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Corporates: KBRA’s Framework for Incorporating ESG Risk Management in Credit Ratings

Environmental technology concept. Sustainable development goals. SDGs.

This 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, this report focuses on the potential influence of ESG topics on KBRA’s analysis of corporate 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 Corporates

Some ESG factors can have a clear, identifiable impact on credit ratings and these are incorporated into 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 company’s 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 ESG risks, and the processes in place for identifying, assessing, and responding to relevant ESG risks and opportunities. KBRA also may seek to benchmark the company’s processes, strategy, and responses to these risks and opportunities relative to its peer group.

There continues to be a heightened awareness of the dynamic ESG-related risks and opportunities that companies face as the world moves toward a low-carbon economy. This awareness has led to rising pressure from legislators, regulators, investors, consumers, employees, and other stakeholders who are pushing companies to be more transparent about their ESG-related management practices and strategy. The investment community is also increasingly integrating ESG considerations into their investment decision-making processes, while regulators and legislators are pushing for standardized and transparent corporate ESG disclosures. Further, consumers and employees are demanding stronger ESG commitments from companies and pushing corporations to focus on topical ESG issues such as sustainability, diversity and inclusion, and closing the gender pay gap. Companies that ignore the relevant ESG preferences of their key stakeholder groups may see a negative impact on their revenue and/or capital access.

ESG issues are becoming increasingly critical to a company’s operational and financial performance. Companies that are responsive to mitigating and managing ESG-related risks and capitalizing on ESG opportunities will be better positioned to boost their performance and profitability in the changing competitive business landscape. As ESG risks and opportunities are often more pronounced for corporates, an analysis of a company’s ESG management approach is an important part of KBRA’s corporate rating analysis.

Environmental Factors

The impact of environmental factors for corporate issuers generally varies by industry and sector, and can be systemic or idiosyncratic at the company level. Environmental factors may arise through the company’s own operations and supply chain, as well as from external forces. Some key environmental factors that may influence corporate ratings include climate change, environmental pollution, and natural resource management, among others. KBRA notes that the impact of environmental factors on corporate ratings can occur over a short-, medium-, or long-term time frame, and as such, KBRA’s credit profiles consider the measures that companies have or are likely to adopt in their efforts to reduce exposure to or manage the impact of relevant environmental factors as they strive to build future resilience.

Climate Change

KBRA considers climate change as an important factor when looking at corporate ratings, as the ever-changing regulatory environment and increasing public pressure for enhanced climate mitigation presents potential operational risks across many industries. Where relevant, KBRA’s corporates analysts examine both physical and transition risks related to climate change. Physical risks such as extreme weather, sea-level rise, temperature rise, or drought, can directly impact a corporate’s product offering, assets, or business operations. In February 2021, Winter Storm Uri caused severe power outages across the U.S. and Mexico that affected many corporate utility providers and notably contributed to the major power crisis in Texas. The state suffered a massive power generation failure as many of the electricity generators had not been winterized and could not operate in the record low temperatures and high snowfall that were produced by the storm. During the crisis, wholesale electricity prices in Texas were as high as $9,000/MWh versus the average wholesale price of around $40/MWh. This new pricing dynamic created massive risks and opportunities to companies in the industry. Those companies that could deliver wholesale power or an intermediary product (such as natural gas to gas-fired generators) were able to benefit, while others who had to procure electricity in the wholesale power market and could not pass on costs to other participants were at a significant disadvantage. As the effects of climate change become increasingly severe, disruptions such as this are becoming more and more frequent.

