Moody’s 2023 ESG Outlook highlights the rising risk to corporate and sovereign debt from ESG factors. While near-term risks stem from climate change, social challenges, and deteriorating economic conditions, longer-term risks arise from the need to reduce waste, physical climate risks, biodiversity loss, and the need for a just transition.
- Global ratings agency Moody’s has analysed increasing corporate and sovereign debt risk in its 2023 ESG outlook.
- Corporate and sovereign decarbonisation plans, ESG regulation and policy complexities, the cost of living crisis, credit risk from deteriorating economic conditions are all contributing factors.
- Longer-term credit implications include climate change, energy and just transition plans, biodiversity and the push towards a circular economy.
Prior Moody’s report highlighted ESG-related credit risks to high-polluting sectors
In November 2022, Moody’s updated its analysis of the impact on companies in 89 sectors with a total rated debt burden of $83 trillion, from five environmental risk categories: carbon transition, physical climate damage, waste and pollution, natural capital dependency and water management.
The oil and gas sector, and its related sub-sectors, had very high or high exposure to all five environmental risk categories. Three of the six sectors facing very high environmental risks are related to fossil fuels, with the remaining relating to coal, chemicals and metals mining.
While the sectors on the list facing very high environmental risks is not new, what is perhaps surprising is that their total debt has nearly doubled since the Paris Agreement was signed. Companies in these sectors are affected by most of the factors contributing to higher ESG-related risks to corporate and sovereign debt in 2023 and beyond.
Emissions reduction and transition plans will invite increased scrutiny
Moody’s 2023 ESG Outlook identifies a heightened credit risk for sectors that have not yet adequately disclosed their transition and decarbonisation plans. This will result from the accelerated implementation of national policies and pledges, with related impacts from financial markets and corporate customers.
The fossil fuel sector serves as a great example: accelerated net zero plans could strand assets for oil and gas companies and require them to increase capital spending. The increased financial burden on balance sheets and profits could lead to higher interest costs, while demand for all goods and services related to fossil fuel also faces declines amid increased scrutiny over supply chains and Scope 3 emissions.
Companies in mining and chemicals could face a similar fate, albeit to a lesser degree. According to Moody’s estimates, 16 sectors with nearly $5 trillion of debt have high or very high inherent exposure to carbon transition risk.
Regulatory risks stemming from ESG disclosure and policy complexities
ESG disclosure and changing political landscapes are also impacting the credit picture in 2023. Companies face complex and varying disclosure requirements across the jurisdictions where they operate, which adds cost and delays to complying with regulations. This is exacerbated by the backlash against sustainability in certain regions.
The response by fund managers to the delayed SFDR level 2 regulations in Europe, and the anti-ESG sentiment in Republican-led states in the US – where regulators also fined banks and asset managers for misstated ESG claims – are perfect examples of these complexities.
In the case of the EU SFDR, fund managers have downgraded funds from Article 9 to Article 8 amid concerns of reputational damage for non-compliance. In the US, while BlackRock (NYQ:BLK), Goldman Sachs (NYSE:GS) and JPMorgan Chase (NYSE:JPM) have been banned from doing business in five states due to their support of ESG strategies, regulators have fined BNY Mellon and Goldman Sachs for misrepresenting the ESG credentials of some of their funds.
Moody’s expects regulatory and political oversight to remain a major factor affecting credit in 2023. While in the near term this may raise costs and reduce competition in financial and non-financial markets, it sees the increased transparency benefiting investor confidence and boosting market growth in the long term.
Credit risk from social impacts of inflation and geopolitical conflicts
Social issues affecting the quality of life of individuals could have a major bearing on monetary and fiscal policies, which could impact sovereign credit and, in turn, affect corporate credit as well. Inflation, food shortages, supply chain breakdowns and the energy crisis are hurting the most vulnerable in society. This has added to the burden on policymakers who have still not fully restored their economies to pre-pandemic levels.
Moody’s expects credit impacts to arise from macro factors such as reduced purchasing power, the effect of windfall taxes on energy and power providers, and a higher fiscal burden on emerging market countries, which are home to a large portion of the supply chain of larger companies in the developed world.
While the ratings agency did not provide an extended outlook for the impact of social risks in the report, it is forecast that economic recovery from the effects of strikes, redundancies and a decline in the housing market in many countries could take several years.
Economic downturn could hurt lower-rated entities
According to Moody’s, credit risks rise the most for lower-rated entities amid challenging macroeconomic and financial conditions. Risk management abilities and governance will be tested as demand slows, input costs rise, and worsening macroeconomic conditions roil markets.
Entities with lower credit ratings tend to have governance attributes that increase their credit risk and lower their ability to withstand external shocks. This could include companies that have highly leveraged capital structures and weak risk management policies in place.
In the case of governments, these shocks could come from a lack of capacity across its financial and regulatory institutions, as well as ineffective policy. Moody’s states that non-financial companies and emerging market governments have exhibited the most negative governance attributes.
The agency also expects private equity-owned companies to account for a majority of potential defaults. These account for 80% of US-based and for two-thirds of EMEA-based companies that are rated B3 negative and below, mostly due to the need to avoid bankruptcy, reduce debt, or extend debt maturities.
Speculative-grade non-financial companies in consumer products, retail and hospitality are likely to face the greatest default risks due to slowing global demand and inflation. Moody’s expects speculative-grade corporate defaults to rise to 4.9% by November 2023, from 2.6% a year earlier. Speculative-grade bonds are also referred to as high-yield or junk bonds.
Future trends impacting credit quality
Moody’s said the impact of other ESG risks will become clearer in 2023 and beyond. Some of the trends highlighted in the report that bear watching are the costs of physical climate risks, including costs for adaptation, integrating a just transition in energy transition, as well as a growing investor and regulatory focus on biodiversity and natural capital risks.
The ratings agency believes a focus on implementing waste reduction and circular economy practices will impact credit in the longer term. Sectors most at risk from physical climate risk include farming and agriculture, coal, and parts of the oil and gas industry.
The energy crisis in Europe stemming from the war in Ukraine highlights the need to provide access to energy for all, regardless of income levels. Governments that account for the social implications of transitioning to a low-carbon economy could potentially face lower social inequality and unemployment risks.
Moody’s has identified nine sectors with an estimated $1.7 trillion in rated debt, which face high or very high exposure to biodiversity, which include mining, livestock and agriculture. Countries at risk from deforestation include Kenya, Gabon, Brazil, Indonesia and the Democratic Republic of Congo.
Sectors most exposed to waste management and recycling risks in Moody’s report include apparel, agriculture, automotive and mining. An expansion in the list of substances deemed harmful to human health and the environment will increase legal risks for manufacturers, regulators and governments.