The classic approach to credit risk management consists of looking at a company's profitability, liquidity and solvency. More and more you read that ESG does have an influence on credit risk assessments and investments. Laws and regulations regarding ESG are also taking shape (think of the Sustainable Finance Disclosure Regulation and the Corporate Sustainability Reporting Directive) and are expanding. Where large companies currently have to comply with the above laws, SMEs will follow in the coming years. If you do not pay attention to ESG factors during a credit risk assessment, then fines may be in the offing, the wrong credit ratings may be assigned, or you may get in trouble with laws and regulations later on. A new way of credit risk assessment offers the solution.
ESG stands for Environment, Social, and Governance (ESG). Environmental ESG factors include how organizations deal with environmental changes, how well companies can deal with them and what natural risks a company faces. Social can include factors such as health and safety, human capital and social capital. Factors belonging to Good Governance are transparency of the board, good reporting and how the board deals with risk management.
Investors are increasingly looking at companies' ESG scores before investing, and ESG is taking on ever clearer forms in law. A company's ESG image is also playing an increasing role. ESG is topical and is slowly seeping into every branch of the organization. In credit risk analysis, ESG first came to light internationally in 2016. In the Principles for Reponsible Investment (PRI), an ESG component was added by the United Nations. The purpose of this was to create more transparency and encourage systematic integration of ESG.
A new form of credit risk assessment
Adding ESG factors to your existing way of analyzing is easiest and works best. Start by defining ESG risks and associated themes. Consider a company's location (high or low risk country, for example), safety management and the like. See which factors are most important in your own industry and weigh certain factors against each other. Some factors you can weight more heavily than others. Make sure you add these factors to your technical and fundamental analysis. After this, you can start looking up this specific ESG information. As a company, you have to decide for yourself which factors to include in this analysis and how heavily to weight them. There is no one right way; credit risk management also knows no one size fits all. Do try to establish one clear guideline for all future assessments you will do, so that you only need to customize when it is really necessary.
After you determine which factors to include in the analysis, you start looking at the materiality of ESG risks. Are these factors that currently pose a risk? Or are they factors that constantly exert some degree of influence? In either case, it is good to know in what way this could affect any profitability of a company (customer or otherwise).
The last thing to consider is how likely these risks are to materialize. Not every risk is preventable, but companies can take ESG risks into account. Look at the level of preparation companies have done and also look at how financially resilient a company is when these risks manifest.
Different sectors under pressure
More and more companies, especially banks and investment companies, are already screening their relationships (suppliers and customers) for ESG risks and adjusting their agreements accordingly. Banks and investment companies are required by law to do this, and as a result you see ESG policy trickle down to smaller companies more and more. Especially with companies that trade in fossil fuels or companies at high risk of acute and persistent physical climate risks have to deal with this kind of screening. Companies that do not pass a screening can be excluded from investments and loans from banks and investment companies.
The classical way of credit risk analysis, give way to a dynamic way of looking at credit due to the pressure of ESG and associated legislation (SFDR, CSRD). Each industry differs on which factors to focus on and which factors carry more weight. However, it has been shown that a strong ESG strategy integrated into credit analyses can contribute to an organization's better financial picture. These organizations tend to be more stable and resilient. Another note is that in addition to pressure from legislation, there is also increasing top-down pressure. Banks have to comply with legislation and are therefore pushing very hard on ESG with their clients, which include smaller companies. This is now mainly felt in specific sectors, but it will not be long before ESG is in the remit of every credit manager.