Why sustainability factors may have little credit rating impact: DBRS

A company acting in an environmentally conscious or socially responsible manner may have a limited impact on its credit rating, according to a new DBRS Morningstar report.

The report explains the difference between environmental, social and governance (ESG) sustainability factors and ESG credit risk factors. Generally, only the latter have the potential to impact companies financially and thus affect their credit rating.

“Although there can be areas of overlap between sustainability and company/financial risks, it is important for investors to be clear about the difference between them, particularly when the benefits and costs are unevenly distributed among corporate issuers,” the report said.

Sustainable investors use investing approaches such as positive or exclusionary screening to make investment decisions, and such approaches assess non-financial factors, the report said.

In comparison, a credit rating agency looks at credit risks “from the viewpoint of how environmental, social or governance factors may affect the financial strength, and by extension, the creditworthiness of debt issuers,” it said.

For instance, credit analysts examine how climate change could damage a company’s infrastructure or whether a company’s actions could trigger regulatory action.

“In contrast, sustainable investors look at how a company’s actions might lead to emitting more carbon gases or otherwise worsening climate change,” it said.

The report noted that acting in an environmentally/socially conscious way doesn’t necessarily result in a positive credit impact for a company unless it’s somehow financially rewarded or avoids financial penalties as a result.

“A manufacturing plant that switches its energy source from fossil fuels to renewable power may get favourable press for voluntarily reducing its carbon footprint,” the report said. “However, the change to renewable energy alone may not have a positive financial impact or otherwise enhance its credit profile, particularly if its major competitors are making similar changes.”

Financial materiality is the “fundamental test” to determine whether a factor has a credit impact, the report said

While sustainability initiatives generally don’t have a material financial impact on companies, “that is not to say that sustainability in investing is not important in its own right,” the report concluded.

For full details, read the DBRS Morningstar report.