Environmental, social and governance (ESG) rankings should reflect the risks that such aspects pose to an organization’s financial performance and the way well equipped the corporate is to administer those risks. Such assessments may assess, amongst other things, CO2 emissions (E), occupational health and safety (S), and executive compensation structures (G).
ESG rankings are based on the concept that firms with higher ESG scores will perform higher financially over time because they’ve lower exposure to ESG risks, are higher capable of manage them, or a mix thereof. Consequently, assuming efficient markets, higher ESG scores must also result in higher valuations.
So, do higher ESG scores correlate with improved financial performance or higher valuations?
There is not any easy answer. The The literature is diverse and lacks a transparent consensus. Part of the issue is how the assessments are conducted. Should researchers compare firms in numerous industries? What role should balance sheet size or market capitalization play? How long is an acceptable commentary period? What is the precise measure of monetary performance – return on assets, net income, operating expense ratio (Opex), free money flow, sales growth, or some combination thereof? Are market prices sufficient for market valuations or should they be adjusted for volatility and liquidity? Should the impact of rising (or falling) ESG scores be considered with a lag, and in that case, how much of it?
To provide a transparent, albeit limited, signal, we formulated a narrow hypothesis: that the bond market views firms with higher ESG rankings as greater credit risks and that these firms’ corporate bonds should due to this fact have lower risk-adjusted returns. If the impact is critical, a sample set that reasonably reflects the general market should display the impact at any time limit.
We created a universe of enormous US firms with ESG rankings and publicly traded bonds due in 2024 and 2025. We chosen 10 issuers from each of the 11 sectors defined within the S&P 500 methodology and derived their risk-adjusted returns (credit spreads) by subtracting the yield of comparable maturity U.S. Treasury bonds from the present corporate bond yield. We collected all of our observations from a single two-day period, April 6-7. April 2023, and our ESG scores were obtained from Sustainalytics.
According to our hypothesis, corporate bond credit spreads must have a negative correlation with ESG rankings. Better ESG rankings are more likely to result in higher bond prices and thus lower risk-adjusted returns.
But that is not what we found. In fact, there was no significant association. As the graph below shows, our results show a large spread and an R-squared of only 0.0146. Because Sustainalytics uses an inverse rating scale, where lower scores indicate higher rankings, the road of best fit actually deviates from our hypothesis. This implies that higher ESG rankings actually correlate with higher credit spreads.
Company ESG scores in comparison with risk-adjusted bond yield
The correlation coefficients varied significantly by sector. Utilities and 4 other sectors show some support for the hypothesis or a positive correlation given the inverted ESG rating scale. Communication services and 4 other sectors take the other view, that higher ESG rankings are related to higher returns. Of course, since there are only 10 issuers per sector, these results will not be meaningful.
Correlations by sector
| sector | R-value |
| Communication Services | -0.66 |
| Financially | -0.29 |
| Healthcare | -0.26 |
| technology | -0.12 |
| Consumer Staples | -0.03 |
| energy | 0.00 |
| Industry | 0.01 |
| materials | 0.02 |
| Property | 0.02 |
| Consumer Discretionary | 0.19 |
| Utilities | 0.45 |
| Average | -0.06 |
Why might bond investors ignore ESG scores when making investment decisions? Several aspects could play a job. First, credit standing practices and rating agencies are well developed much more consistent are given greater consideration of their decisions than ESG rating agencies. As a result, bond investors may feel that ESG scores contribute little to their credit risk assessment.
Even if bond investors imagine that ESG scores provide real information, they might not view the risks that such metrics measure as an important. The bond buyer’s primary concern is the corporate’s contractual obligation to make debt service payments in full and on time. While worker diversity and board structure play a big role in ESG rankings, they will not be viewed as particularly critical by bond buyers.
If you enjoyed this post, do not forget to subscribe.
Photo credit: ©Getty Images /Liyao Xie
