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:

  1. 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.
  2. 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
  3. 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.
  4. 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.

So the credit standing of borrowing firms is influenced by legal, reputational, and regulatory risks associated with environmental accomplishments. Companies with weaker environmental performance pay a premium for debt financing and companies with better scores pay less for debt. The study found that spread can be as much as 64 basis points (0.64%) and it is growing.

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.

Please feel free to add your comments and questions using the Comment link below. For email subscribers, please click here to visit my site and provide feedback.

Bob

2 Responses to “4 ESG-Friendly Findings about Borrowing Rates”

  1. Bob Willard says:

    Thanks for your comment, Marco. I agree. Up until now, companies have been able to externalize the costs of their damage to eco-systems. There are glimmers of hope that this will change. In 2011, the World Business Council for Sustainable Development (WBCSD) published a Guide to Corporate Ecosystem Valuation (CEV), a document intended to help companies start down the path of assessing the cost of their damage to eco-systems, and the World Resources Institute published the Ecosystem Services Review tool as a companion document. And Puma published its ground-breaking corporate environmental profit and loss statement this year, acknowledging it would have to pay $133 million a year to just cover its impacts on water and climate. Maybe there is hope …

    Bob

  2. Dear Bob,
    Thank you for the post, very good insights as always. As part of my work here at the MSLS I am reading articles on governance of our commons in these very days. One reflection as I was reading your post is this: The so-called “ecosystems services” have for so long been ignored by any balance sheet, but there is an increasing pressure to take those services into account in our economy as nature (and not money) will become the scarcest resource that needs to be maximized and is not substitutable. So as assets of Natural Capital become scarce and price-able, those who perform poorly among their competitors in terms of efficiency might be negatively impacted as ‘wasteful’.
    Cheers,
    Marco

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