Elon Musk is not a fan of Environmental, Social and Governance ratings. On June 10 he tweeted, “Why ESG is the devil,” in response to an article that explained how S&P Global gave Phillip Morris International a higher score than Tesla.
Aaron Sibarium of the Washington Free Beacon wrote at the time, “the electric car company….earned just 37 points on the 100-point scale compared with the cigarette giant’s 84.”
S&P and others rate thousands of corporations on their efforts to promote ESG. The scores inform “sustainable” investing decisions and determine inclusion in indices like the S&P 500 ESG Index, which is offered by S&P Global subsidiary S&P Dow Jones Indices.
S&P Global’s other notable subsidiary is S&P Global Ratings. That arm of the firm pushes so-called sustainability as well, incorporating ESG metrics into credit ratings. While firms like BlackRock have been criticized for their promotion of ESG, the equally influential credit rating agencies have gone largely unnoticed.
In January 2019, Fitch Ratings announced it would publish ESG Relevance Scores. Moody’s and S&P soon followed with their own relevance scores, called Credit Impact Scores and Credit Indicators, respectively. These “Big Three” credit rating agencies control 95 percent of the market.
All three companies use a one-to-five scale, with five signaling a very strong impact on credit. For example, oil companies often receive lower credit ratings than they otherwise would have due to climate concerns – so they’d get a “four” or “five” relevance score. These scores are supposed to only account for factors that materially impact creditworthiness.
Impact factors are highly politicized. Environmental considerations are obvious, but the Big Three also use vague terms like “demographic and societal trends” or “social capital” issues to disguise their social impact criteria. S&P provides some context on its “Social Equity” page. According to the firm, “social issues are controversial at times, yet stakeholder capitalism, gender and racial diversity, and income inequality are driving investment and innovation in markets.”
But how does racial diversity affect debt repayment capability? The Big Three punish corporations for taking the “wrong side” on controversial issues that are unrelated to their business performance.
ESG relevance scores have an overwhelmingly negative impact on credit ratings. In the first half of 2023, S&P Global issued 100 negative ESG-related credit actions, including 47 downgrades, compared to only 33 positive actions. The firm targeted some sectors more than others. Nearly every single oil and gas corporation rated by S&P received a four out of five environmental credit indicator.
Likewise, Fitch released a report in February 2022 titled “ESG Impact is Rarely Credit Positive.” The firm rated over 10,500 entities, but only gave a positive score to roughly 310 of them. According to Fitch, 16 percent of transactions received negative scores, compared to only two percent that had positive ones.
At Moody’s, “the credit impact of ESG considerations is highly negative or very highly negative for about 20 percent of the more than 5,700 corporates, financial institutions, sovereigns, sub-sovereigns and public finance entities to which we have assigned ESG scores.” Another 30 percent face potential future negative action. By contrast, only four percent of entities received a positive rating.
The use of ESG factors to determine credit ratings presents a significant ethical concern. For example, as of July 24, the ICE BofA AA US Corporate Index yielded 4.91 percent, while the corresponding Single-A Index yielded 5.35 percent. That’s a significant jump in the cost of debt for just one downgrade. Yet the Big Three have no issue strong-arming corporations into ESG compliance and punishing corporations that fail to meet sustainability standards with higher financing costs.
ESG factors should not be used to make financial decisions that address matters like companies’ abilities to borrow and repay money. In spring 2022, top elected officials in Utah and Idaho demanded S&P quit using sustainability factors in state credit ratings, but their demands haven’t moved the needle yet.
The tide is turning against ESG. Under intense criticism from journalists and lawmakers alike, BlackRock CEO Larry Fink has stopped using the term. Executive diversity officers are leaving in droves. Congress is finally acting to limit the power of proxy advising duopoly Glass Lewis and ISS.
It’s time to apply the same scrutiny to the Big Three credit rating agencies.
