ESG factors can and do affect a finance entity's cash flows and likelihood of default, and thus finance companies are placing an ever-increasing focus on disclosure from borrowers. But public finance entities, themselves, are also facing increased focus on ESG disclosure: S&P Global Ratings, for example, incorporates ESG risks and analysis into its credit ratings of public finance entities. In a new report, S&P Global Ratings details how it evaluates credit qualities across public finance, including how it incorporates ESG risk.
The report encourages better reporting and transparency from finance entities, particularly in terms of governance, strategy, risk management, and identification of specific metrics and targets.
The strong linkage between ESG factors and their effects on cash flows has been made especially clear in recent years, particularly following events like the devastation of hurricanes in Texas and Puerto Rico, S&P Global Ratings says. "Declines in economic activity and revenues are key contributors to our view of credit strength," according to the report. "If extreme weather events become more frequent and the potential effects of longer term climate change become prominent, the interaction between climate and finances will remain a rating consideration, whether it involves the short-term ability to absorb financial shocks during an acute event or the longer term finances of issuing debt to plan and protect against future ones."
The analysis for the ratings looks at a public finance entity's ability to plan and prepare for these longer term issues.
In addition to extreme weather events such as hurricanes, environment-related risks that S&P Global Ratings examines include: sea level rise, island flooding, longer-term climate changes that affect water supply and agricultural production, supply chain disruption, necessity to transition production processes due to environmental regulations, management of carbon emissions, and more.
But challenges remain when it comes to disclosure practices. ESG analysis will increasingly require a qualitative view of an entity's capacity to anticipate a variety of long-term plausible ESG-related disruptions, but that can be difficult to provide when there are no standards of reporting. Often, organizations - particularly government and not-for-profit enterprises - wait for formal guidance, accounting standards, or guidelines on financial reporting determined by regulators. S&P Global believes consistent disclosure will be a key component to supporting the continued evaluation of these issues issues within public finance.
Disclosure also requires an honest assessment of the awareness of management and its ability to adapt to changes in order to preserve their financial and organizational resiliency. "There are many examples from our ratings' analysis where changes in management policies or risk management have caused rating changes or outlook revisions," according to the report.
Despite these challenges, S&P Global Ratings anticipates that over time - and as the market evolves - disclosure from borrowers will converge and increase transparency on ESG factors.
