Credit events such as defaults or bankruptcies can often be traced to issues that in retrospect might have seemed glaringly obvious. ESG-related infringements like poorly designed governance frameworks, environmentally damaging activity or weak health-and-safety standards will almost inevitably undermine a company’s financial performance.

By considering ESG factors in the investment decision-making process, the Robeco credit team gains a better and more complete picture of the fundamental credit quality of the companies in their investment universe, which in turn supports their ability to select quality assets for portfolios.

“The key focus of Robeco’s credit analysis is the cash-generating capacity of the issuer, the quality of cash flows, and the ability to repay debt,” says Rachel Whittaker, Robeco’s Head of SI Research. Analysts evaluate five factors to reach a conclusion on this, which is expressed in the form of a fundamental score – referred to as an F-score. The issuer’s ESG profile is one of these five factors, alongside its business position, strategy, financial position, and corporate structure and covenants.

“We believe in the principle that using financially material ESG information leads to better-informed investment decisions,” she says.

The assessment of ESG factors and their implications for an issuer’s fundamental credit quality involves four elements: the impact of the product or service produced, the company’s governance system, how the business is positioned in terms of the key ESG criteria relevant to each sector, and its climate resilience and decarbonization strategy.

The credit analyst team keeps track of the extent to which ESG considerations have a substantial impact on the credit fundamentals of the companies in their coverage universe. The bottom line is that this analysis plays a key role in shaping analysts’ findings: data for January 2023 shows that ESG information has a financially material impact in about 28.6% of company profiles, of which 22.4% is negative and 6.2% is positive.

The value of clearly defined methodologies such as the ESG integration framework is that they take the emotion out of the equation.

“It gives me peace of mind that, by using the methodology, I can make clear, substantiated recommendations that are consistent with the recommendations our team makes across the universe of companies we cover,” says Ihor Okhrimenko, Credit Analyst at Robeco who specializes in the utilities and infrastructure sectors. “This is especially helpful in clarifying thinking about topics or sectors where we as analysts might have strong personal opinions.”

He believes that it is particularly important to apply fundamental analysis when it comes to ESG, given that the data quality in this realm is not always as rigorous as it is for financial indicators. “As analysts we know the companies we cover well and know when a data point doesn’t make sense. So that's where we can add value to the proposition.”

Every company report produced by the credit analysts has an ESG integration section, including a climate score and an SDG score. The sustainable investing (SI) profiles produced by Robeco’s SI Research team are used as input for this, along with internal data tools and data from third-party ESG data providers.

“Our role in the process is to go deeper in the sustainability assessment and to help fixed income investors understand the risks,” says Gabriella Abderhalden, Analyst in the SI Research team, who specializes in consumer discretionary companies.

“We read the published ESG reports, which of course all sound great. But it’s a matter of figuring out if there are any pitfalls for investors. We have all these nice [ESG and sustainability] targets, but in some instances this is not founded on a solid strategy. They talk about recycling, but there's very little information on what they do in this area, and how they have improved over the last, say, three or five years. These are all elements of greenwashing. And that's what I'm trying to identify.”

The first pillar in the ESG integration framework involves looking at the impact of the products that a company sells, to determine whether these entail financially material risks for the business. This is based on our view that companies that produce unsustainable products and services could face additional and financially material risks, which in turn could pose risks for credit investors.

“Airlines or oil companies are examples of businesses that might be under pressure, because the environmental impact of their products and services could eventually lead to reduced sales, or because there is a risk that carbon taxes could dilute a company’s earnings,” Okhrimenko says.

The second pillar of the ESG framework considers corporate governance. “This is an especially important element since, if there's a corporate governance issue, it's almost always financially material,” he explains.

The third pillar evaluates key ESG risk factors, which differ by sector. Robeco’s SI Research team features prominently here, as they provide a materiality framework per sector, in each case reflecting elements critical to that industry.

For the automotive industry, Abderhalden highlights human capital management in the transition to electric vehicles as one of the relevant sector-specific themes that she investigates and communicates to the credit analyst, especially in light of the enormous shifts that the industry is undergoing. Most automotive manufacturers are currently ill-prepared to face union-related issues and concerns about what the energy transition implies for the labor force.

“The fact that car makers have to launch battery cars is a huge human capital risk, because the workforce is large and the question is: how do you reskill everyone?”

The issuer’s exposure to climate change and its readiness to mitigate the effects are the theme of the final pillar of the framework. Here, the credit analyst uses an issuer-specific climate score, generated in accordance with the methodology created by the specialists in the SI Center of Expertise. This score reflects an assessment of the company’s influence on climate.

Okhrimenko explains that, “unlike in the other three pillars, we here consider double materiality: not only the financial risks of climate for the company, but also the company’s impact on climate.” This pillar requires the analyst to draw a conclusion on the issuer’s carbon intensity as well as the credibility of the company’s decarbonization strategy.

Here, too, the automotive industry is an interesting example. Abderhalden describes how she applies the methodology to assess the merits of a carmaker’s spending plans to finance its transition to electric vehicle production. She runs the numbers to estimate what it would cost the company to set up production facilities for batteries and battery cars, and the implied capex requirement for the coming five years. This is then compared with what has been communicated to the market. “If their capex budget falls short of our estimates, I would regard it as a warning sign and would flag it as a risk in the SI research report. The relevant credit analyst and portfolio managers would then pick this up.”

The value of Robeco’s ESG integration framework needs to be seen in the context of the full spectrum of sustainability-related tools that the credit teams apply. As Okhrimenko puts it, “ESG integration is important, but I view it as being the very first – and basic – element of a sustainability toolkit. It considers only the financial risk faced by the bond issuer, and is not necessarily about making the world a better place. The critical aspect in our move towards a more sustainable future is to have a focus towards impact.”

In that regard, he says, Robeco has powerful tools including its work on decarbonization, its ESG bond selection framework and the Robeco SDG Framework.

This is an extract from a longer publication: