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How to lower your cost of capital using ESG
As ESG investing becomes more popular, companies with poor ESG credentials face rising costs of capital, either because their cost of debt increases (banks already incorporate ESG factors in their lending criteria and charge lenders with higher ESG risks more) or because their cost of equity capital increases. On the latter one, though, the evidence is very weak or non-existent.
One thing we know is that divestment campaigns don’t affect the cost of equity capital of a company. In theory, divesting from a certain industry should push the share price lower and thus increase the cost of equity capital. But a recent study confirmed once more that the price impact of divestment or low ESG credentials is on average zero. The study looked at the share price impact of inclusion in a widely held ESG index, in this case, the FTSE4Good index. In the United States, stocks that are included in the FTSE4Good index on average experience a return boost of 0.24% from that inclusion – too small to be significantly different from zero and certainly not meaningful for investors. Getting a good ESG rating and being included in ESG indices does nothing to reduce your cost of equity capital and as a result, divestment campaigns do nothing to meaningfully influence the share price or the cost of equity capital either.
But there seems to be a way how companies can meaningfully reduce their cost of capital using ESG data: By becoming more transparent. A team of researchers from PanAgora Asset Management and Google Research investigated the amount of ESG data disclosed by companies and its relationship with ESG ratings and the cost of capital. As it turns out, disclosing more ESG data helps a company reduce its cost of capital and improve its ESG ratings.
On the ratings side, this is probably a bad thing, because it indicates that most ESG ratings still aren’t looking under the hood of a company but instead simply take ESG data at face value and then compare it to the data retrieved from peers of a company. If a company’s ESG data is better than that of its peers, the company gets a better rating and that’s the end of it. If a company doesn’t disclose the data but its peers do, the company will face a worse ESG rating. That many smaller companies don’t have the resources to generate this data and disclose it then creates a large cap bias in ESG investing that I have written about before. I don’t like ESG ratings for many reasons, but this simple box-ticking exercise that is all too common with ratings agencies is one key shortcoming of ESG ratings.
However, on the cost of capital side, it makes sense that companies that disclose more data have lower costs of capital. After all, an investor wants to know what is going on in a company and if a company is more transparent about non-financial risks, that should reduce uncertainty in investors and hence lower the cost of capital. There likely is also a behavioural bias at play insofar as investors who get more ESG data seem to perceive a company as greener and less risky. But there is also a fundamental component where companies that publish positive ESG news get rewarded by the market and companies with negative ESG news get punished. But whether it is a psychological or a fundamental effect, the result remains the same. Companies can actively reduce their cost of capital by becoming more transparent about their ESG risks.