Capturing Human Risk’s Influence on Credit Risk Remains Elusive – But That Might Be About to Change

by Stuart Woollard – co-founder and council member The Matutirity Institute – as published in Bonds & Loans – July/August 2019 edition

ESG – shorthand for environmental, social and governance – considerations are increasingly being prioritised by organisations, investors and lenders alike. But quantifying its influence on credit risk and funding is proving to be quite elusive. A group of former finance professionals and academics is trying to change that by putting “intangibles” like human risk, corporate culture and values at the centre of that relationship.

For some, ESG is a way of generating non-financial benefits and outcomes; for the more cynical, it’s a means to appease shareholders, investors and regulators. ESG has become a catchall for myriad business practices aimed at delivering non-financial outcomes – improvements to the environment, community and social health, or improved organisational culture, for example – while at the same time improving shareholder value.

Indeed, a growing body of research suggests there is a positive correlation between long-term capital gains among organisations, and their prioritisation of ESG factors – one of three reasons it has become something of a fad for investors.

The other two: regulation, with governments increasingly compelling companies to disclose greenhouse gas emissions and submit to other non- financial reporting obligations; and reputation, whereby investors can gain a competitive edge by playing to the shifting moral sentiment of new – younger – capital holders.

To that end, a wide range of ESG rating and ranking service providers have emerged to guide borrowers – on how to improve their scores, whether it be in the form of using more renewable energy to power their operations, or to introduce internal policies aimed at making the workplace more diverse – and investors on which organisations are taking tangible steps towards becoming more sustainable.

Yet these rankings are often backwards- looking and superficial, analysts argue, and don’t really get at the heart of the kinds of risks that punctuate corporate scandals. Perhaps more importantly, they fall short when it comes to providing investors, CFOs and corporate boards with a forward-looking assessment of how non-financial factors – particularly those related to corporate culture and decision-making – feed into financial risk

Are we Measuring the Right Stuff?

While the going view is that greater prioritisation of ESG often leads to better long-term financial returns everywhere we look in both emerging and developed markets – whether the UK’s Carillion, the US’s Wells Fargo and Goldman Sachs, Brazil’s Vale or South Africa’s Eskom or Steinhoff, to name a few – we seem to consistently find potent examples of events that materially damaged shareholder or investor value, events that ultimately seem to stem from types of risks that are extremely difficult to quantify or simply aren’t effectively captured by current ranking systems.

Take Goldman Sachs as an example. “At Goldman Sachs, we view the consideration of Environmental, Social and Governance (ESG) factors as an important driver of the way we advise clients and conduct our business,” reads the organisation’s 2017 sustainability report. The investment bank, which consistently rates at the top end of the spectrum on fulfilling various ESG criteria, was recently rapped for its complicity in the 1MDB scandal; the investment bank helped the Malaysian development fund raise USD6.5bn through three bond offerings in 2012 and 2013, of which prosecutors allege USD2.7bn was embezzled in the following years to bribe various government officials.

It was a massive bribery and money laundering scheme that reverberated throughout Malaysia, arguably taking down then-Prime Minister Najib Razak; led to the investment bank being blacklisted by Abu Dhabi’s sovereign wealth fund, Mubadala, pending the outcome of litigation; and saw at least one of its bankers alongside senior Malaysian government officials charged for their involvement.

1MDB was one of the most “controversial” companies of 2016, according to a report published by RepRisk, a respected and widely used ESG ranking provider, and the threat of related lawsuits in Malaysia, the US and elsewhere has prompted Goldman Sachs to warn investors of the potentially serious balance-sheet implications of the penalties it may face as a result.

Recent events involving Brazilian miner Vale vividly illustrates the limits of using these ratings to extrapolate future risk of incidents. In July 2018, Vale’s combined CSRHub rating – a composite of 25 ESG and CSR data providers – had Vale at 75 out of 100, putting it on the higher end of the ESG-compliance spectrum, and above the industry average. Following a January breach at the Brumadinho dam, which led to the deaths of more than 300 people and which preliminary reports suggests may have resulted from executives’ efforts to quash a safety audit on the structure, its rating slipped 30 points to 45.

