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SRI

Fitch to rate all green bonds with new investor-paid ESG grades

Fitch NY from Alamy 16Sep21 575x375

Agency aims to combine high quality with comprehensive coverage

Fitch Ratings has joined the crowded market for environmental, social and governance ratings with a new set of products branded Sustainable Fitch — in-depth ratings by analysts, paid for by investors. It will roll them out without waiting for issuers to ask for them.

The agency had lagged behind Moody’s and Standard & Poor’s in its response to the growing consciousness of ESG in the last five years.

But since 2019 it has been working on developing a fresh suite of ratings, which has been in intensive development since early 2020.

On Wednesday it unveiled them in beta form and launched its Sustainable Fitch division, which will be headed by Andrew Steel, until now global head of sustainable finance at Fitch Ratings.

Sustainable Fitch is designed to contain all Fitch’s pure ESG products and to co-ordinate at group level everything the firm is doing on ESG, including the ESG analysis that feeds into its credit ratings, its climate risk and scenario analysis, some data and training products, and the new ESG Ratings.

“We’ve done it because investors wanted a transparent and cross-comparable methodology,” said Steel. “We look beyond the labelling to assess the ESG fundamentals. And what we are very conscious of, having spent a lot of time with investors, is that coverage is very important. At the moment it tends to be very patchy — it’s skewed to entities that feel they are good at things. We’re starting by producing coverage sets.”

Three linked ratings

There will be three kinds of rating, each with a five point scale, of which 1 is the highest. ESG Entity Ratings (ER1 etc) will be for companies, banks and governments, looking at their ESG performance in the round.

ESG Framework Ratings (FR1 etc) are for labelled bonds and loans, including green, social, sustainable and transition use of proceeds instruments and sustainability-linked ones based on key performance indicators.

The third set is ESG Instrument Ratings. These can apply to ordinary bonds and loans, in which case they are derived from the Entity Rating plus analysis of the debt documents. But when assigned to labelled debts, they will draw on the Entity and Framework Ratings.

The three sets of ratings use the same five point scale, so investors can read across between them.

Fitch is beginning by rating the universe of green, social and sustainable bonds and their issuers. It reckons there are 1,315 instruments from about 580 issuers. So far it has rated 200 issuers and will be publishing the ratings gradually on its website, as the associated 15-20 page reports on each make their way through the editing and publishing process. Issuers will be sent the reports on them.

By the end of this year, it hopes to have all of those bonds and issuers done. It will then turn to issuers of non-labelled debt, starting with the leveraged finance market. “Ultimately we have the capability to cover the entire fixed income and loan markets,” Steel said.

Fitch is conscious that the Entity Ratings would also be useful to equity investors, but has not given credit to this in its business plan.

All these ratings will be assigned by a dedicated team of analysts, ringfenced from the Fitch Ratings credit analysts — they will not even share information. By the end of this year Fitch will have hired and trained over 50 of them, initially all based in London and New York. They come from a broad range of backgrounds from universities to business.

Investors can test the information now and will be able to subscribe from January. The cost would be comparable with other ESG rating services, Steel said, taking into account the so far smaller coverage universe.

New business model

Fitch was not first off the mark in the ESG race between the major rating agencies. Moody’s and S&P Global have launched a variety of green bond and ESG assessment products which issuers could commission, and have also made major acquisitions in this field.

S&P acquired environmental data specialist Trucost in 2016 and Moody’s bought Vigeo Eiris, the ESG rating agency and green bond second opinion provider, in 2019.

But Fitch believes it has taken the time to develop something from scratch that investors really want, based on extensive discussions with them.

“When we looked at this market and talked to investors, we found that when they try to compare deals, they can maybe get coverage of 40% of the market from one supplier,” Steel said. “So we have developed something that covers bonds and loans, not just labelled instruments, that is on an absolute scale and cross-comparable across all industries.”

The business model for the new product has been conceived as a new one. The big ESG rating providers like MSCI and Sustainalytics rate thousands of issuers, who do not ask for the ratings or pay them. Investors pay for the service by subscribing. These ratings are based largely on computers gathering public information on the companies, which are fed through systems to produce the scores and ratings.

This is very different from the credit ratings of Moody’s, S&P and Fitch, which are based on detailed research by analysts and conversations with the issuers, and are paid for by issuers.

Moody’s and S&P have taken the high quality, issuer-paid model into the world of ESG ratings, producing assessments which occupy a similar space to the second party opinions offered by firms such as Sustainalytics, Cicero, Vigeo Eiris, ISS and DNV GL on labelled bonds. But none of these services cover large shares of the issuer spectrum.

Fitch wants to combine the high quality of rating agency analysis with the comprehensive coverage and investor subscription model of an MSCI.

Full-on analysis

“The ESG Ratings will have the level of detail of a credit rating,” said Steel. “The information we are using is different, but the granularity and rigour are the same.”

Ratings will be produced by analysts, reviewed by senior analysts and approved by committees.

Issuers will be able to solicit and pay for ratings, but rather than wait for its coverage to grow slowly as issuers commission ratings, Fitch is investing substantially over several years to build a broad coverage universe, and hoping investors will find the data valuable and want to pay for it.

This pattern may not be unique — Moody’s has also recently rolled out a five point scale of Issuer Profile Scores for each of E, S and G issues, which feed into a five point Credit Impact Score, showing how exposed issuers are to these issues.

These are for all issuers, not just those which have paid for them. One of the inputs to its Environmental IPS ratings is Carbon Transition Assessments which rank how well companies are positioned for the shift to low carbon, on a 10 point scale.

But Fitch appears to be making a bigger bet on the high quality, investor-paid model than others have so far.

Absolute ambition

One of the complaints investors have about some ESG ratings is that they are assigned on a relative basis within an industry. Thus the most ESG-conscious tobacco and oil companies can have quite high ratings. This is useful when comparing them with industry peers, but less helpful if an investor wants to compare the ESG merits of a tobacco bond and a healthcare one.

An investor in the Netherlands said he was "pretty critical" of this. His firm applies sectoral adjustments to its internal scores, which are derived from data bought from a major ESG ratings provider, to compensate for this.

Fitch is trying to avoid this pitfall by assiging all its ESG Ratings on the same scale, which it regards as an absolute one.

This is based on conventional credit ratings, which are not simply a ranking within a category, but are designed to be an absolute scale, in the sense that a given rating indicates a certain probability of default. Over time, this can be checked and the ratings recalibrated if they have departed from that probability.

Tying ESG ratings to an absolute scale is a more difficult enterprise, but that is the philosophy with which Fitch has approached building its new ratings.

At the same time, it also has a sense of how it expects the ultimate ratings to be distributed across the spectrum. It expects all 36,000 debt instruments in the world to be spread in something like a normal distribution across the ESG Rating spectrum, with far more in the middle bands than at the ends.

For labelled bonds, it expects a normal distribution with a higher midpoint, around the boundary between the 2 and 3 rating bands, and with few or no members in the lower 4 and 5 brackets.

The Dutch investor said Moody's and S&P now included information on how credit ratings were influenced by ESG factors, which he found "very useful", but he found that the degree to which these were integrated was still limited and they usually did not have a great influence on the rating.

He also said he would find it useful to have two separate analyses: one on how ESG characteristics affected credit ratings and one showing "what is the sustainability impact on society?"

“Do you still want to invest in a company that is active in oil and gas?” he said. “For the next four or five years its credit quality will still be pretty high but maybe clients don’t want to invest in it any more because of the social aspects. So separation between the two is important.”

All on one scale

The Fitch system also appears innovative in the way it brings together ordinary ESG ratings on companies or governments and assessments of specifically structured ESG debt instruments.

Fitch’s approach chimes with the trend among green and social bond investors to look not just at the specific projects financed with the bond, but the issuer as a whole.

Many ESG evaluation systems treat either entity characteristics or bond features, but not both together.

“It’s not easy to have a good idea of the quality of the green bond and how it links with the overall ESG strategy of the issuer,” said Alban de Faÿ, head of fixed income SRI processes at Amundi in Paris.

Amundi’s approach is to analyse the structure and whether it is aligned with the Green Bond Principles, then the issuer’s ability to provide detailed reports on the use of proceeds and impact, and then to consider its alignment with the issuer’s ESG strategy — so as to avoid green bonds from companies that were still developing coal power plants, for example.

“To me, a use of proceeds ESG rating should take into account the framework and the overall ESG rating of the issuer,” de Faÿ said.

Steel’s view is similar: “You can have a Framework Rating that just analyses the quality of a structure, but we don’t believe an instrument rating should be out there without taking account of the entity’s overall activities,” he said. “If you have an individual instrument assessed within the context of the entity, you can start to compare a conventional bond from a telecoms company with a green bond from an oil and gas company. If you are trying to think about a whole portfolio of bonds, that’s helpful.”

Philosophy matters

One difficulty in combining ESG ratings on entities and specific frameworks is that it involves value judgements.

An example is the value of sustainability-linked bonds. Some argue that if the targets they are tied to are the same as regular targets of the issuer, the SLB should not be valued more highly than its ordinary bond.

Steel said that if a KPI-linked bond solely had targets that were identical to the corporate targets, it would be unlikely to have a higher Instrument Rating than the Instrument Rating for the entity’s conventional bonds.

Others might take a different view, judging that the investor received protection against downside from the step-up coupon on an SLB, or that by creating the instrument, the issuer was putting money on the table and therefore greater weight ought to be attached to its sustainability commitments, even when considering its conventional bonds.

Green bonds have their own philosophical conundrums. How important is the use of proceeds, relative to the issuer’s overall activity?

In weighting the Entity and Framework components of its Instrument rating on a green bond, Fitch would have to make a call on that question.

Steel declined to say how the two elements were weighted, but he did say the same method was used for all issuers.

Breaking it down

Fitch’s answer to the problem of embedded value judgements is to give investors the granular scores that underlie each rating.

“One thing that became very clear when we were testing and trialling this is that no two investors use ESG information in the same way,” said Steel. “Some don’t look at instruments, they want entity ratings. Others have a really heavy focus on the environment but probably wouldn’t use the social scores. That’s why we designed this in a modular way. The overall score probably has limited use. Separating the components is far more useful, because investors can use them to do their own analysis.”

The headline ER, FR and IR ratings will be public and freely available. The granular scores underlying them are for subscribers only.

Investors are likely to use that information, as they are already wrestling with issues like how to weight and compare green or sustainability-linked and conventional bonds.

“You could have a very sustainable company like Iberdrola which already has a very high ESG score, like 90 out of 100,” said the Dutch investor. “If it issued a green bond the extra uptick would be limited. Or if a company has a low issuer score like ABN Amro, in the 50s, it could issue a green bond at 85, where there is a real pick-up. How you reward issuers for issuing sustainable bonds is difficult.”

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