In my last blog, I outlined three concerns that lending institutions have about companies with poor environmental, social, and governance (ESG) track records. First, environmental practices may expose borrowers to expensive legal, reputational, and regulatory risks that could jeopardize their solvency. Second, lenders want to ensure they are not stuck with the borrower’s current and past environmental liabilities if the borrower defaults on the loan. Third, lenders are wary of risks to their own reputations if the public perceives they are abetting the borrower’s irresponsible corporate behavior.
For these three reasons, laggard companies with poor ESG track records may find they pay a higher rate for their borrowed capital. The Social Investment Forum’s 2010 Moskowitz Prize for scholarly research on socially responsible investing was awarded to Rob Bauer and Daniel Hann for their paper, “Corporate Environmental Management and Credit Risk.” In it, they analyzed 1996 to 2006 data on the environmental profiles of 582 U.S. public companies and their associated cost of debt. They found:
- Companies with low environmental scores pay a premium for debt financing, and consistently have lower debt ratings from agencies like Moody’s and S&P.
- Companies with better scores pay less for debt, but they tend not to be rewarded for their environmental performance by the ratings agencies. The agencies seem to lag individual bond investors regarding the significance of ESG metrics
- The link between environmental performance and credit risk is, in fact, no stronger in “dirtier” industries than it is for the market as a whole. The authors attribute this to the “heterogeneity” of a sector’s risk profile: a belief that every company in a sector like coal mining, faces environmental liabilities similar to its peers in other sectors.
- Perhaps the study’s most intriguing finding is that the link between environmental risk and debt costs has strengthened. For example, bond investors seem to be pricing climate change-related credit risk in anticipation of laws yet to be passed.
Interestingly, this is an absolute spread, not a relative one. Regardless of the interest rate, a company may receive as much as a 0.64% lower rate for borrowed capital if they have an exemplary sustainability track record. Rounding the spread to 0.60%, if a company has long-term debt of $1,000,000, the savings on annual interest payments could be $6,000. On debt of $50,000,000, the interest savings could be as much as $300,000.
In times of tight credit, it pays to be a better ESG risk.