It’s no secret that investors and asset managers alike have been assigning growing importance to environmental, social and governance dimensions during the selection of assets in portfolios. Now, when they assess if corporate bond issuers will be able to pay back their obligations, credit rating agencies also are increasingly viewing risks through an ESG lens. The UNPRI (United Nations Principles for Responsible Investment) Statement on ESG in credit risk and ratings, supported by more than 180 investors (with over $40 trillion in collective assets under management) and 28 credit rating agencies (CRAs) including Fitch, Moody’s and S&P, recognize that “ESG factors can affect borrowers’ cash flows and the likelihood that they will default on their debt obligations.”
ESG factors, therefore, are important elements in assessing the creditworthiness of borrowers. For corporations, concerns such as stranded assets linked to climate change, labor relations challenges or lack of transparency around accounting practices can cause unexpected losses, expenditure, inefficiencies, litigation, regulatory pressure and reputational impacts.
The research into the effect of sustainable investment strategies on corporate bond portfolios—including the 2020 study “Primary Corporate Bond Markets and Social Responsibility,” the 2021 studies “Does a Company’s Environmental Performance Influence Its Price of Debt Capital? Evidence from the Bond Market,” “ESG Screening in the Fixed-Income Universe” and “How ESG Affected Corporate Credit Risk and Performance” and the 2022 study “Corporate Social Responsibility and Default Risk: International Evidence”—has found that not only do high ESG scores lead to lower corporate bond spreads, but also lower exposure to systematic volatility, lower levels of idiosyncratic risk (less likelihood of suffering from issuer-specific risks), less exposure to the credit factor and reduced tail risk. The research also has found that after adjusting for credit quality, the higher-ESG-rated issuers still had lower spreads compared to the lower-ESG-rated issuers.
The research (such as the 2021 study “Dynamic ESG Equilibrium”) found the same impact on equities—higher ESG scores lead to higher valuations. Thus, a corporation’s focus on sustainable investment principles leads to a lower cost of capital, providing them with a competitive advantage.
New Evidence
Laura Bonacorsi, Vittoria Cerasi, Galfrascoli Paola and Matteo Manera, authors of the November 2022 study “ESG Factors and Firms’ Credit Risk,” investigated whether and how ESG factors (the ESG “raw” information used by the ESG rating agencies for constructing their ESG scores) representing a firm’s concern toward sustainability and ethical behavior, affect the creditworthiness of a company. Their rationale was motivated by research showing a wide dispersion of scores across the various rating companies. Thus, their results are independent from the ESG rating provider chosen.
They used a cross-section for 2019 of European-listed companies for which they were able to obtain ESG raw factors. Then, using machine-learning techniques, they built a measure of creditworthiness. Their starting point was the ESG “raw” information sourced from MSCI—their choice among the ESG rating providers, as it stores this information for a sufficiently large number of companies. MSCI’s database includes about 700 ESG variables, ranging from carbon emissions to worker fatalities per company, as well as governance information (for instance, on board diversity and composition). The authors’ measure of credit risk was the Altman Z-score, which is constructed from accounting variables.
They explain: “The Altman z-score classifies companies in three categories: for scores below 1.1, companies are considered distressed; if the score is above 2.6, a company is considered safe; all companies whose score is in between these thresholds are instead considered to be in a ‘grey’ area, i.e., we cannot robustly classify them based only on balance sheet information. The majority of companies in our sample (48%) are safe, whereas 23% are distressed and 29% are in the grey area.”
After scrubbing for missing data, the final data set included 102 ESG factors (51 E factors, 43 S factors and 8 G factors) for 1,067 European companies. Following is a summary of their key findings:
Environmental Factors
Companies involved in financing projects with an environmental impact exhibited higher creditworthiness only if they belonged to the manufacturing sector.
Carbon-intensive lines of business negatively affected creditworthiness, which was instead enhanced by having activities in countries subject to adequate carbon regulations, especially for manufacturing firms. Effective reduction target for carbon emissions did not improve the Z-score—this may have been due to a rising impact on costs necessary to achieve the substantial reduction in carbon emissions. The same rationale applies to companies that are compelled to meet high energy requirements and green regulations with respect to the buildings in which they operate.
Large amounts of Scope 2 greenhouse gas emissions had detrimental implications on creditworthiness of firms, pointing at the crucial role of emissions caused by the generation of electricity purchased by companies rather than those from sources directly owned or controlled by them.
Holding assets in regions that are typically highly water intensive had a detrimental, though moderate, effect on creditworthiness perception.
Social Responsibility Factors
Poor safety levels and quality induced a loss in creditworthiness. Yet, interestingly, participation in activities with low worker injury rates had a harmful effect on corporations, while operating in regions with high injury rates was beneficial for creditworthiness—perhaps this was due to a cost channel because companies allocating lower resources for safety protection of their workers have higher liquidity and higher Z-scores.
Companies with large revenues from countries where unsustainable lending practices were present faced an adverse effect on their Z-score. The opposite was true if revenues originated from lines of business that were reliant on highly skilled or better-educated workers.
Their findings led the authors to conclude that the introduction of the ESG factors among the covariates in the full sample improved the explanatory power of default risk by 5-6%. They added: “Companies with a moderate, rather than large, proportion of revenues related to carbon emissions or to green building have a higher credit risk, implying that an effort in reducing pollution or energy requirements is costly. On the contrary, hiring more skilled workers reduces credit risk, as it is associated to a greater company’s productivity. Interestingly, we provide evidence of a positive externality from environmental friendly locations, since companies located in regions where carbon regulation is stricter exhibit a lower credit risk. Also companies located in regions with better data protection show a lower credit risk.”
Investor takeaways
The empirical evidence shows that ESG factors increase the explanatory power of credit scores in estimating the probability of default—when including the ESG factors in an OLS model in order to explain credit risk, together with the traditional accounting variables, they contributed to improve the fit of the model by reducing the mean squared errors. With rating agencies and investors paying more attention to ESG factors, and default risk being inversely related to the cost of debt, companies are likely to pay increasing attention to their behaviors related to ESG factors because the cost of capital impacts competitiveness.
Larry Swedroe has authored or co-authored 18 books on investing. His latest is “Your Essential Guide to Sustainable Investing.” All opinions expressed are solely his opinions and do not reflect the opinions of Buckingham Strategic Wealth or its affiliates. This information is provided for general information purposes only and should not be construed as financial, tax or legal advice. LSR-22-426
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