ESG Risk Factors by Sector
Overview
Both issuer and transaction-specific ratings incorporate ESG and other risks for the life of the rating. The probability of a specific adverse event may be much lower under a two-year time horizon than the probability of the same event occurring over a 30-year time horizon.
ESG risk factors are part of the rating process across the four credit rating groups — Governments, Financial Institutions, Corporate Finance, and Structured Finance — and where appropriate are detailed in press releases and rating reports.
Examples of Significant ESG Risk Factors by Sector
1. Emissions, Effluents, and Waste
Do the costs or risks result in changes to a government’s financial standing or relation-ship with other governments, and does this affect the assessment of credit risk?
- A municipal government may incur increasing costs associated with hazardous waste, cleanup, and disposal efforts
Do we consider that the costs or risks result, or could result, in changes to an issuer’s financial, operational, and/or reputational standing?
- A financial institution faces reputational risk for its lending practices to environmentally sensitive industries that are under increasing scrutiny from investors and regulators.
Do we consider that the costs or risks result, or could result, in changes to an issuer’s financial, operational, and/or reputational standing?
- A mining company incurs remediation costs or regulatory penalties for discharging processing waste into a local river.
- A manufacturing plant incurs increasing disposal costs for industrial waste as part of its production process.
Do the costs or risks result in a higher default risk or lower recoveries for the securitized assets?
- A commercial real estate (CRE) environmental report shows contamination issues (e.g., mould after flooding) that would require investment to rectify.
2. Carbon and GHG Costs
Does a government face coordinated pressure from a higher-tier government or from numerous foreign governments as a result of its GHG emissions policies, and does this affect the assessment of credit risk?
Will recent regulatory changes have any adverse impact on economic resilience or public finances?
- A major industry struggles to adapt to new environmental regulations, particularly in the face of international competition from less-regulated economies, resulting in weaker economic growth and declining employment.
Does the issuer face increased regulatory pressure relating to the carbon impact of its or its clients’ operations resulting in additional costs?
- Lending to companies with high GHG emissions could have a reputational impact on the financial institution.
- Aircraft leasing companies could face pressure from increasing scrutiny for the high GHG emissions of flights.
Does the issuer face increased regulatory pressure relating to the carbon impact of its or its clients’ operations resulting in additional costs?
- An airline faces increasing societal pressures about the high GHG emissions of its flights.
- A coal plant faces rising costs in buying carbon credits to offset emissions
Do the costs or risks related to GHG emissions result in higher default risk or lower recoveries of the securitized assets?Are there potential benefits of GHG-efficient assets on affordability, financeability, or future values (recoveries)?
- A mortgage portfolio from a “sustainable lender” that contains only loans backed by properties with top energy ratings may have less-volatile property values and higher recoveries.
- Regulatory restrictions for landlords related to meeting minimum energy-efficiency standards could result in higher default risk and lower recoveries in the short to medium term.
- In aircraft asset-backed secu-rities, using more fuel-efficient engines and lighter airframes can reduce GHG emissions; this may negatively affect the values of older equipment
3. Resource and Energy Management
Does the scarcity of key resources impose high costs on the public sector or make the private sector less competitive? Is the economy reliant on industries that are vulnerable to import or export price shocks?
- Industrial production undergoes a structural decline due to rising prices for key inputs.
Unlikely to apply.
- Not applicable.
Does the scarcity of sourcing key resources hinder the production or operations of the issuer, resulting in lower productivity and therefore revenues?
- A global shortage of lithium preventing a car manufacturer from meeting electric vehicle demand and meeting revenue forecasts.
Unlikely to apply.
- Not applicable.
4. Land Impact and Biodiversity
Is there a risk to a government’s economic or tax base for failing to effectively regulate land impact and biodiversity activities?
- Natural resource exploitation without sufficient public savings results in a sustained gradual decline of national wealth.
Unlikely to apply.
- Not applicable.
Is there a financial risk to the issuer for failing to effectively manage land conversion, rehabilitation, land impact, or biodiversity activities?
- The forestry industry over-harvests old-growth forests, resulting in future shortages and price volatility.
- An oil exploration company is required to rehabilitate lands contaminated by its resource extraction.
Unlikely to apply.
- Not applicable.
5. Climate and Weather Risks
Will climate change and adverse weather events potentially destroy a material portion of national wealth, weaken the financial system, or disrupt the economy?
- Frequent droughts and extreme heat lead to more forest fires, resulting in infrastructure damage and increased public expenditure.
Will climate change and adverse weather events potentially disrupt issuer or client operations, causing a negative financial impact?
- More frequent P&C claims because of extreme weather events.
- Potentially higher losses on mortgages secured by commercial or residential properties in regions that are affected by adverse climate or weather.
Will climate change and adverse weather events potentially disrupt issuer or client operations, causing a negative financial impact?
- More frequent and volatile storm systems may adversely affect tropical tourism desti-nations and the industries that support them.
Are the securitized assets in regions exposed to climate change and adverse weather events affecting expected default rates, future valuations, and/or recoveries?
- Potentially higher losses on mortgage portfolios secured by commercial or residential properties in regions that will likely be affected by adverse climate or weather.
Prominent ESG Risk Factors by Rating Group
The primary ESG risk factors uniquely affect each of the four different rating groups. In the Governments rating sector, 10 ESG
risk factors could be considered in the analysis, but just six of these factors are prominent. Similarly, of the 12 Financial
Institutions factors, seven are most prominent; of the 15 factors in Corporates, 10 are most prominent; and for Structured
Finance, seven of the eight factors are most prominent.
ESG Framework by Sector
The following section provides a high-level overview of how ESG risk factors and related considerations affect
Governments, Financial Institutions, Corporate Finance and Structured Finance sectors from an analytical perspective.