Social risks can be credit risks

By Andrew Steel, omfif.org

August 11, 2022

There are financial implications for failing to manage human rights issues

Over the past few years there has been an expansion in the social factors considered by investors and other stakeholders. Topics such as health and safety, diversity, workers’ rights and human rights have become more central to sustainability strategies for a wide range of bond issuers from corporates to sovereigns. This is supported by a more consistent and comprehensive reporting environment, regulations and improved market standards.

Frameworks and standards addressing social issues include the United Nations’ sustainable development goals, the UN Guiding Principles on Business and Human Rights and the International Labour Organization’s Decent Work Principles. The latest draft of the European Union’s social taxonomy, published in February 2022, is a comprehensive approach to the role of social factors within a sustainable finance strategy.

The draft taxonomy has three core objectives: decent work, adequate living standards and wellbeing for end-users, and inclusive and sustainable communities and societies. The third objective considers land, indigenous and human rights as well as access to basic infrastructure. The proposal also links an entity’s social impact to operating and capital expenditure, and turnover.

A range of disclosure requirements for large and/or listed companies in markets including the EU, UK and Japan has expanded the sustainability information available to investors for use in evaluating investments. Increasingly investors are expressing a strong interest in analysing social risk factors for portfolio companies. According to external asset managers for Japan’s Government Pension Investment Fund, which has more than $1.7tn in assets under management, health and safety is the second-most critical environmental, social and governance issue in the international fixed income market. Human rights and community, supply chain and diversity also rank in the top 10.

Social factors are reflected within Fitch’s ESG Relevance Scores, indicating the materiality and relevance of social risk elements on the credit rating outcome, on a scale of 1 (irrelevant) to 5 (a key rating driver). Social issues are assessed under Fitch’s framework, including labour relations and practices, employee wellbeing, human rights, community relations, access and affordability, customer welfare and exposure to social impacts. These are analysed to look at the interactions between the issuer and its different stakeholders, both within the entity and in the market, community and broader society.

Human rights is an important community-related issue, especially for companies operating in jurisdictions where the rule and enforcement of law varies. Economic activities that involve changes in land use, resource extraction, large-scale construction or the provision of essential services entail the largest exposure to community-related credit risks. The political and regulatory conditions of the countries where extractive industry companies operate due to the location of natural resources contribute to human rights risk exposure. Many resource-rich regions have high levels of conflict or political instability. Entities in the energy, natural resources and utilities sectors are most likely impacted by these issues.

Failure to manage human rights concerns can financially impact an issuer. This may be caused by higher resourcing requirements to address human rights-related issues – for instance, for extra security or higher pay for workers to cross through protest zones – work stoppages, physical damage and violence, as well as fines from violations. A 2014 Harvard Kennedy School study of extractive industry companies associated with community problems estimated that production delays at a major mining project with capex of $3bn-$5bn cost an estimated $20m a week. This did not include costs associated with addressing negative publicity, repairing physical assets or responding to legal challenges.

Several entities with Fitch credit ratings have been involved in community rights controversies or incidents, primarily in the oil and gas and mining sectors. In some cases the impact of the incident has been financially material and affected the issuer’s credit rating as a result. In all of these cases, work stoppages or damage to physical assets related to community unrest caused financial losses as a result of operational disruption.

Andrew Steel is Head, Sustainable Fitch.