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Check your portfolio for this hidden credit risk

Articles | 02 March 2018

Don’t invest in the next emissions cheating scandal. If Environmental, Social and Governance (ESG) factors aren’t high on your check list, you could be in for a nasty surprise.

At a time when Volkswagen was seen to be investing in their green credentials, our credit team was concerned with other ESG issues such as the company’s weak governance, the complex group structure and ethics controversies. Factoring in these considerations, we assessed Volkswagen’s ESG risk to be high, which in turn saw our internal credit rating sit lower than those of the major credit ratings agencies. 

Volkswagen later admitted it had deliberately defrauded regulators over the emissions testing of its diesel-engine vehicles. In 1400 lawsuits, investors sought over AU$12 billion in damages and the Dow Jones Sustainability Index pulled Volkswagen from its indices. 

While the scandal was impossible to ‘predict’, this highlights the importance of scrutinising issuers on a case-by-case basis. First and foremost, our credit research team look at a broad range or risks. Warning bells range from safety lapses, regulatory fines and environmental breaches. In the electronics industry, we look for exploitation in factories in the supply chain, while the biggest area of scrutiny for banking is lending. If a company is managing these visible risks poorly, then we don’t have confidence in other risks being well managed.

Improving disclosure of ESG risks is an industry-wide effort. While credit rating’s agencies are attempting to systematically incorporate ESG factors into their ratings this is not without its challenges – credit issuers may lack transparency and offer poor disclosure of ESG risks. We prefer to treat ESG risks as we would any other kind of risk – seek to understand it as well as we can, and ensure we are being compensated appropriately if we accept that risk. This allows us to assess each opportunity on a case-by-case basis and helps our credit managers ‘look ahead’. For example, we have developed a ‘stranded assets framework’ for long-dated bonds, which is used to assess the risk that climate change will erode the value of some assets over time. 

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