ESG factors will depress Middle East’s credit ratings

Reuters//Abdel Hadi Ramahi

How should the GCC interpret Standard and Poor’s decision, taken last month, to stop issuing separate ESG (environment, social and governance) scores on the governments and companies that it rates?

Was the agency caving in to political pressure, or simply recognising that assigning a standalone ESG rating is analytically unsafe when there is still so much uncertainty about the impact that its factors have on companies’ financial performance?

The answer will have a significant impact on regional credit ratings in the years ahead, and on the ability of governments and companies in the GCC and the wider Middle East to access investment and finance their deficits.

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S&P says that it will continue to include “narrative paragraphs” about companies’ ESG exposure in their rating reports. But in future this narrative will not be distilled into a single alphanumeric score (A+, A, A- etc.)

The ratings agency is being investigated by nearly 20 US states, mostly Republican-controlled, which are alleging that the agency is “politicising” credit ratings by including non-financial factors in its analysis. Doing that violates US laws on consumer protection, the states say. 

In 2022, S&P assigned ESG ratings to US states that, in most cases, were either “neutral” or “moderately negative”. For state authorities that hold AAA credit ratings, such as Utah and Texas, even a “neutral” score can be seen as a threat to their pristine credit ratings. 

Credit ratings matter not only because they affect the cost of borrowing but also because high ratings are a source of pride, particularly for governments and local authorities. 

The states’ complaints will be familiar to anyone who has assigned credit ratings for one of the big agencies, as I did for Moody’s some years ago.

Simply put, if those states had received top ESG ratings, they would be trumpeting their credentials to anyone who would listen. But when they receive a lower score that threatens their AAAs, they go on the attack. 

S&P should have stood its ground, just like it does when it downgrades credit ratings on governments, local authorities and big companies.

But there is a problem here. 

Unstable methodologies

S&P – and other credit rating agencies – are being told by their regulators to include ESG factors in their rating analysis. They are also being asked to demonstrate how they are doing that.

Investors also demand information on companies’ environmental footprints, and the extent to which climate-related factors may affect their financial strength in the years ahead. 

The credit rating agencies want to show that they understand how ESG factors can affect bond issuers’ ability to meet their repayment obligations. But there is no historical data that can be modelled to help predict future defaults.

ESG-related risks are changing all the time.

Governments introduce new climate-related policies, such as tax incentives for renewable energy production.

And social expectations change – who knows what working conditions will be considered “acceptable” for a company’s garment-making subsidiary in Dhaka five years from now, ten years from now, and beyond?

The methodologies for assigning ESG scores are unstable and, for the moment, it is impossible to validate their predictive power. 

In contrast to S&P, Moody’s continues to issue distinct scores on ESG profiles of the companies and countries that it rates.

The firm’s Credit Impact Scores (CIS) indicate the extent to which ESG factors are weighing, either positively or negatively, on the client’s overall credit rating. 

So, when Moody’s assigns a “highly negative” or “very highly negative” CIS (which would be 4 or 5 respectively) the agency is saying that the overall rating is lower than it would be if ESG factors did not exist.

Moody’s assigns CIS scores of 3 (“moderately negative”) to five of the six GCC states. Bahrain has a 4.

No rated country in the Middle East has a Moody’s CIS score of 1 or 2, meaning that in every case ESG factors are depressing the overall credit rating rather than strengthening it. 

Ratings can still improve

ESG scoring has come a long way in recent years. Despite the challenges involved, we must expect them to become more consistent, more transparent and therefore more widely used in the years ahead. 

It is surely only a matter of time before S&P reinstates some form of alphanumeric ESG scoring.

Moody’s will continue to refine its CIS scores, and the other agencies will also develop their rating opinions: Fitch already assigns Climate Vulnerability Scores: “Climate.VS”. 

Middle Eastern governments may not be complaining about their ESG scores in the same way as the US states that are taking on S&P.

But unless they reduce their exposure to climate risks, improve public policy on social issues, and strengthen governance standards, their credit ratings will continue to be depressed by ESG factors, rather than pulled up.

Andrew Cunningham writes and consults on risk and governance in Middle East and sharia-compliant banking systems