The European Commission’s Action Plan has the potential to enhance ESG-related governance and build on the role of sustainability in risk management. Creating a unified classification system for sustainable activities, standards and labelling in the context of financial products will take place alongside support for investment in green assets with the European Fund for Strategic Investments (the “Juncker Plan”). Many of the proposed steps, including progress on an EU taxonomy for sustainability and development of an EU green bond standard, are envisioned within the next year.

The Action Plan has moreover been boosted with a package of proposed legislative measures, including proposals for the regulation on disclosures relating to sustainable investments and sustainability risks, which will introduce requirements on how institutional investors and asset managers disclose integration of ESG factors in risk processes.

Sustainable investing is gaining in importance. Social and sustainability bond issuance remain on a growth path, with over EUR 7bn in new debt issued by end-April 2018, comparing favourably versus the EUR 16bn issued in 2017 for the full year. Tied to ESG, green bond issuance continued to grow at a double-digit rate in 2018 and will continue advancing beyond the roughly USD 400bn level of cumulative issuance reached by end-2017.

Below, Scope’s public finance analysts explain how credit rating agencies can incorporate ESG factors when assessing sovereign risk:

Can rating agencies evaluate ESG risks at the same time as credit risk?

In some areas, we do so already. Scope evaluates a subset of ESG variables and considerations in the “Institutional & Political Risk” and “Domestic Economic Risk” categories of its sovereign methodology—so overlap exists. This means that ESG is not, so to speak, stand-alone. However, we do observe that the correlation between Scope’s ratings and ESG is highest on “G” and “S”, and much less on “E”.

In the future, rating agencies need an overarching regulatory framework, which in particular allows them to better reflect environmental risks. For example, the credit risk of a sovereign is mostly disentangled from the level of CO2 emissions that nation is responsible for as higher emissions are a negative externality for the global commons and could harm the creditworthiness of a third country more than the emitter itself. A “polluter pays principle” necessitates a generally accepted definition of stranded assets and/or classification of environmentally sustainable economic activity, as in an EU taxonomy to “internalise the externalities”.

What are Scope’s plans to take ESG into greater consideration in its public finance ratings?

Scope’s sovereign methodological update in May 2018 increased the weight of sustainability in our quantitative and qualitative analysis benchmarks. Scope’s communication of ESG integration in sovereign rating decisions was made more explicit with the addition of a new “Factoring of ESG” section in sovereign rating announcements and rating reports that was launched this August.

As Scope extends its rating coverage to cover supranationals—Scope published its inaugural supranationals methodology recently and called for comments—an important part of our credit assessment here will be the ability of a supranational to appeal to investors with its issuance of green or social impact bonds.

Sustainability could be further considered in Scope’s risk assessment via either research on how to measure sovereigns’ performance on ESG by further integration of material sustainability variables to the respective methodologies and/or via the design of a sovereign ESG scoring system separate from credit ratings. Successful integration requires that the assessment of sustainability related to ESG factors gradually but seamlessly becomes part of the legal framework, similar to the Basel rules that address financial stability risks.

What of the costs of sustainable finance initiatives and evidence that they are required or work?

Sustainability can, if considered systematically and transparently, give markets more of a long-term focus and enhance financial stability, by correcting market failures or by pricing in today the ESG tail risks which might emerge, possibly, tomorrow. While there are associated transitional costs in the near term especially, this holds the potential to make markets more efficient and stable longer term. Fostering longer-term decision-making in the financial industry is vital to the reorientation of capital flows towards a more sustainable global economy. The greatest challenge on the way towards more sustainable finance is a generally accepted classification and definition of (un-)sustainable activities. The EU’s Action Plan is a step in this direction.