Credit Rating Agencies Turn their attention towards Racial Equality and the “S” in ESG
On the 15th July, Moody’s discussed how failing
to narrow the wealth gap between white and black Americans, as just one indicator,
could
eventually tarnish the country’s credit rating. The focus on the economic
angle of the issue of race within the US is not surprising, but it provides for
something quantitative that rating analysts can factor in. The article by CBS
News suggests that the growth in net worth between white and black
households (a growth of 43% to $61,200, compared to a maintaining of $35,400
for black households), with the Moody’s report stating that ‘the
unequal position of the Black community in the US is a salient and persistent
feature of the inequality dynamic that exemplifies and exacerbates
credit-relevant social risks’. This is not
the first time that Moody’s has raised this issue, but the report is
emphatic in that it states that ‘inequality is driven both by macro trends and
by obstacles specific to the Black community’, with one of those specific
obstacles being the concept of ‘redlining’,
within which black applicants for credit are disproportionately less likely to
receive it in comparison with white applicants, despite having the same credit
scores. Moody’s go on to state that ‘institutional features that limit the
educational and economic opportunities of a material share of a country’s
residents ultimately limit its long-term economic potential’.
Moody’s is not alone in these assessments. Standard & Poor’s
stated in a report from last Thursday that ‘we
believe racial injustice is becoming a material issue that has the potential to
change our ESG Evaluations and credit perspectives, although the full effects
are not yet clear’. They follow this up with a belief that ‘more
corporations will announce tangible steps to align themselves with stakeholders’
social values’, and that ‘companies are realising that failure to listen to all
stakeholders, nurture a diverse and inclusive workforce, and engender strong
community relations can damage their reputations and undermine their business
models. The next step could be the elevation of social factors to the same
levels the environment and governance’. Whilst I shall not address perceived
inequality between the consideration of “E” and “G” here, the sentiment coming
from S&P is that not focusing on the “S” could have negative effects
for companies, in what is a potentially threatening-like sentiments i.e.
negative based. However, Moody’s have taken a slightly different approach.
In what the Financial Times are calling a first of
its kind for Moody’s, the recent announcement from Lloyds Banking Group, that
they would develop a programme aimed at increasing the number of black senior
employees, has seen Moody’s declare that the programme is ‘credit positive’.
The FT remarks that this marks ‘the
first time that the rating agency has explicitly linked a company’s stability
to ethnic diversity measures’. The report, which incidentally is located
behind a pay-wall for subscribers, notes how the Bank’s ‘Race Action’ plan is
‘credit
positive because they will improve staff diversity at all levels and reduce
Lloyds’ exposure to social risk’. Moody’s recognise the purposeful and
targeted nature of Lloyds’ plan and noted that they have ‘taken a specific
action on a specific category to close a gap within the gap. That’s a step
further than what we’ve seen elsewhere’, and that despite Lloyds’ rating not
changing, it was to be regarded as positive towards their future exposure to
risk.
The issue of ESG, and how ‘material’ it is to financial
investment, is of constant concern and produces lively debate. It is also tied
to ideologies, with it being noted that, for example, the UK
wants its pension funds to disclose their climate change plans, whilst the US
wants to limit the same sector’s ability to consider environment-based issues
in their deliberations (which is not surprising given the country’s exit
from the Paris Accord and a focus on prioritising domestic fossil fuel
production). However, the suggestion is that the US is also focusing on
limiting the consideration of “S” and “G” related issues, which is concerning
for the development of ESG-related financial decision making in the country.
Yet, despite agencies such as the Department of Labor stating that ESG
investment vehicles are expensive and often vaguely defined, the issuance of sustainability-related
bonds is expected
to rise by nearly 25% this year. Fitch has noted that the focus on ESG is persisting
despite the pandemic, and Moody’s have noted how considering ESG-related
issues is having a demonstrable effect on the credit risk of sensitive areas of
the economy, with the US’
coal provision being a prime example.
ESG and the concept of sustainable finance are here to stay,
irrespective of any ideological opposition that may want to return to classic
economic investing principles. However, in a recent discussion with somebody
researching the industry, the question was raised as to the differing roles of
those within the credit rating dynamic in regards to ‘making a change’. It was
a difficult question to answer of course, but a fruitful one to consider. I
focused on the role of investors, in terms of pushing issuers to disclose more
and better quality information to rating agencies (and the marketplace more
generally), and then pushing the rating agencies to be more proactive in
incorporating that higher quality information and then transmitting to the
investor base how it was incorporated – this all under the hypothesised threat
of investors not choosing to utilise credit ratings if these demands were not
met. Issuers, naturally, have a massive role to play. With regards to social
and environmental changes, they are the vehicles that have to bring about change
in such areas. Regulators, after considering their efforts and impact since the
Financial Crisis (and before), have a lot of ground to make up as their
reputation as drivers for change arguably lies in tatters, if they ever had
one. However, rating agencies have a crucial role, which arguably goes against
the calls for them to be sidelined by critics. For example, the sentiment
offered by Moody’s regarding Lloyds, and to a lesser extent S&P, suggests to
the marketplace that positive action with regards to “E” and “S” components
will be just as positively regarded as developments with “G” components. The
question then is what message does that send to market participants? To
issuers, it says that proactivity will be rewarded, rather than worrying about
the threat of inactivity, which is very different concepts. To investors, it
shows that rating agencies are not only considering these issues and
starting to find them ‘material’, but crucially that they are beginning to act,
which is a stark difference to the usual process of the rating agencies. For
the rating agencies themselves, such developments are perhaps the green shoots
of recovery since the Financial Crisis, and evidence that the movement into sustainable
finance and the delivery of data to that movement, via partnerships and
takeovers, is starting to bare fruit in that agencies can be increasingly
confident that non-financial aspects can be, and are material. Such
developments will not stop the criticism of the agencies, and nor should they.
I am, of course, biased seems as I exclusively research the industry, but there
is plenty of evidence out there if one is willing to look and consider it that
rating agencies are central to the efficient functioning of the market.
That they are starting to turn a page is positive, but it is only one page in a
particularly long story of an industry that has been particularly
transgressive. Further action will be credit positive, but for the
agencies themselves.
Keywords – credit rating agencies, race, ESG, investing, @finregmatters
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