In contrast to the physical risks from climate change, transition risks are indirect and relate to an entity’s ability to shift to a lower-carbon economy, including potential expansions in environmental regulations, supply and demand changes, and/or increased reputational risk. For corporates, transition risk exposure is especially prominent and can affect the cost of products and/or services, as well as introduce capital expenditure compliance requirements that can influence financial performance. Regulators are increasingly mandating emissions reductions in the utilities sector, which has a large carbon footprint. In 2002, for example, the California Public Utilities Commission (CPUC) established a renewable portfolio standard (RPS) that requires all load serving entities (LSE)—utilities, electricity cooperatives, and community choice aggregators—that operate in the state to ensure renewable energy constitutes a specified minimum portion of the electric load. Currently, the RPS mandates that LSEs must ensure 60% of their electric load is met with renewable energy by 2030 before rising to 100% by 2045. The regulatory environment has led to a flurry of new investments and development activities in renewable energy generators, thereby creating a favorable situation for investors and developers of renewable assets. Meanwhile, for many of the LSEs in the state (especially legacy investor-owned utilities that serve as the electricity provider of last resort), the regulatory environment requires them to undergo a holistic assessment of how to produce (or procure) new renewable energy to meet the increasing RPS standards. To that end, California’s LSEs have taken several actions including increased renewable energy-focused capital expenditure as well as stranding and retiring fossil fuel-fired generators. Further, the LSEs have adjusted their transmission and distribution assets to account for the introduction of intermittent renewable generation.

Where relevant, KBRA requests information on how a corporate not only evaluates its climate-related risk exposure, but also prepares for potential regulatory changes and incorporates relevant environmental risks and opportunities into the company’s risk management processes. KBRA may also analyze the corporate’s processes for identifying, assessing, and responding to relevant environmental risks and opportunities relative to its peer group. In KBRA’s view, corporates that adequately identify and assess climate-related risks will be better positioned to manage their exposure, mitigate risks and capitalize on opportunities over the longer term. Companies with management teams that are not planning for future environmental risks will likely face declining productivity, reductions in the scope of their operations, increased capital costs, and in some severe cases, the complete loss of corporate assets and business operations.

Environmental Pollution

Environmental pollution remains one of the most serious global challenges facing corporates, with companies continually balancing corporate growth with the potential negative externalities that are generated from their production processes. KBRA believes it is critical to understand a company’s negative effect on the environment and the pollution that is produced as a result of its operations. Environmental pollution is the introduction of foreign contaminants into a natural environment that causes adverse changes to the surrounding ecosystems. Forms of pollutions include, but are not limited to, nuclear plant leaks, oil spills, and toxic waste that introduce foreign substances into the land, water, or air. The credit quality of a corporate may be impacted by pollution risk should government regulation or changing consumer views cause the company to internalize the cost of the pollution.

Retailers, for example, face a range of environmental pollution issues including an increasing carbon footprint, health and ecological problems arising from the disposal of packaging, and direct air and water pollution generated from the distribution and transportation of goods to retail stores. Corporate retailers have generally responded with increased transparency, acknowledging that there are potential environmental health and safety concerns regarding their products’ life cycles. Further, some retailers have developed initiatives to reduce their environmental impact wherever possible. Measures adopted to reduce pollution risk, including mitigation efforts, remain an area of focus in KBRA’s rating process.

Natural Resource Management

Natural resource management may be an important credit consideration when a corporate’s business model relies on the health and productivity of a given natural resource. Natural resource management encompasses issues concerning the sustainability of finite resources such as land, water, soil, plants, and animals.

KBRA notes that corporates that rely on natural resources for revenue may experience declining credit metrics in the absence of, or in the loss of productivity in, the natural resource, especially as climate change intensifies. Corporates that have articulated and complied with an effective natural resource management program may benefit not only from the continued sustainability of the income-producing natural resource, but also from the barriers to entry that were developed as a result of the implementation of the program. For example, Canada’s forest product industry continues to maintain its international reputation as a trusted source of legally and sustainably sourced lumber. In conjunction with the Canadian government, producers in the Canadian forest products industry have implemented a strict land-use planning, permitting, and enforcement aimed at maintaining and enhancing the long-term health of the natural forest ecosystem, while retaining economic opportunities for the industry. This sustainable resource management practice ensures that less than 1% of managed forests are harvested each year and that seedlings are replanted following harvesting on public lands. Such measures have helped the Canadian forest product industry to achieve a decades-long record of zero net deforestation. The reputation that accompanies producers of Canadian forest products—a well-earned reputation through effective corporate and government partnership—underpins the premium prices that Canadian forest products producers can attain in the marketplace. Meanwhile, in countries that lack effective forestry management practices, illegal logging and unsustainable harvest practices are common.

Typical guiding questions on environmental risk exposures include:

  • How does the corporate evaluate the impact of climate change on its business and financial risk profile?

    • Does the corporate take into consideration different climate-related scenarios including a rapid acceleration of changes in the climate or stricter regulations related to climate change?

  • How would the introduction of carbon or methane regulation impact the corporate’s profitability and ease of business development?

    • Does the corporate currently use internal carbon/methane pricing or have future plans to adopt such pricing?

  • Does the corporate calculate carbon emissions? If so, what were the annual Scope 1, 2, and/or 3 carbon emissions levels and how are these calculated?

    • Does the corporate engage in third-party emissions reporting verification?

  • What is the corporate’s level of exposure to physical climate risks (hurricanes, floods, droughts, wildfires, etc.) that could potentially have a financial impact?

  • What is the corporate’s level of exposure to transition risks (including potential regional and federal regulatory changes) that could potentially have a financial impact?

  • Does the corporate consider the environmental impact of its operations and is the corporate actively planning to reduce this exposure?

Social Factors

Social factors can be an important component of corporate analysis and can positively or negatively impact creditworthiness. A corporate’s social awareness and practices may enhance brand equity and create new channels of demand for a product or service. Shortcomings can create operational inefficiencies and alienate potential customers. Key social factors that may influence the ratings of corporate issuers include stakeholder preferences and reputational risk, among others. KBRA notes that while these social factors may arise and could impact a corporate’s credit quality, any impact has historically been well managed.

KBRA assesses the impact on corporate credit by evaluating how social factors could affect performance and KBRA notes that this assessment sometimes becomes very nuanced. For example, an e-cigarette company may find that its reputation has become negatively impacted due to shifting perception about its products and a rise in usage among teenagers. That said, the credit impact of these factors may be mitigated due to the demand stickiness and relative price inelasticity of its product. The credit impact of social factors may also be mitigated by the company’s efforts to protect its reputation or stay ahead of shifting social issues. In the above example, a few companies have proactively stopped selling flavored e-cigarettes to get ahead of upcoming regulation and signal to the market that they are aligned with the public interest.

Stakeholder Preferences

In relation to corporates, social issues are most likely to be incorporated in KBRA’s analysis of stakeholder preferences. KBRA believes it is important for corporates to demonstrate awareness of, and disclose the ESG preferences of, their key stakeholders and how these preferences may impact the corporate’s operating, capital, and financial strategies. Labor management, employee health and safety, and community relations, among other potential stakeholder issues, can affect a company’s reputation and revenues. Stakeholder views on a company’s board composition, executive compensation policies, supply chain management, tax strategy, or cybersecurity systems, can potentially affect its reputation and ability to access capital, which is a key credit risk. A company that ignores relevant ESG factors deemed a priority by society (such as its contribution to climate change) could face backlash from its stakeholders, which can negatively affect creditworthiness.

For example, community opposition to energy companies that derive most of their revenues from the burning of fossil fuels has been a common occurrence in recent years and can delay or halt the capital expenditure of many industry participants. As is the case for numerous midstream energy corporates, KBRA points to the increasing concerns raised by surrounding communities around the negative ecological impact that constructing and operating new pipelines may have on water quality, wildlife, and the outer environment.

In the event of significant community backlash, KBRA believes it is critical for corporate management teams to interact with the community and have clear plans in place to manage their concerns and mitigate any potential adverse risks. For many companies, effective communication and ongoing community engagement may be needed for long-term success. KBRA believes that when corporates maintain a constructive relationship within their communities, they are generally better aligned with the preferences and demands of stakeholders. KBRA notes that community relations may influence the long-term performance of a corporate as these may affect demand trends through its influence on consumer preferences. Corporates may positively improve their relationship with the broader community through forms of social outreach initiatives, such as community service and donations, which may improve the socioeconomical conditions of the surrounding area. For example, a company could support and invest in a local recreational center, school, or community park. In turn, the corporate may be able to attract new consumers and enhance its brand and company loyalty, which may become valuable in helping the corporate manage through business cycle fluctuations. Likewise, proactive labor management that prioritizes emergency preparedness and the health and safety of employees is important for corporates, given that a positive working relationship is a prerequisite for organizational success.

