ESG is a trust issue

When I talk to corporate executives who want to know what to do in the ESG space, I tell them that, unlike financial targets, ESG is not about meeting some target number, it is about building trust. And building trust requires extended effort and consistency.

If you want to show how building trust in ESG works, you would be hard-pressed to find a better example than the analysis of Aleksandar Petreski and his colleagues of the cost of capital of Swedish real estate companies.

Using Swedish real estate companies has two advantages. First, they operate under a single regulatory framework and have been early adopters of ESG practices, so one can get a lot of data with a consistent history. In the case of this study, they looked at 73 listed Swedish real estate companies and their issuance of both green bonds and conventional bonds from 2011 to 2021. Second, because the real estate sector is one of the sectors with high greenhouse gas emissions, the importance of green bonds was recognised early, and investors will likely have paid more attention to green practices in the real estate sector than in other sectors.

What they find in their analysis is that companies benefit from building a reputation for green practices over time, i.e. they benefit from building trust in the form of lower cost of debt and – get this – lower cost of equity.

The evidence that improving green credentials reduces the cost of debt is widespread. I have been writing about this for example here. What the new analysis shows is that companies that issue green bonds more and more often benefit more over time. On average, the study finds that issuing an additional green bond reduces the cost of debt by some 5.7bps. That’s not bad, but what the study also found is that by issuing more and more green bonds over time, the company builds a reputation for good governance and business practices. They find that over time, issuing new conventional bonds reduces the cost of long-term debt by 5bps, but issuing more and more green bonds reduces the cost of debt by 7.6bps. That doesn’t mean that companies should issue more and more debt as this will inevitably drive up the cost of debt. This shows that if the debt level is held constant and old debt is replaced by new debt it matters whether that debt is green or conventional. Investors need to build trust with an issuer that the debt is serviced properly and thus the cost of debt declines the more often a company issues and services its debt. But if the bonds issued are green bonds rather than conventional bonds, the increase in trust is faster and more pronounced leading to a bigger decline in the cost of debt over time.

And here comes the kicker. While the study could not find a link between the cost of debt and the cost of equity for conventional bond issuance, it found that as companies issued more and more green bonds, their reputation increased to such a degree that they could find a significant decline in the cost of equity as well. On average, the cost of equity dropped by 13bps if a company continues to issue green bonds over time. The weighted average cost of capital thus benefitted from both a decline in cost of debt and a decline in cost of capital which on average combined to lowering the cost of capital by 8bps. And while that doesn’t sound like much, it is real money, particularly for real estate firms which typically have to issue a lot of debt to finance their projects.