Aviation: KBRA’s Framework for Incorporating ESG Risk Management in Credit Ratings
This Kroll Bond Rating Agency (KBRA) report is a follow-up to a research publication on KBRA’s general approach to incorporating environmental, social, and governance (ESG) factors in KBRA’s credit rating process across corporate, financial, and government (CFG) ratings, which we describe as ESG Management. While our previous publication provided a broad overview of KBRA’s ESG Management approach (summarized below), this research report focuses on the potential influence of ESG topics on KBRA’s analysis of aviation ratings. It is important to note that this research is not methodology. KBRA’s cross-sector ESG methodology can be found here.
Overview of KBRA’s ESG Management Approach
KBRA believes that ESG issues are best examined through the lens of active risk management. Under our ESG Management framework, we seek to understand how an issuer or transaction identifies, addresses, and mitigates relevant ESG risks or capitalizes on ESG opportunities.
KBRA believes that credit-relevant ESG risks and opportunities are unique to every rating and issuer. Our approach to evaluating the management of ESG issues is a bespoke and dynamic process.
KBRA does not deploy subjective value-based ESG scoring rubrics.
KBRA understands that better quality ESG-related disclosure is needed to understand an issuer’s exposure to credit-relevant ESG issues.
Our direct dialogue with management teams enhances our understanding of credit-relevant ESG issues while also improving the quality and consistency of ESG-related disclosure.
Consistent with how we assess default and recovery risk, we view the management of ESG factors as a dynamic process, rather than a point-in-time judgment.
In addition to the unique ESG risks related to each specific debt issue or issuer, KBRA’s analysis of ESG Management typically includes a review of broadly relevant topics such as climate risk, stakeholder preferences, ESG reputational risk, and cybersecurity.
We believe the risk management framework should be comprehensive, yet also dynamic and flexible enough to accommodate evolving factors, including ESG considerations.
KBRA’s ESG Management Analysis Framework for Aviation
Some ESG factors can have a clear, identifiable impact on credit ratings, and these are incorporated in KBRA’s rating analysis. However, KBRA believes that the relative ability of issuers to identify, disclose, and address a broader array of ESG factors that may be less direct or immediate is an increasingly important credit consideration.
As part of our due diligence process, KBRA evaluates, where relevant, the overall effectiveness of the risk management framework to determine whether it adequately captures and addresses the plausible risks to which the entity is exposed. When relevant, we may analyze management teams’ awareness of existing, emerging, and potential risks, and the processes in place for identifying, assessing, and responding to relevant ESG risks and opportunities, as well as how these functions compare to peers.
In recent years, the shift toward a lower-carbon economy has led to technological advancements that have reduced the cost of alternative fuel and expanded access to clean energy sources. While this shift is providing opportunities for some companies, it also poses risks for companies that are dependent on fossil fuels and produce high levels of greenhouse gas (GHG) emissions.
Environmental impacts on the aviation sector can be seen at the individual company level, as well as through systemic sector risk. As such, KBRA’s credit profiles consider the planned or established mitigation measures that companies have to reduce their exposure to environmental risks, as well as how their strategies manage these risks and capitalize on opportunities.
Investing in new aircraft is currently the most immediate and effective way for an airline to reduce its GHG emissions and reduce environmental risk exposure. However, the aviation sector is highly fragmented, with small companies often competing for the same market share against larger, publicly traded multinational corporations. As global regulators establish stricter emissions standards, the cost of operating older aircraft will increase, and fees for noncompliance are expected to be high, pressuring profit margins of smaller carriers at a cost disadvantage that are unable to upgrade equipment. On the other hand, KBRA recognizes that airlines with strong capital structures may find opportunities in the low-carbon transition. While the upfront costs are projected to increase, well-capitalized companies that can make the necessary fleet investment will likely see future cost-saving from fuel purchases and lower regulatory costs.