Further, stakeholder preference may also affect a company’s reputation risk. Reputational risk represents the potential threat of negative public perception and publicity that can befall a corporate and, consequently, financial performance. Reputational risk could arise through corporate, employee and external actions and can influence corporate credit through multiple areas such as employee behavior, safety, demand for services and products, and lawsuits.

Any corporate may be negatively exposed to reputational risk that could adversely affect its overall financial performance. For example, food and beverage companies may be susceptible to reputational risks due to the nature of the industry. Restaurants are in daily contact with consumers who directly observe the quality of the food, service, and staff as well as the cleanliness of the space and its surroundings. The cost to a restaurant of not focusing on food safety and public health issues can directly affect the company’s operations and profitability, especially following a food safety incident. In addition to costs related to food recalls and other expenses for legal fees and increased sanitization measures, food safety incidents also significantly damage the reputation of a restaurant, leading to declines in the company’s same-store-sales and revenues at a time when the company’s expenses are most likely rising as it deals with the incident. Even after the food safety incident has been successfully alleviated, it may take some time as well as significant effort for the company to repair its reputation and improve its profitability profile.

Supply Chain Management

Supply chain management is becoming increasingly important, especially in light of the COVID-19 pandemic and the subsequent supply chain disruptions that followed. A company’s management oversight of all the processes and workers involved in the production of its goods and services is an important ESG credit consideration. Historically, companies have aimed to manage their supply chain in such a way to deliver their products or services as economically and efficiently as possible. As supply chain management has become more complex, companies are also beginning to focus on sustainable and environmentally friendly operations, especially as they outsource various stages of the supply chain process to suppliers in countries with a cost advantage. Unsurprisingly, stakeholder pressures have led to increased scrutiny of corporate supply chain management. Overall, supply chain management provides several opportunities for companies to improve their profitability and is especially important for companies with large and international operations. However, supply chain mismanagement can led to shortages of raw materials, workforce health and safety incidents, labor disputes, corruption and bribery charges, or other geopolitical considerations that can arise when managing a large and often global supply chain. This mismanagement can also lead to stakeholder and reputational pressure.

The apparel industry is especially prone to ESG-related supply chain risks due to the sector’s global supply chain that involves many players across various countries; making it difficult to effectively control all portions of the supply chain. The industry’s supply chain includes companies that source fibers and raw materials, design and manufacture the apparel, ship the finished product to end markets, and market and sell the finished product. As various steps in the supply chain are labor-intensive, large multinational corporations often outsource these areas to various company in developing countries, while managing the brand in a developed country. For example, many of these large multinational apparel companies have been exposed to reputational risk and litigation following reports of suppliers exploiting forced labor in developed countries.

Typical guiding questions on social risk exposures include:

  • Who are the corporate’s key stakeholders (investors, lenders, business owners, consumers, employees, etc.)? What risks or opportunities do these stakeholders pose to their business?

    • Do the preferences of the corporate’s key stakeholder groups pose risks to long-term operational and/or financial stability?

  • Has the corporate been involved in any ESG-related controversies, litigation, misconduct, penalties, incidents, or cybersecurity attacks that may have implications on stakeholder/reputational risk?

  • Has the corporate faced backlash related to its management of the health and safety of its employees and/or its ability to create a safe working environment (including workers in its supply chain)?

  • Has the corporate experienced pushback from stakeholders about its strategy for dealing with its identified ESG risks?

    • Are stakeholders pushing the corporate toward a different strategic undertaking?

