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Global credit rating agency, S&P Global Ratings, have recently announced that it will stop providing numerical scores against ESG criteria for corporate borrowers. This announcement has put credit ratings, credit rating agencies and ESG assessments in the spotlight.

In this article, we seek to explain what credit ratings and credit rating agencies are, the role they play on a capital markets transaction, how they assess a borrower's ESG exposure and recent developments in the market.

What is a credit rating?

A credit rating is an independent assessment of a borrower's ability to pay back a debt. It is based on an assessment undertaken by a credit rating agency and is designed to provide potential investors with an evaluation of a prospective borrower's creditworthiness and risk. They are assigned by a credit rating agency and use letter designations ranging from A (as a high, or "solid", credit rating) to C or D (as a low, or riskier, credit rating). They can be assigned to individual borrowers, but can also be assigned to financial instruments issued by those borrowers. Rating agencies stress that the ratings they issue are an independent opinion of the borrower and that they are not a guarantee of total risk exposure.

What is a credit rating agency?

A credit rating agency is an independent company that analyses a borrower's creditworthiness, or the financial instrument being issued by a borrower and assigns them a credit rating. The three major credit rating agencies are S&P, Fitch and Moody's. The financial instruments that a credit rating agency typically provides a rating on are debt products such as bonds.

What role do credit ratings play on a transaction?

On a capital markets transaction, borrowers obtain a credit rating from a rating agency in order to showcase their credit profile to investors. 

This takes the form of a letter designation, giving the potential investor a snapshot insight into the creditworthiness of the borrower. The letter designation varies from rating agency to rating agency, but essentially range from a designation implying an investment grade status (which means, in the opinion of the rating agency, the borrower is likely to be able to meet its debt obligations) through to a designation implying a higher risk of default (sometimes referred to as 'junk'). 

The credit rating is obtained prior to the transaction and can change, depending on the borrower. On some capital markets transactions, rating changes can trigger coupon increases or decreases. 

How do credit rating agencies assess a borrower's ESG exposure and what recent developments have there been?

In addition to providing a credit rating, some ratings agencies (and other assessors) issue analysis of a borrower's environmental, social and governance (or, ESG) exposure as part of its evaluation of the borrower and/or its financial instrument. They then ascribe a numerical value to the borrower based on that analysis. 

In assessing ESG risks, S&P Global Ratings had previously ascribed a numerical value as well as providing detailed written analysis of the ESG risks, but it has since taken the decision to remove the numerical score from their assessment. In contrast, other credit rating agencies (such as Moody's) continue to provide a numerical assessment that rates ESG criteria on a scale of one to five. 

ESG ratings – and the credit rating agencies behind them – have come under intense scrutiny recently, particularly in the United States where certain Republican states are challenging reliance by investors on ESG as an investment criteria for state pension funds. In the lead-up to the US election next year, this scrutiny may continue.

Similarly, ESG ratings may differ as between the assessors. For instance, an emphasis on different objectives may lead to different rating outcomes, such as an overemphasis by one assessor on the financial costs of net zero transition measures by a borrower as opposed to an overemphasis by another assessor on the environmental impact of the activities of the borrower. It is possible that these different methodologies could lead to different rating outcomes which, in turn, can be confusing for the borrower and investors alike. 

Financial regulators in the UK have been exploring potential regulatory reforms to ensure there is transparency and good conduct in the ESG ratings market. HM Treasury has recently concluded a consultation on expanding the regulatory oversight of the Financial Conduct Authority to cover ESG ratings providers and we await the outcome of that consultation as at the date of publication.

Therefore, borrowers looking to showcase their ESG credentials, or investors looking to invest in prospective borrowers or products based on a desire for exposure to ESG, will need to carefully scrutinise how the relevant ESG rating has been arrived at as part of the transaction process.

In our experience, borrowers and investors are increasingly focussed on ESG metrics as part of their business strategies and this will no doubt intensify as markets continue to adapt to the UK's net zero transition. 

We will be pleased to address any questions that you may have.