In their commitment to offset and reduce carbon footprints, many airlines are participating in the Carbon Offsetting and Reduction Scheme for International Aviation (CORSIA) program. CORSIA aims to reduce the industry’s emissions in three stages: a 1.5% improvement in fuel efficiency each year from 2009 to 2020; carbon-neutral growth from 2020; and 50% absolute reduction in carbon emissions by 2050.
Where relevant, KBRA analysts examine both physical and transition risks related to climate change. Physical risks—such as extreme weather, sea level rise, or drought—can directly impact assets or business operations. In contrast, transition risks are indirect and relate to an entity’s ability to shift to a lower-carbon economy because of potential changes in environmental regulation, supply and demand changes, and/or increased reputational risk.
Regarding physical risks, KBRA analysts will often analyze the potential impact of climate change on an issuer’s physical or financial assets, including operating facilities, revenue-generating assets, or financial assets (such as insurance policies and business loans). In addition, when appropriate, KBRA seeks to understand the process through which an issuer determines its exposure. The process an issuer uses to determine its environmental risk exposure can provide insight into the robustness of its risk management framework, which has implications on creditworthiness. Though there are exceptions, KBRA believes this line of inquiry is increasingly relevant across most companies in the aviation sector.
Climate change presents material risks to the aviation sector, and to the extent these forces increasingly disrupt operations and threaten assets and infrastructure, issuers will need to adapt. The aviation sector is highly vulnerable to the physical impacts of climate change such as rising sea levels, changes in temperature, and extreme weather events, all of which can affect aircraft assets and operations. Temperature changes can affect aircraft performance, infrastructure, and demand patterns. Rising sea levels and increased storm frequencies cause schedule and network disruptions.
Collectively, the aviation sector accounts for 2.4% of GHG emissions, with passenger transport producing 81% of global commercial aviation emissions and air freight generating the remaining 19%. (Environmental and Energy Study Institute, “The Growth in Greenhouse Gas Emissions from Commercial Aviation,” October 17, 2019.)
Evolving regulations that limit and provide financial penalties to assets that exceed a predetermined GHG emissions threshold are likely to impact the financial performance of some aviation companies. KBRA believes that management teams that proactively plan for these events will likely have a competitive advantage over companies not actively preparing for climate-related regulation. Companies that do not invest in innovative monitoring and new technologies are vulnerable to regulatory changes that may reduce the value proposition of some of their assets or market share.
KBRA believes that a responsible owner/operator with a proven record of managing its assets may reduce some of this risk exposure by investing in fuel-efficiency measures and new technology aircraft, reducing exposure to older technology, and anticipating new regulation and evolving customer demand. Assessing a company’s historical performance, maintenance and technology strategies, and engagement with external parties can provide insight into the likelihood of declining financial performance due to environmental concerns.
KBRA favorably views issuers that are actively pursuing a range of adaptive practices to stay ahead of current and expected disruptions, such as airlines with carbon offset programs that allow passengers to purchase carbon offsets for their flights, active re-fleeting programs, and more fuel-efficient aircraft. In some cases, these practices are intended to protect the value of existing assets and systems. In others, practices are aimed at creating value through innovation and meeting new needs that stem from climate change.
Climate change exposure can vary widely by company, but typical guiding questions include:
Does the issuer have climate-related goals or targets in place? If yes, what are they? If no, why not?
How do they measure progress toward their stated goals?
Does the issuer calculate carbon emissions? If so, what were their annual Scope 1, 2, and/or 3 carbon emissions levels and how did they calculate them? If they did not calculate them, why not?
Does a third party verify their emissions reporting?
Are there any self-initiated or third-party required plans to reduce them?
What level of exposure does the issuer have to physical climate risks (hurricanes, floods, droughts, wildfires, etc.) that could potentially have a financial impact? What risks have they identified?
What level of exposure does the issuer have to transition risks that could potentially have a financial impact, including potential regional and federal regulatory changes? What risks have they identified and how are they managing them?
What is the entity’s exposure to stranded asset risk and how is the issuer managing this risk?
What is the entity’s exposure to a potential international carbon tax, cap-and-trade programs, or other regulated carbon-pricing scheme?
For the aviation sector, social issues are often meaningful drivers of the rating analysis. Labor management, employee and customer safety, and community relations (among other potential ESG issues) can affect a company’s reputation, market share, and financial performance. Passenger airlines can also be affected by exogenous shocks such as terror events and war.
Stakeholder Preference and Reputational Risk
KBRA views the management of stakeholder preferences around ESG issues as crucial for any issuer. For the aviation sector, these stakeholders include funding providers, employees, customers, and regulators, among others.
Over the long term, consumer preferences are projected to continue to shift to more environmentally friendly activities. In recent years, “flight shaming”—or discouraging people from flying due to its environmental costs—has been trending in parts of Europe, where there is a growing anti-flying movement due to aviation’s carbon footprint, and this may become more mainstream across the world. Airlines and aircraft lessors operating older, less fuel-efficient aircraft with higher GHG emissions may become less competitive and face stakeholder backlash, resulting in decreased revenue and market share. Similarly, access to financing in the capital markets may evolve as investors prioritize sustainability and favor newer, more fuel-efficient aircraft collateral.
Airlines are also labor-intensive, and relations between employees and such businesses can influence the availability of services, which can subsequently impact revenue and cost trends. Labor across the sector tends to be unionized, which can lead to contentious labor negotiations between airlines and unions. Strikes can negatively impact employees, the issuer’s business operations, and consumers, which has implications for revenues and creditworthiness. As part of our analysis, KBRA’s aviation team considers the issuer’s track record in managing labor disputes and evaluates disruptions in services due to labor relations.
Typical guiding questions include:
Who are the issuer’s key stakeholders (investors, lenders, business owners, voters, consumers, employees, etc.)? What risks or opportunities do these stakeholders pose to their business?
Do the preferences of their key stakeholder groups pose risks to long-term operational and/or financial stability?
Has the entity been involved in any ESG-related controversies, litigation, misconduct, penalties, incidents, or cybersecurity attacks that may have implications on stakeholder/reputational risk?
What were the ramifications? What were the lessons learned?
Governance is an important component of KBRA’s credit analysis of aviation companies, as an issuer’s commitment to accountability, integrity, transparency, and responsibility in all its practices is often reflective of its creditworthiness. It is also increasingly important to understand how aviation companies prioritize stakeholder ESG issues in long-term operational and financial planning, including through investing in green technology and converting business models to be more sustainable. Good corporate governance and proactive management of ESG issues often ensures a positive relationship between the issuer, its various stakeholders, and government agencies. A typical KBRA assessment of corporate governance could include, among other things, an evaluation of an issuer’s record in dealing with government agencies and its ability to manage cybersecurity.
An issuer’s business model, ownership structure, and management profile, as well as its strategy and internal policies related to ESG issues, are important factors that give a holistic understanding of management and its risk oversight. KBRA may also look to an issuer’s risk management procedures and financial flexibility. Poor governance can damage an issuer’s reputation, result in fines and lawsuits, and increase regulation and debt repayment risk, which may be reflected in our analysis.
KBRA also reviews the board of directors’ engagement and oversight of ESG issues and the issuer’s performance on relevant ESG metrics. KBRA also believes relevant ESG events should be reported to the board in keeping with the issuer’s established risk-reporting procedures. Either the board of directors or a dedicated group of directors should engage with management and external parties regularly to understand the interplay between ESG and the organization’s operational and financial performance, goals, risks and opportunities, and reputation.
A company’s relationship with its customers and employees can be severely damaged if confidential data become public. Cybersecurity breaches can have a direct impact on trust and loyalty, and a high-profile breach can damage a company’s brand, market share, and ability to generate revenues. KBRA believes that an effective management team should, at a minimum, have an effective security response plan that can quickly identify breaches to its internal networks. The ability for aviation companies to swiftly adapt to security lapses is critical, considering the negative impact that technological breaches could have on operations, customer demand, and financial performance.
