As the conversation about climate change and the need to act around it intensifies, banks and other financial institutions face an ever-increasing pressure to consider Environmental, Social, and (Corporate) Governance (ESG) when making investment decisions. The evolving regulatory landscape around this topic further sets the context to have a mechanism in place that allows banks to incorporate ESG factors in their risk frameworks. This article discusses how ESG factors can be incorporated within the credit appraisal process.
What is ESG?
ESG is an acronym for Environmental, Social, and (Corporate) Governance — the three pillars that primarily evaluate a company’s commitment and advancement in sustainability and climate change related objectives.
The figure below briefly describes what each of these pillars constitutes:
|Environmental: Captures the impact of externalities, such as climate change, climate-related policies, use of natural resources in operations, etc.||Social: Represents how the organization focuses on social issues, such as labor laws and animal welfare, inside and outside||Governance: Deals with the structure and responsibility of the senior leadership toward employees, shareholders, society, etc.|
Traditional credit appraisal process
The credit appraisal process has traditionally been based on two fundamental assessments to estimate credit worthiness: (i) financial and (ii) non-financial.
Financial assessment involves analyzing historical and forecasted financial trends of key metrics, such as revenue growth; earnings before interest, taxes, depreciation, and amortization (EBITDA) margins; leverage; and debt repayment capacity.
Non-financial analysis involves studying business, industry, management, etc. These assessments help the credit appraiser understand the inherent risk in the proposal/transaction, which translates into an appropriate internal rating/grading for the borrower.
Evolution of ESG in the credit appraisal process
The world has become socially and environmentally more conscious. Market players including issuers, intermediaries, and banks are facing significant pressure to assess the influence of ESG factors on their activities.
As climate change events become more frequent, climate-related risks can no longer be ignored. They tend to have both financial and non-financial implications for organizations globally. In addition, workforce inclusion and other human capital related issues in business strategies have gained prominence. These factors have potential reputational risk implications if not appropriately addressed.
The United Nations-backed Principles for Responsible Investment (UN-PRI) also recognized that ESG factors can affect borrowers’ cash flows and the likelihood of defaulting on debt obligations. Therefore, ESG factors have emerged as important elements in assessing the creditworthiness of borrowers.
"To fully address major market and idiosyncratic risk in debt capital markets, underwriters, credit rating agencies, and investors should consider the potential financial materiality of ESG factors in a strategic and systematic way." - UN-PRI
This view has been further reinforced by key global regulators pushing for mandatory ESG disclosures.
For example, the European Banking Authority (EBA) issued guidelines that require banks to assess the risks associated with ESG factors on borrowers’ financial stability — in particular, the potential impact of environmental factors and climate change. In India, the Securities and Exchange Board of India (SEBI) introduced the Business Responsibility and Sustainability Report (BRSR) guidance in May 2021. These guidelines are built on previously issued business responsibility report guidance and mandate the top 1,000 listed entities to report their ESG-related disclosures in a prescribed format.
Globally available and accepted accounting standards (with new standards expected to be published in the next few years) also enable computing several key ESG parameters in a scientific way. This will help overcome challenges of non-availability of such data points.
The increased availability of relevant data is expected to ease the challenges associated with including the ESG view within risk assessment frameworks of financial institutions, especially during credit appraisal. This will help assess the downside risk of credit investments that can further be translated into internal grading of borrowers affected by ESG factors.
ESG overlay on credit appraisal
A rational approach to do this involves using a scoring methodology to overlay an ESG view within the credit appraisal process. The scorecard intends to assess a borrower on several parameters within each ESG pillar, using both quantitative and qualitative techniques for risk assessment. The figure below indicates the structure that could be used within such an ESG scorecard:
The scorecard can bring in a sector-wide approach, where each borrower’s performance is benchmarked against others in the same industry. Appropriate weights can be assigned to each parameter within the three pillars, ensuring that sector-specific variations in parameters are also captured.
Based on the ease of availability of input data, a disclosure adjustment/modifier can also be assigned. For example, a higher score is assigned to a company if the input data is publicly available.
After a score has been computed against each individual pillar, a normalization technique can be used to arrive at an overall ESG score for the borrower. This score can then be used to overlay the borrower’s rating grade/score obtained using existing rating models. Banks can also choose fewer parameters from each pillar they may deem more relevant in the context of their portfolios.
Integrating ESG factors into credit analysis strengthens a financial institution’s ability to assess the downside risk of its credit investments in light of the transition and physical risks associated with climate change.
An overlay approach to ESG assessments is an important first step toward achieving this objective. A scorecard is scalable and can be adapted to a bank’s varied requirements while being flexible to respond to the regulations applicable to the jurisdiction in which each bank operates.
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