs From ESG Ratings

India Ratings says it's different from scores measuring compliance of ESG-related criteria. "We are not making any moral judgements on any company. It's not up to us to say whether ESG practices of a company are good or bad."

Valecha explains that their commentary will provide the relevance of ESG factors to the credit rating. He gives an example:

"Take the coal industry. You would obviously classify it as one of the most polluting, and hence, that will negatively impact its ESG rating. But from a credit perspective, those risks may not play out in the next five years. The pace of transition from coal to renewable will remain an evolving process. So, it may not see its credit rating being negatively impacted, at least for now."

However, if local restrictions or social unrest cause a particular polluting unit to shut down in view of the larger impact to the society, then the credit rating may be impacted, he said.

"The impact has to be tangible, measurable and material. We do not intend to make hypothetical judgments."
Rakesh Valecha, Senior Director and Head—Core Analytical Group, India Ratings

Increasingly, analysts and investors have been attempting to find out how ESG factors are linked to credit risks for a company.

While ESG ratings can help benchmark the sustainability of a business over the long term, they continue to lack common ground for assessment, making it harder for investors to make sense of them.

Credit ratings, on the other hand, have established standards that have been harmonised over the years. The United Nations Principles for Responsible Investment has also urged credit raters to start incorporating ESG in rating decisions as these would be important in assessing the creditworthiness of borrowers and likelihood of defaults.

Globally, credit ratings providers like S&P, Fitch Ratings and Moody's Investors Service already bake in ESG factors into their ratings action. However, it is relatively newer for India.

Besides India Ratings, Acuite Ratings & Research, too, has started incorporating ESG factors into its credit ratings. They will disclose the "financial materiality" of the ESG issues to the credit ratings in their analysis. Crisil Ltd. has its own ESG rankings separate from credit ratings.

That isn't to say that ESG factors were not being included in the ratings action earlier. After all, ESG risks are business risks that credit raters have to consider anyway.

"What we are now trying to do is drill down further into the sub-factors," Valecha said. "If we can zero in on the ESG factors that play a role in the ratings, then the investors can decide whether it makes sense for them or not, and ultimately take a call on investing in that company."

"Investors can take binary calls over ESG like not wanting to invest in coal completely, and only invest in green technologies. But when a decision has to be made where you need to figure out the risk premium for lending to a business with ESG issues, then such disclosures can help them decide how to price that risk," Valecha said.

"That's how investors have been mostly using it globally, as far as our parent Fitch's experience is concerned."