Management teams that do not spend adequate time and resources on a comprehensive cybersecurity plan and infrastructure are exposing the company to significant risks. In some cases, these risks could have a severe impact on operations. Without proper cybersecurity systems in place, KBRA believes these risks increase the probability of default, which will likely have a negative impact on creditworthiness. As part of KBRA’s evaluation, the analytical team identifies the frequency in which the company’s board reviews the overall cybersecurity strategy, as well as the potential threat and breach response plans.
Government Relations and Regulatory Oversight
Strong government and agency relationships can enable aviation companies to achieve greater strategic autonomy, easing regulatory pressures and reducing the risk of adverse government action. A good relationship can foster greater government support, as evidenced by global governmental assistance for the aviation sector during the outbreak of the COVID-19 pandemic by offering capital infusions and the extension of grants, low-cost loans, and various payroll subsidies.
The aviation sector is also subject to highly variable and unpredictable demand that is particularly sensitive to changes in economic conditions and evolving regulatory requirements. There are a significant number of governmental agencies and legislative bodies that have the ability to directly or indirectly affect the sector financially and operationally. KBRA evaluates the issuer’s compliance with regulatory bodies and identifies any possible civil penalties related to regulatory violations.
Geopolitical dynamics have historically been part of KBRA’s credit analysis of aviation companies. Issuers often operate global businesses with significant operations outside of the U.S. Business activities can be adversely affected by government policies, reversals or delays in the opening of foreign markets, exchange controls or other restrictions on funds, currency and political risks. More generally, a large portion of the demand for passenger and cargo air services comes from business in support of global trade. Should governmental policies—such as increased tariff barriers and travel limitations—reduce global commercial activity, the result could be a material decrease in the demand for aviation services. KBRA reviews the issuer’s ability to manage the threats that escalating international and internal political tensions pose to its operations and performance.
The COVID-19 outbreak, along with the containment measures implemented by governments and private organizations, has resulted in a severe decline in demand for air travel. The pandemic has adversely affected the aviation sector in many ways, including halting operations and damaging the financial conditions of various entities in the industry. Travel restrictions (including testing regimes, quarantine orders, and limitations on public gatherings), cancellation of public events, and increases in remote work have significantly reduced demand for both domestic and international business and leisure travel. KBRA believes issuers must learn from the COVID-19 pandemic, plan for potential future epidemics, and strategize on incorporating epidemic planning in business continuity. KBRA assesses the effectiveness of an issuer’s strategies through previous outbreaks, including its ability to adjust fleet capacity, implement cost-reduction plans, and preserve its liquidity position.
Typical guiding questions on ESG-related governance issues include:
When and how do ESG-related risks and opportunities influence the issuer’s strategy and/or financial planning?
Describe the issuer’s process for identifying, assessing, and responding to ESG-related risks and opportunities.
How does the organization report ESG-related information?
Describe how the organization is preparing for anticipated social, technological, and other demographic changes associated with the shift toward a lower-carbon economy.
Do these changes present potential risks or opportunities for them?
Does the entity have a cyber risk management program? Do they assess their threats and vulnerabilities and determine acceptable risk thresholds? Do they manage risk by prioritizing and structuring their information security program based on the cyber threats most relevant to them?
How is the entity assessing and managing the potential impact of a pandemic on its financial position, operations, and staffing using multiple scenarios? What are the entity’s plans for scenarios that are likely to result in an increase or decrease in demand for services during a pandemic (e.g., cargo and/or passenger capacity)?
ESG factors are complex, dynamic, and some are likely to become more relevant to credit over time. As the world moves toward a lower-carbon economy, ESG issues will continue to evolve as shifts in public sentiment and regulatory action influence changes in supply and demand. As we develop and advance our understanding of these complex topics, KBRA aims to understand, identify, and disclose an issuer’s unique ESG risk exposure and its relevance to credit. We will continue to communicate these findings in our rating, surveillance, and research reports as we gather data on relevant ESG considerations for our rated universe.