How to incorporate ESG into traditional credit analysis

Traditionally, credit analysis includes using financial ratios, cash flow analysis, trend analysis, and financial projections to evaluate a firm’s ability to pay its obligations. However, it’s becoming more and more important to incorporate environmental, social, and governance (ESG) factors into credit analysis.

For most sectors, a competitive profile assessment allows for peer comparisons that will better identify best or questionable ESG practices. These risk factors will typically be a mix of quantitative and qualitative assessments. To incorporate ESG into your traditional credit analysis consider the steps below:

• Step 1: Define ESG Risk Dimensions and Factors – Start by integrating ESG into your fundamental and technical analysis. Then, gather information about a company’s ESG issues. This allows you to focus on ESG issues that are most relevant to your investment.
• Step 2: Assess Materiality of ESG Risks – Are the ESG risks currently a factor or are they closer to a worst-case scenario? Either way, it’s important to know if the ESG risks have the potential affect profitability.
• Step 3: Assess Likelihood of ESG Risks to Materialize – ESG risks are inevitable at some level, but companies are working to limit their impact in the short and long-term. Is the company actively adjusting their business model? What is their level of preparedness for various impactful events? Finally, use stress testing to assess the magnitude of ESG risks and how they might change in different scenarios.

Helping to identify the key ESG credit risk factors and scores will empower investors to take more transparent steps of helping achieve the global goal of a “Net Zero Carbon Economy”.

S&P Global Market Intelligence’s Credit Assessment Scorecards provide a structured framework for assessing credit risk, generating credit scores that are designed to broadly align with credit ratings from S&P Global Ratings.^[1]  Our Scorecards enable ESG factors to be considered in credit risk analysis in a transparent and structured way, while working through the regular credit assessment process.