Scrap ABC in ESG

In the world

🗺️ Hot on the heels of the warmest July on record, insurance firms have painted a grim picture of 2023 so far. The financial costs of climate change are racking up, and many of them are unprotected. Munich Re reports that nearly 90% of natural disaster-driven losses in Europe were uninsured in the first six months of 2023. In the same period, the global insurance industry was met with $50bn in losses from natural catastrophes, according to Swiss Re, with storms in the US alone resulting in a record $34bn bill for insurance firms. 

🇬🇧 Even as the US pours yet more money into green industry and infrastructure, the UK offshore wind industry — starved of investment — is reportedly “at a tipping point.” Clean-energy giant Ørsted has warned that the sector will struggle to lure new offshore wind projects due to its soaring costs. The UK oil and gas industry, on the other hand, appears to be enjoying more favourable terms, having been granted lucrative new North Sea licences. That opportunity could create a dilemma for ESG-committed banks, argues Stuart Kirk, though fellow columnist Patrick Temple West contends that the odds are still stacked against fossil fuels and supportive fossil-fuel policy in the longer term.

In the news

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In the spotlight: Scrap ABC in ESG

This week, S&P Global decoupled alphanumeric ESG scores from its credit ratings. Notwithstanding a slew of misleading (albeit clickable, presumably) headlines speculating about anti-ESG “political backlash,” an S&P insider told Bloomberg the decision was “unrelated to political attacks or legal threats.” Instead — and no less significantly — it is allegedly a response to client confusion. It turns out that investors prefer text to a 1-5 rating system when it comes to non-binary information.

In a statement, S&P explained that “the dedicated analytical narrative paragraphs in our credit rating reports are most effective at providing detail and transparency on ESG credit factors material to our rating analysis,” adding that “this update does not affect our ESG principles criteria or our research and commentary on ESG-related topics, including the influence of ESG factors material to our rating analysis.”

S&P introduced its ESG scale to credit scores in 2021, following similar moves by Moody’s and Fitch. “They were meant to be easy-to-visualise scores that conveyed the relevance of environmental, social and governance factors in a credit rating analysis,” reports Bloomberg, but the concept soon ran into two practical problems. 

1. Investors don’t find an alphanumeric scale as intuitive a benchmark for a company’s social and environmental risk as it is for its creditworthiness. 

This is a topic on which we’ve taken a stand many times before, both in this newsletter and in the press (here and here and here and here and… you get the picture). Bundled ESG scores are ineffective at best and dangerous at worst. They blend often-unrelated information, which leaves critical investor insights overlooked (accidentally) or obscured (deliberately).

2. Risk rating agencies don’t find social and environmental risk, particularly climate change, as straightforward to quantify as they do credit risk. 

On the one hand, that’s neither a surprising nor a unique problem. Mapping the financial effects of climate change is a fiendishly complex and relatively young science. On the other hand, recent research by the European Central Bank (ECB) and, just this week, the University of Cambridge suggest that credit ratings agencies are making it harder for themselves by mapping the wrong type of thing. 

Growing weather extremes will have dramatic financial consequences for the $133 trillion global bond market. The University of Cambridge researchers suggest that weather-induced sovereign downgrades could arrive as soon as 2030. Despite their statistical significance, however, the ECB reports that climate variables have little influence on sovereign ratings. 

In research published this year, it warned that climate-related fiscal risks have been overlooked relative to climate-related financial stability. Moreover, the ECB findings imply that rating agencies are taking a rose-tinted view of sovereign risk where governments have put in place mitigation measures, even if their efficacy is dwarfed by the impending economic effects of climate change. 

In other words, financial institutions are underestimating the economic effects of climate change on a systemic scale. Their methodological bias towards governance rather than absolute environmental impact is deepening a looming insurance and investment crisis. It may be time to axe ESG scores, but only because they say too little — not too much.