Bond investors are not pricing ESG risks
I have recently written about ESG factors as an externality that is not priced into financial markets. As if on cue, a couple of days later a new paper by Edith Ginglinger and Quentin Moreau from the Université Paris-Dauphine landed in my inbox that investigated the link between climate risks and the credit structure of companies.
The authors looked into the debt structure of 1,212 French firms covered by the CRIS climate risk database from 2010 to 2017. The CRIS methodology assesses the potential impact of climate-related events like floods, droughts, wildfires or sea level rises on individual companies. The authors speculated that companies with higher climate risk should have a harder time getting loans from banks or placing bonds in capital markets than companies that are less affected by climate risks. This could be either because some banks and bond investors are unwilling to do business with companies that are more at risk from climate change, or because these companies have to pay a higher risk premium that increases the cost of capital. As a result, companies with bigger exposure to climate risks should have a lower financial leverage ratio (measured here as long-term debt to total assets), everything else held equal.
And indeed, the median leverage of companies with above-average climate risk was 0.176x while the median leverage of companies with low climate risk was 0.219x. This difference is significant and a 10-point increase in the CRIS climate risk scale triggered on average a 1.0% decrease in their long-term debt ratio. After the French government adopted a law in 2015 that forced all French companies to publicly disclose climate risks, the long-term debt ratio declined an additional 0.8% for every 10-point increase in climate risk.
But what I found really interesting is that this decline in leverage comes predominantly from banks who are reluctant to lend to companies with high climate risk. The researchers found no link between climate risks and credit ratings, implying that credit ratings do not pay attention to these risks – a serious omission by rating agencies in my view. Furthermore, the study found that the impact of climate risks on the public bond market was less than half the size of the overall impact on the company. This implies that banks are far more reluctant to lend to companies with higher climate risk than bond investors. It seems as though bond markets are largely discounting climate risks as just another externality that does not matter for performance – that is, of course, until some climate events create an existential crisis for a company, as has happened in the case of US utility company PG&E, which was forced into bankruptcy early this year after the company was held accountable for some of the destruction created by the California wildfires last autumn.