Measuring Intangibles

Investigations in both 1MDB’s and Vale’s cases are ongoing. But while these organisations, like many others before and likely many after, inevitably end up pointing to “a few bad apples” as the cause of their tribulations, others see nebulous, but no less important things like uncooperative corporate culture and poor social values, as key ingredients that create the conditions for bad – or in extreme cases illicit – behaviour to thrive.

Stuart Woollard, Managing Partner of Organizational Maturity Services LLP and co-founder and council member at the Maturity Institute (MI) says that most ESG ratings frameworks don’t take into account the complex web of internal and external relationships contributing to an organisation’s health, value, and risk.

“Whether you look at companies like ENRON or you look at European banks tied to money laundering scandals, find me a massive corporate failure with subsequent severe market and financial repercussions that wasn’t caused one way or another by our inability or unwillingness to appreciate and protect against human systems failure and risk,” Woollard explains. “The challenge is that if you don’t know what to measure, you are in no position to quantify value and risks; and if you can’t really quantify value and risks, then how can you expect to change the behaviour of organisations – and by extension, investors and regulators?”

“[ESG] has become supremely important, and financial stakeholders and regulators agree with varying levels of sincerity. Yet when we talk about governance, corporate culture and values, internal or external relationships, leadership – most organisations, and regulators and investors, don’t really have a clue what to measure, and how it feeds into our overall sense of value and risk. There is clearly a gap here.”

The Maturity Institute (MI) is a multi- disciplinary non-profit organization pioneering a way to plug that gap. Broadly speaking, it tries to provide a coherent framework for understanding risk and value in organisations (Total Stakeholder Value, to use its language); above all, Woollard says it’s about harmonising the needs and demands of capitalism (i.e. growth of shareholder value) with the needs and demands of society (i.e. sustainable well-being), two competing objectives most market observers and practitioners know don’t always converge but which they nevertheless, increasingly agree, should.

Underpinning this is the view that people – and the relationships between them, organisations, and society – are at the heart of that junction, and to that end it has created an organisational maturity index (OMI) based on what it calls the OM30, a composite measure encompassing 32 different factors with different weightings and values that together paint a picture of an organisation’s ‘maturity’.

The MI looks at factors like ‘coherence between market and human values’ (i.e. To what extent is the organization’s business and/or operating model predicated on reconciling its (market) value with changing societal values?); Trust (i.e. To what extent are the leadership and management team trusted by customers, employees, and other key stakeholders?); Value potential (i.e. To what extent does the organization seek to maximise the value it generates from all of its human capital – both directly employed and within its supply chain and wider society?); Never-ending, continuous improvement (i.e. To what extent is the philosophy and practice of never-ending improvement embedded throughout the whole organization?); Authenticity (i.e. The size of the gap between the organization’s statements, external communications and claims of success, relative to the reality found in the evidence); and people risk (i.e. To what extent does the organization have a comprehensive system for measuring and assessing the current level of human capital management risk within the organization?).

The index also tries to capture how much an organisation values open and frequent communication, how enthusiastic and cooperative an organisation is – from the mail room to the Board room, and the extent to which high-level decision-making in an organisation is ‘collegiate’ or aligned within the business.

Its relevance in the credit world, and particularly in emerging markets, was clear from the outset. In 2014, it worked with Chile-based Feller Rate – at the time, an S&P affiliate – on the early stage development of its organisational maturity rating system, a precursor to the OMI.

Pricing Intangibles – And the Search for the Holy Grail

The MI is working with a number of academic institutions to flesh out the relationship between the OM30, current ESG frameworks, and credit risk. While much of that research is currently under wraps, early indications suggest it is starting to bear fruit.

