Fitch Ratings outlined its approach to incorporating environmental, social and governance risk into its work, in a new report from the credit rating agency.

The report was produced in response to increasing focus on ESG risk from investors and requests for increased transparency on how Fitch captures ESG risk in credit ratings. It also provides examples of how ESG risk factors have affected the agency's rating actions.

"Fitch's criteria and analysis incorporate ESG risk factors, but only where they are relevant to the assessment of credit risk." These factors are included in an assessment when Fitch deems them to have a financial impact on the rating over the relevant time period. "It is rare for ESG risk to be the main driver of credit risk or a rating action,"

Good governance provides a base to achieve a minimum rating in most sectors, but this cannot override weak financial metrics, the report said. "Where Fitch observes a deficiency that may diminish debtholder protection, the consideration may have a negative impact on the rating assigned."

However, for sovereign ratings, governance indicators carry the greatest weight of any variable in Fitch's sovereign rating model. The agency uses governance indicator in sovereign ratings "to capture the capacity and willingness of authorities to mobilize resources to fund debt payments and the risk that this might be disrupted by civil unrest, political instability or conflict, as well as the effectiveness of government and institutions in managing economic activity and absorbing adverse shocks," the report said.

Regarding environmental issues, trends and regulatory requirements are one of the factors driving expenditure, capital and operational decisions in many corporate and public sectors, including manufacturing, natural resources, energy and utilities sectors. "The risk to creditworthiness associated with environmental factors includes the security of long-term resource supply, the cost of compliance with regulations and of fines in the event of non-compliance," the report said.

When it comes to social risk, this is "typically not a key factor in credit analysis with the exception of sovereign ratings, for which political risk is an important input." Social risk appears in only a few instances within Fitch's criteria.

"Fitch Ratings Approach to Capturing Environmental, Social and Governance Risk in Credit Ratings" is available on the agency's website. Registration is required.

This article was originally published in Pensions & Investments.

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