Credit Ratings versus ESG Ratings

Over the past year, the municipal market has been increasingly drawn into the cultural and political wars over the increasing integration of “ESG” factors in investment management. Several conservative-leaning states have joined together to decry the potentially negative impact of ESG factors on their debt ratings. They have put the rating agencies on notice about integrating non-financial, values-based factors into their rating process. The latest salvo came from the State of Florida, which has pending legislation to prohibit ESG designations for municipal bonds issued within the State. We believe that the leading Credit Rating Agencies’ approach to ESG, with some exceptions, have contributed to the confusion about what credit ratings and ESG ratings mean, and fostered issuers’ distrust of any ESG-aware approach to credit ratings.

Credit Ratings and ESG Ratings

Credit ratings are designed to provide investors with an assessment of the creditworthiness and the probability of default for an issuer (or a specific instrument of such issuer). The basic analytical approach is well understood and fairly consistent, with only minor variations, among the leading Credit Rating Agencies (“CRA”) such as Moody’s, Standard & Poor’s, Fitch and Kroll.

What the so-called “ESG” ratings represent is not so clear-cut. According to a recent paper by the United Nation’s Principles of Responsible Investment (“PRI”), “ESG Ratings are typically produced by ESG information providers and are non-credit products. They are synthetic indicators of the ESG characteristics or exposure to ESG risks of an issuer of equity or debt instruments”.

Another key difference: credit ratings are usually solicited and paid for by the entities being rated. ESG ratings or scores are usually unsolicited and usually paid for by the investor or by investment service providers.

Yet, ESG ratings do have a credit component. Certain “ESG” factors can be shown to have a direct impact on an issuer’s creditworthiness, notably “environmental” factors such as climate change and “governance” factors such as public pension funding or cybersecurity exposure. Such factors have long been part of traditional municipal credit analysis. Only recently have they been teased out specifically as “ESG” components in an effort to capitalize on investor demand for sustainability information.

This overlap between credit ratings and ESG ratings has given rise to much confusion, a situation that has been exacerbated by the credit agencies’ own approach to ESG.

The Rating Agencies’ Role

The CRAs undoubtedly play a critical role in the smooth functioning of the credit markets. If nothing else, they provide investors with a common credit benchmark the market can agree or disagree with. Unfortunately, their foray into the fledgling world of ESG has done the municipal industry a great disservice.

Even after all the reform initiatives stemming from the Great Financial Crisis of 2008-2009, the CRAs’ own business model remains conflicted. Even though their ratings are ostensibly meant to inform the investing public, their services continue to be paid by the very issuers they rate.

In response to rising investor interest in sustainable strategies, the Big Three rating agencies (Moody’s, S&P and Fitch) have set up separate subsidiaries to provide ESG scores or ratings. That would’ve been fine, as long as the ESG side is kept separate from the bond rating side. Unfortunately, the agencies also tried to make their traditional credit rating methodology more relevant by specifically calling out ESG factors as a component of their bond ratings.

Credit should be given to the Kroll Bond Rating Agency (“KBRA”) for not falling into this ESG trap like the Big Three agencies did. KBRA has steadfastly refused to integrate “ESG” into its rating approach, arguing that such factors as climate risk and governance risk already belong to traditional credit analysis and don’t need to be called out as separate “ESG” factors. To this day, to the best of our knowledge, KBRA still does not have a stand-alone ESG product.

By trying to have their cake and eat it too, the CRAs (again with the notable exception of Kroll) have put themselves, and by extension our entire market, in an untenable position. Under fire by some of their own clients (the issuers), the agencies are now forced to back-pedal and minimize the potential impact of ESG factors in their rating process. In all honesty, one can hardly find an instance where ESG factors actually tipped the scale for an issuer’s bond rating.

And yet, by calling out the so-called “ESG” components in their credit rating methodology, the CRAs have unwittingly invited the wrath of some of their conservative-leaning clients and put the municipal industry in the cultural war crosshair.

A Failure of Both Credit and ESG Rating Services: Silicon Valley Bank

At the end of the day, the difference between credit ratings and ESG ratings boils down to the distinction between the “Risk” component and the “Impact” component of ESG, something we have discussed at length in prior articles.

Failure to make the distinction between the “Risk” and “Impact” components of ESG can result in wildly inaccurate credit ratings and ESG ratings. Just consider the recent case of Silicon Valley Bank (“SVB”): Prior to March 8, 2023. Moody’s and S&P had A3 and BBB bond ratings for SVB, respectively, both fully investment grade ratings. A mere two weeks later, SVB filed for bankruptcy, in the process triggering a market-wide confidence crisis in the regional banking system.

The major ESG rating services did not fare any better: as reported by Barron’s, “before the collapse, the bank was rated “A,” or average, by MSCI (MSCI), the largest ESG ratings company. Average refers to “a company with a mixed or unexceptional track record of managing the most significant ESG risks and opportunities relative to industry peers,” according to MSCI’s website (…) ESG ratings provider Morningstar Sustainalytics gave SVB an ESG risk rating of “medium risk” and a controversy score of 1, or low.” Of course, as the banking crisis unfolded, both ESG services scrambled to adjust their ratings for SVB, thus displaying exceptional after-the-fact hindsight.

Speaking of hindsight, the rating agencies reportedly overlooked the bank’s lack of sound risk management practices. Its loan portfolio was heavily concentrated in the technology industry, making it particularly susceptible to a run on the bank by a few large depositors. SVB was also caught flat-footed by the speed and magnitude of the Federal Reserve’s tightening policy as it massively increased its mortgage security portfolio exposure back in September of 2022, at a generational low in interest rates.

From an ESG angle, could it be that SVB ’s close ties to the tech industry, particularly with startups in so-called “green” industries, blinded the ESG rating agencies to its woeful “governance” practices? This should lead to some serious soul-searching at Sustainalytics and MSCI.

It’s also a worthwhile lesson for the municipal market to ponder as it tries to integrate sustainability concerns into its best practices.

The Investment Case for ESG

The key factor that makes the ESG investment approach vulnerable to criticism is the fact that the investment case for ESG remains largely unproven in the municipal market, at least in the short term.

For investors, “Green” sectors have yet to outperform other sectors in any significant and consistent way, even through last year’s brutal market selloff. Over the past three years ending March 31, 2023, the annualized return for the S&P US Municipal Green bond Index was a negative 0.07%, actually underperforming the +0.42% annualized return for the S&P Municipal Bond Index over the same period.

Issuers have seen very few instances where they actually reduced their borrowing costs by issuing sustainable bonds. This has made it easy for public officials to dismiss ESG concerns as “woke” politics, with no real impact on public finance.

The institutional buy side has to shoulder some of the blame here. For years, the marketing pitch for a sustainable strategy is that investors can “do well while doing good”. This attempt to “have your cake and eat it too” is rather naïve and can create unrealistic expectations on the part of the investing public. There is no such thing as a free lunch in investments, only trade-offs.

In fairness, the best investment case for a sustainable strategy in fixed-income lies in long term risk management rather than short-term return enhancement. Since bondholders are inherently risk-averse, this should be a very legitimate strategy for long-term investors.

If “doing well” can be defined more narrowly as reducing your risk and preserving your capital, then ESG should allow you to “do well by doing good”, even if the benefits may take a while to show up in investment performance. There is no doubt in our mind that the market will sooner or later either penalize or reward municipal issuers based on their perceived climate risk and/or governance risk exposure. All it takes is a catalyst event, whatever that may turn out to be.

Away from risk mitigation, if investors truly want to promote social equity and other worthwhile non-financial goals, they should really step up and reward “ESG-friendly” issuers with a lower cost of capital. After all, when it comes to the bond market, public officials are primarily motivated by bond ratings and the resulting interest cost.

“Risk” versus “Impact”

The municipal market is unique among all fixed-income sectors as it stands at the intersection of public policy and finance. In order to sidestep the current cultural and political minefields, we believe the industry should focus on objective, quantifiable ESG risk factors as part of the traditional credit risk assessment process and leave “Impact” considerations to the buy side’s discretion. It will be hard for even the most politically motivated public official to attack a credit rating that incorporates climate and governance risks, as long as they’re clearly identified as credit factors.

Perhaps we should even dispense with the whole “ESG” moniker. which is susceptible to misinterpretation and misunderstanding, and just use “Climate Risk” or “Governance Risk” instead?