Last year, using three research case studies on large publicly traded organisations like Unilever and Barclays, the MI and Australian consulting firm KBA Consulting Group developed a framework to measure a company’s intangibles – factors including corporate governance, company culture and the management of human capital – and value them as a portion of overall market capitalisation. They looked closely at Unilever before and after the 2017 bid by Kraft-Heinz to establish a direct link between the OMINDEX and a company’s ability to create wealth for shareholders on an ongoing basis.

The preliminary analysis demonstrated “how this episode has led to the market value of Unilever increasing significantly, yet its capability to deliver on this increase in market capitalisation deteriorating as a consequence of the actions taken by Unilever to secure its independence,” the organisations argue in Aligning the Interests of Business and Society, a jointly-authored paper exploring the findings.

“Unilever’s OMINDEX rating spanning the period [end 2016 to end 2017] was downgraded from BBB- to BB+ and the impact of this in market value terms was negative GBP3bn… More worryingly, this deterioration, together with higher market value arising from increased investor expectations opened up a much bigger value gap of GBP39.5bn (measured as at 31 December 2017).”


Crucially, the organisations were able to assign a dollar value to intangibles – something ESG-focused market participants looking beyond carbon emissions have struggled to do.

Further preliminary research looks promising. Another project involved overlaying the OMINDEX’s rating scale measuring governance and culture risk with traditional credit ratings provided by S&P for global investment banks to see how closely both approaches harmonised.

The results showed some fairly stark deviations between the two ratings, and indeed raise new questions about whether we are missing something when looking deeper at some of the high-profile scandals that have unfolded at a number of the world’s largest investment banks in recent years. According to a recent Cambridge Judge Business School study which looked further into the correlation between the OM30 factors, ESG, and risk events:

“…there is very strong negative association between OMR [Organisational Maturity Rating] and all aggregated indexes of not only S, G but also E risks/incidents/controversial issues….This strong negative association remains when investigating further into each specific issue. OMR and TSV [Total Stakeholder Value] are significantly negatively correlated with all 30 controversial issues. Two of the strongest issues for banks are “Fraud” and “Violations of National Legislation”.

Woollard says further work with academics, financial institutions and investors will be needed to really cement the relationship between risk in a holistic sense and asset prices – but there need to be detailed, unified and coherent underlying standards for terminology and measurement if it is to be successfully realised. As alluded to at the outset, that detail, coherence and unification – or the lack thereof – seems to be one of the key issues at present (and one we’ve written about elsewhere).

Traditional credit rating agencies are looking closely at this as they roll out their own ESG ratings frameworks for investors and seek to understand how credit ratings are influenced by environmental, social and governance factors. For instance, Fitch recently published a set of “ESG relevance scores” to help quantify the scale of influence each factor has on credit ratings.

Given the weight traditional credit ratings have in determining asset pricing, pinning down these relationships is crucial. Fernanda Rezende, Senior Director, Corporates at Fitch Ratings says the industry still has some way to go – but things are heading in the right direction.

“Currently, these relevance scores add another dimension to the information available to investors, but they don’t yet provide a clear linkage between the credit and the price. That said, we are starting to produce data and research that helps to understand how ESG risk is incorporated in traditional credit risk. We have a better understanding of how this data impacts ratings, but it will take a bit more time before we understand how these relevance scores influence pricing.”

“We are at the point where we have a better understanding of how the lack of prioritisation of ESG-related characteristics – strong corporate governance, for instance – impacts risk, rather than how the prioritisation of these factors enhances a borrower’s risk framework… As more information about the linkage between ESG and credit quality emerges, however, this could change.”

If the price of assets is to reflect risk in a deeper, more holistic sense–and, at a higher level, if the convergence between the needs of capitalism and those of society is as necessary as many increasingly believe it to be, establishing these linkages is of paramount importance; while they may have remained shrouded in darkness until now, it is encouraging to see a broad swath of industry stakeholders start to cast them in new light.

“Society has come around to the fact that companies need to be more responsible to it, and investors to the fact that companies need to be less vulnerable to corporate scandals because they adversely skew market performance. The link between price and risk is in dramatic need of correction, and intangibles are at the heart of that,” Woollard concludes.

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