InSight: Scope outlines its ESG considerations for credit ratings

Scope Ratings, the largest European credit rating agency, has outlined its ESG considerations for rating pharmaceutical companies. Olaf Tölke, head of corporate ratings, and senior analyst, Azza Chammem, explain how its ESG framework evaluates the extent to which ESG factors are credit-relevant for different industries.

Scope’s corporate credit rating analysis is focused on credit quality and credit drivers, with ESG factors considered relevant to the rating process if there is a discernible and material impact on the rated entity’s cash flow profile and, by extension, its overall credit quality. Contrary to ESG ratings, which are largely based on quantitative scores for different rating dimensions, credit relevant ESG drivers are mostly qualitative and based on relative opinion.

‘We have to cover it because our customers, which are not only the companies we rate but the investors that buy bonds, want to know our opinion on the ESG performance of a company,’ said Tölke.

Olaf Tölke, head of corporate ratings, Scope Ratings

The importance and relevance of environmental and social factors is specific to each rated entity, industry and region. ESG factors can directly or indirectly affect all the rating elements which make up an assessment of an issuer’s business risk profile, financial risk profile and supplementary rating drivers.

‘We thought it would be good to look at the pharma industry,’ said Chammem.

Azza Chammem, senior analyst, Scope Ratings

Pharma may not be the most emission heavy industry, but that increases the relative importance on the social and governance elements of a firm’s operations and that is reflected in Scope’s approach to assessing the ESG performance of companies in that sector.

‘We don’t deny there is a greenhouse gas emissions problem with pharma,’ said Chammem.

‘Pharma companies are aware of the importance of addressing CO2 emissions, and they are trying to control it – reputations are at stake – but this is not really their main concern.’

So, when evaluating the ESG factors and risks that are relevant to rating the pharmaceutical industry and pharma companies, Scope highlights three interlinked challenges to business-model sustainability based on S and G: litigation risk; pricing; and innovative power.

‘With ESG in pharma companies, you need to look at risks other than emissions. The sector is highly exposed to litigation risk, there is sensitivity around pricing and then there’s the question of sustainability – the pressure in keeping a pharma business going when patents start to drop off,’ said Tölke. ‘There has to be an opinion on all these factors.’

Legal opinion

Pharmaceutical companies have long been exposed to litigation risk. Various lawsuits have alleged over-charging, harmful drug side effects, manufacturing issues, lack of oversight of opioid distribution and deceptive marketing. The more complex the companies become, the higher the range of liability issues. A tighter focus on ESG will help companies reduce the potential for damaging litigation.

‘Litigation risk and credit ratings have an inverse relationship,’ said Chammem. ‘Major lawsuits can cause serious reputational damage, which may push investors and relevant parties to boycott companies, and litigation can cost companies billions of dollars, which can materially affect cash generation, squeeze market capitalisation and constrain access to capital.’

‘Credit quality may worsen as a result,’ she said.

Pricing pressures

From a social standpoint, the pricing of medicines is one of the most pressing issues for the industry. Not all demographics or countries can afford treatments and being seen to make profits at the direct expense of people’s welfare can hurt the industry.

‘There can be ethical pricing and unethical pricing, and that is particularly evident if you go to emerging markets. So, there has to be an opinion as to whether the price of a drug is too high for a particular country,’ said Tölke.

As the wealth gap increases, the challenge for pharma companies is to ensure that new treatments and vaccines are affordable and available in certain countries such that they can avoid accusations of profiteering and discrimination. Negative social impacts are likely to lead to a negative reaction in press and social media, and that can affect reputation and brand value.

New drugs please

The pharma industry also faces considerable productivity challenges in terms of identifying, testing, and bringing new drugs to market.

‘The pressure in keeping a pharma business going comes when patents start to drop off,’ said Tolke. ‘It’s a challenge that perhaps no other industry faces. You need to be ready to replace patents to become sustainable, and that’s a real challenge for management.’

Manufacturing technologies continue to evolve as the emergence of the Internet of Things, artificial intelligence, robotics and advanced computing begin to challenge traditional approaches, practices, and business models.

Industry 4.0, the next tech-driven phase of the Industrial Revolution, has the potential to dramatically increase the agility, efficiency, flexibility, and quality of the production of medicines, according to Scope, and underlines the increased importance of efficiency in R&D in driving a more sustainable future.

‘Companies that have demonstrated a capacity of efficiently delivering their product pipeline will be in a better position to meet forthcoming industry challenges and maintain competitive advantage,’ said Tölke. ‘There is a clear correlation between R&D expense and product pipeline. The main challenge is efficiency. In our rating approach, we consider product pipeline to be one of the main components of business-model sustainability.’

Sensitive to sentiment

ESG considerations are going to become a more important component in assessing the creditworthiness of firms in the future. This is particularly relevant in the pharmaceutical sector, which is a high risk, high reward industry; one in which firms can earn huge profits with the right molecule but one which is also prone to negative public sentiment and the risk of debilitating litigation.

The extent to which ESG issues will impact the overall credit quality of a company – the ability for it to pay its bills from cash flows – is difficult to answer, however, particularly where views are subjective and sometimes not easy to reconcile.

‘Investors would like an opinion so our analysts need to position themselves accordingly despite the ambiguities that exist,’ said Tölke.

‘For example, a tax payment for our ESG impact division is something positive because money goes to the government to do positive things for society. But from a credit perspective, a tax payment is negative because cash goes out of the company.’