Matthew Mitchell, senior director at S&P Global Ratings, explains why ESG is becoming an increasingly important factor when it comes to credit ratings of all types

That is why S&P Global Ratings recently announced it will publish ESG credit indicators for structured finance transactions to increase the transparency of how these factors influence its credit rating analysis. The ESG credit indicators will supplement the current ESG narrative using an alphanumerical scale, ranging from a positive influence in the credit rating analysis (E-1/S-1/G-1) to a very negative influence (E-5/S-5/G-5).

A variety of ESG factors can influence credit analysis, while legal and structural mechanics characterising securitisation can also mitigate the risks. As such, issue credit ratings may not be affected even where there are material exposures to ESG factors. For example, common transaction features such as credit enhancement, deleveraging, eligible collateral requirements, concentration limits, replacement and performance triggers, insurance policies, tenor of the rated debt, and isolation of assets from an originator's bankruptcy may mitigate any negative influence of ESG factors.

Environmental factors tend to be characterised by physical risks, which can disrupt collections, impact the credit quality of obligors, or materially reduce collateral values. Typically, physical risk is more pronounced for concentrated pools of immovable assets, such as in certain CMBS transactions, where a local area or specific asset location could be affected. For transactions with highly diversified collateral pools – including by obligor and geography - physical risks would likely have a neutral influence – this is more common in RMBS and ABS.

In addition to physical risks, there is also climate transition risk which could impact collateral values in asset classes such as auto ABS. Our analysis tends to categorise this as a moderately negative influence. However, this can adjust depending on the pool – for example, where the collateral has relatively high emissions or are located in jurisdictions likely to experience tougher regulation.

A key social factor that we consider in our analysis is conduct risk, which can present a social capital exposure for lenders and servicers, particularly as regulators are increasingly focused on ensuring fair treatment of borrowers. We generally see social factors as having a neutral influence for pools comprising prime borrowers with lower interest rates. In these pools, influence is greater for borrowers where affordability considerations, higher interest rates, and servicing policies and procedures could increase legal and regulatory risks, particularly for nonprime borrowers. Social factors may also have a larger influence in our analysis in asset classes – such as residential mortgages - with strict regulatory requirements and where enforcement of security could experience delays.

Health and safety factors are more likely to influence our analysis when there is a concentrated exposure, including by obligor, industry, or geography, or where the collateral backing the securitized assets could be affected by health and safety risks. For example, sectors reliant on social gathering, such as hotels, may have relatively higher exposure to a pandemic, while vehicle safety and product recalls are a risk for the automotive sector.

Securitisation issuers are typically established as bankruptcy-remote, special-purpose entities where each transaction party's roles and responsibilities and the allocation of cash flows are well defined, and transactions are structured to isolate the assets from the seller. This makes the transaction documentation, outlining the management and operation of the structure, a key component of our analysis of the governance framework. The analysis also takes into account other governance considerations such as key transaction parties including the originator, servicer, and transaction counterparties.

As securitisation is highly regulated, we generally view governance factors as having a neutral influence in our credit rating analysis. However, structural features such as revolving collateral pools or prefunding may have a negative influence because the assets' risk profile could change over time and expose investors to the risk of looser underwriting standards or potential adverse selection. For this reason, the documented requirements for making amendments to a transaction, such as selecting alternative interest rates, or replacing a transaction party following a deterioration in their creditworthiness or non-performance, may also be reflected in our governance credit indicator.

Governance considerations for the originator or servicer could also influence our analysis, such as our view of their risk management and internal control frameworks, and any third-party oversight. Where originators or products are new, the lack of a track record may also have a negative influence in our credit rating analysis.

In considering all of the above, our ESG credit indictors aim to isolate our view of the influence and magnitude of ESG factors before accounting for any benefit of legal or structural mitigants.

For more insights into how we incorporate ESG into our credit ratings, please click here.