9 Questions about credit investing | Question 6
What role does ESG play?
Credit analysis assesses an issuer’s capacity to generate cash, the quality of cash flow, and their ability to repay debt. Our credit analysts evaluate five factors that contribute to a fundamental score, known as an F-score.1 One of which is the issuer’s environmental, social and governance (ESG) profile, alongside its business position, strategy, financial status, corporate structure, and covenants. How does ESG information, being a significant component, aid in identifying the risks and rewards of corporate bond investments?
Integrating ESG factors in credit analysis
Since 2010, our credit team has integrated ESG analysis into bottom-up security selection to assess the risk and reward of corporate bond investments. This involves evaluating four key elements: the impact of the product or service, the company’s governance system, the position of the business in relation to key ESG criteria, and its climate resilience and decarbonization strategy. We also apply fundamental analysis to ESG, as the data quality is not always as rigorous as it is for financial indicators. Every company report produced by the credit analyst has an ESG integration section that includes a climate score and an SDG score to assess the company’s alignment with the 17 UN Sustainable Development Goals.
The four pillars of ESG integration explained
The first pillar looks at the impact of the products a company sells to determine whether these entail financially material business risks. Companies that produce unsustainable products and services could face financially material risks which could impact credit investors. For example, an oil company might come under pressure because the environmental impact of its products and services could lead to reduced sales, or carbon taxes could dilute its earnings.
The second pillar focuses on corporate governance, an essential element because any issues in this area are almost always financially material, affecting a company’s operational and financial integrity.
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.
The final pillar concentrates on the issuer’s exposure to climate change and their readiness to mitigate those effects. Here, the credit analyst uses an issuer-specific climate score that reflects the company’s impact on the climate. This pillar tackles double materiality by addressing both the financial risks of climate for the company and the company’s impact on climate. The analyst then draws a conclusion on the issuer’s carbon intensity as well as the credibility of the company’s decarbonization strategy.
Case study: the automotive industry
An example of the importance of the fourth pillar can be seen in the automotive industry, which is currently facing challenges amid its significant transition. Most automotive manufacturers are currently ill-prepared to face union-related concerns about what the energy transition implies for the labor force. Launching battery cars is a huge human capital risk: with such a large workforce, the issue of reskilling employees is both challenging and critical.
The analyst then applies the methodology described above to assess the merits of the carmaker’s ability to finance its transition to electric vehicle production. The numbers are run to estimate what it would cost to set up production facilities for batteries and battery cars, and the implied capex requirement for the coming five years. This is compared to what has been communicated to the market. If their capex budget falls short, this is flagged in the SI research report and the credit analyst will potentially adjust the credit opinion if they see a financial material impact on the credit from this risk.
The integration of ESG factors into credit analysis is not just a trend. By incorporating ESG considerations, particularly in sectors undergoing significant transformation, analysts are better equipped to identify risks and opportunities. And by combining fundamental analysis with ESG insights, we are more informed and aligned with broader societal goals, and better prepared to enhance long-term value for investors.
Footnote
1The Piotroski F-Score is a financial tool developed by Joseph Piotroski that assesses a company’s financial strength. Scores range from 0 to 9, with higher scores indicating better financial health.
