The Principles for Responsible Investment’s (PRI) third report on environmental, social and governance (ESG) and credit risks, specifically focuses on solutions for fixed income (FI) investors and credit rating agencies (CRAs), examining how to consider ESG factors in credit risk analysis. The report is a result of dialogue with CRAs and investors to promote understanding of practices, identify gaps in the consideration of ESG factors in credit risk analysis, and find ways to address those gaps. This dialogue has highlighted that ESG consideration in credit risk analysis is still not addressed consistently and systematically by all FI market participants but has also brought to light that:

• Many positive developments are gaining rapid momentum including expanding resources and increasing transparency efforts by many investors, and CRAs explaining how ESG factors feature in their analysis;
• The idea that ESG consideration is part of a holistic approach to assessing credit risk;
• Perceptions are shifting and ESG signals are beginning to be used not only to manage downside risks but also to spot investment opportunities; and
• FI investment and credit ratings have different objectives; whereas a credit rating will only include ESG factors if material to credit risk, investors looking for guidance on ESG factors in a FI investment may also use standalone ESG scores and assessments.

This report features a list of action areas aimed at improving the process and output of ESG considerations in credit risk analysis. The list consists of emerging solutions discussed during 15 investor-CRA forums that the PRI organised globally.

The report also highlights differences in awareness and advancement between regions, the regulatory environment, and attitudes towards ESG risks, ESG risks assessment between sovereign and corporate credit issuers, and CRAs’ approach to ESG factors. The report also highlights the shared challenges that credit practitioners face as they build a more systematic framework to consider ESG factors, and that more work needs to be done to:

• Assess ESG factor materiality and, in the case of investors, performance attribution;
• Monitor the ESG triggers that may alter credit risk assessments and threaten the sustainability of business models over the long term; and
• Reach a minimum level of ESG standardisation.

The bulk of the report contains investor case studies with over 15 investors featured and covering:

• Why – The motivation behind the need to address the action areas for ESG consideration and their drivers.
• How – The inputs, framework, methodology and the roles, of different stakeholders in taking into account specific ESG dynamics in credit.
• Practice – Evidence of implementation of the investment process, with examples on sovereign or corporate bond issuers.
• Lessons – The lessons learned, the challenges encountered, what could have been done differently and the plans for the future.

The report is the third in a three-part series, and builds on part one, which describes the state of play of ESG consideration in credit risk analysis, and part two, which focuses on the results of roundtable discussions exploring those disconnects.

1. ESG consideration as part of a holistic approach to assessing credit risk is growing in the market place.
2. This report highlights the positive developments gaining pace such as expanding resources and transparency by many investors and credit rating agencies (CRAs) to explain how ESG factors feature in their analysis.
3. ESG signals, which initially are used to identify downside risks for fixed income investors, are beginning to be used not only to manage downside risks but also to spot investment opportunities.
4. The use of ESG factors differ between fixed income investments and credit ratings - credit ratings will only include ESG factors if material to credit risk, whereas investors may use standalone ESG scores and assessments.
5. The growth in adoption of ESG factors by CRAs - from 6 in 2016 (including the two biggest global rating agencies Moody's and S&P) up to 18 in 2019.
6. Growth in CRA action on sustainable finance includes dedicated working groups and clear senior leadership in the three global CRAs. All three large, global CRAs have published notes explaining how ESG factors are considered in their methodologies.
7. Growing recognition that ESG factors may alter the estimate of collateral values and recovery rates, and the need to make different loss assumptions if assets become stranded because of climate-related risks, new regulations, technological developments, changing norms or in the interpretation of existing legislation.
8. Shared challenges faced by both CRAs and investors where action is needed including improve engagement, outreach and collaboration on ESG topics.