Governance Factors

Governance issues have historically been important considerations in credit analysis as good governance practices are frequently drivers of financial stability and creditworthiness across corporates. A capable management team that can plan for and mitigate the company’s unique challenges (ESG-related or otherwise) is crucial for financial stability, in KBRA’s opinion. In addition, a corporate’s commitment to accountability, integrity, transparency, and responsibility in all its practices is often reflected in its creditworthiness. KBRA’s evaluation of governance includes a review of the corporate’s management policies, potential regulatory changes, and cybersecurity plans. A corporate’s business model, ownership structure, and management profile, as well as its strategy and internal policies, are important factors that KBRA typically considers in the ratings process. It is also increasingly important to understand how corporates prioritize ESG issues into their long-term operational and financial plan. KBRA may also look to a corporate’s risk management procedures, financial flexibility, and its accountability and transparency related to ESG issues.

Poor governance can damage a corporate’s reputation, resulting in fines and lawsuits, and can increase regulation and debt repayment risk, which may be reflected in KBRA’s analysis. KBRA also reviews the board of directors’ engagement and oversight of ESG issues and the corporate’s performance on relevant ESG metrics, with a particular emphasis on cybersecurity. KBRA believes that, with a clearer view of ESG risks and opportunities, companies can better allocate its resources and remain compliant with shifting regulations and policies. KBRA considers the long-term planning that a company has in place to mitigate ESG risks and capitalize on opportunities, including how the company approaches ESG conversations with external clients, vendors, and other relevant external parties and how the company discloses ESG issues.

Cybersecurity

Cyberattack risk continues to increase as most corporates have become more reliant on technology. However, the impact of these attacks varies greatly across industries. Many of the recent cybersecurity attacks have impacted companies that operate in crucial industries such as energy, industrials, and health care, and are particularly worrisome given the critical infrastructure these companies employ. A cyberattack in these industries can result in explosions or environmental damage, sensitive data leaks, or supply issues, all of which could endanger civilian lives and cause billions of dollars in damages.

KBRA believes that an effective management team should, at a minimum, have an effective risk management procedure that can quickly identify breaches to its internal networks. The ability for corporates to swiftly adapt to security lapses is critical, considering the impact that technological breaches could have on the operations and financial performance of a company. A corporate can improve its risk management practices by actively implementing risk infrastructure and improving the quality of its technology and data. By being proactive in identifying ongoing risks, a company can continually strengthen its risk management processes. Management teams that do not spend a substantial amount of time and resources on a comprehensive cybersecurity plan and infrastructure are exposing the corporate to significant risks. Without proper cybersecurity systems in place, KBRA believes these risks increase the probability of default, and in turn, will likely have a negative impact on creditworthiness.

While the analytical assessment of governance risks can vary depending on the nature of a company’s operations, typical guiding questions on governance risk exposures include:

  • When and how do ESG-related risks and opportunities influence the corporate’s strategy and/or financial planning?

    • Describe the corporate’s process for identifying, assessing, and responding to ESG-related risks and opportunities.

    • Describe how the corporate is preparing for anticipated social, technological, and other demographic changes associated with the shift toward a lower carbon economy.

  • Does the corporate have a cyber risk management program?

    • How does the corporate assess threats and vulnerabilities to its internal system? How does the corporate determine acceptable risk thresholds?

    • Does the corporate manage risk by prioritizing and structuring its information security program based on the most relevant cyber threats?

  • How is the corporate preparing for future epidemics and what were the lessons learned from the COVID-19 pandemic?

  • How does the corporate approach ESG conversations with external clients, vendors, and other relevant external parties?

  • Does the corporate have an established framework for corporate oversight committees on ESG issues? Do they report these ESG issues to the board of directors?

Conclusion

ESG factors are complex and 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 a corporate’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 .


Contacts

Shane Olaleye, CFA, Senior Director

+1 (646) 731-2432

shane.olaleye@kbra.com

Adam Gracely, Associate Director

+1 (646) 731-3329

adam.gracely@kbra.com

Andrew Giudici, Senior Managing Director

+1 (646) 731-2372

andrew.giudici@kbra.com

William Cox, Senior Managing Director

+1 (646) 731-2472

william.cox@kbra.com

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