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Does good ESG performance lower the cost of capital?

© Shutterstock / Dilok Klaisatapornwooden blocks spelling 'risk' and 'return'

There is an assumption today that good ESG performance will result in access to lower cost capital. What drives that assumption and is it true? Is it simply about good governance and corporate management, is it about taking action on climate change or even about social action on health, equality or education? More importantly, is it the only benefit?

The simple answer is that cost of capital should be lower for businesses that are effectively managing risk, especially in terms of licence to operate. It’s well established that investors are drawn to companies with lower risk profiles.

Today companies with poor ESG compliance risk poor publicity, lawsuits, worker and stakeholder unrest, at the very least. Yet is lower cost capital worth it considering the cost of action?

There is little question that incorporating ESG criteria in a business strategy will result in a short-term fixed cost increase, as there is a time and money investment required to access date, analyse it and set out a strategy and targets. Where the situation becomes interesting is how that cost is weighed against the benefit, and over what period.

Vaughan Lindsay, chief executive of Natural Capital Partners, believes that there is a difference in cost of capital for businesses focused on climate action. This is a major market trend, and one that is not going away. He says that “If you are undertaking meaningful climate action people believe that your business will grow quicker.”

There are two issues at play here. The first of which is resilience to changing market structures and expectations, and the second of which is changing consumer appetites. Lindsay says: “In the UK 60% of consumers will choose a product with strong ESG credentials if the price is the same. In the EU the figure is around 80%, while in the US it’s around 65%. If you’re not taking action, you’re not giving consumers what they want.”

Action on climate change is one aspect of ESG, and Lindsay says that “There is strong evidence of correlation of climate action and cost of capital. I haven’t seen the evidence, but the logic is clear that ESG compliance will have the same effect.”

ESG results in lower cost of capital

Robin Nuttall, who leads McKinsey’s ESG and regulatory work has said that a McKinsey analysis of over 2,000 research papers suggested a better ESG ratings score should equate around a 10% lower cost of capital, although the definition of ‘better’ remains fairly flexible. Alternatively MSCI analysis from 2020 shows only fractional differences between cost of capital for the highest performing and lowest performing companies, in terms of ESG factors.

What’s interesting here is that there is a stronger correlation between low performing ESG scores and a higher cost of capital. The MSCI analysis showed higher ESG-rated companies were more competitive and generated above normal returns, often leading to higher profitability and dividend payments, especially when compared to low ESG-rated companies.

At the very least, research suggests that high performing ESG scores correlate to greater resilience in the face of systemic risk – certainly ESG stocks performed well during COVID, losing less than companies operating under BAU approaches.

At the same time, previous research from Bank of America Merrill Lynch showed a correlation between companies with poor environmental and social records and bankruptcy filings. Fifteen out of 17 bankruptcies in the S&P500 from 2005 to 2015 were from companies with a poor track record.

Calculating long term ESG benefits over short term costs differs by sector

It can be difficult to calculate whether the short-term costs are adequately compensated for by a longer term lower cost of capital and higher earnings on the bottom-line.

Rosalind Kainyah, founder and managing director of Kina Advisory Limited, believes though that ESG is not just a ‘nice to do’, and even though important, it isn’t just for risk management and compliance. She says, “ESG practices can create value for business – adding to the financial bottom line. Optimal profit and sustainability are comfortable bedfellows.”

It’s important to remember that different market dynamics play out across different asset classes. Srinath Narayanan, CEO and Founder of Project Energy Reimagined Acquisition Corp (PEGR), points out that “For public companies across specific sectors such as manufacturing, utility, agriculture, mining, construction and logistics, there is a strong negative correlation between ESG ratings and corporate bond costs and ratings.

This may be attributed to the fact that higher level of disclosures from ESG mitigates information asymmetry and allows investors to understand and price risks better. However, on the equity capital side, investor drive for quarterly EPS growth trumps ESG demands within the acceptable guidelines of ESG specific to the industry.”

Investor appetite will continue to drive down cost of capital for ESG leaders

A major determinant of cost of capital, especially for equity capital, is the determination and interest of a particular investor. The return expectation when shareholders buy a stock is usually driven by combination of baseline expected returns from the reduction of cost of capital and upside unexpected returns driven by cash flows.

Unless ESG frameworks are standardised and the underlying risk factors made comparable and systemic, it could be difficult to assess any significant reduction in cost of capital – especially in many traditional industries where it has been challenging to identify impacts in a definite way.

We have seen ESG performance allow companies in energy transition industries to capitalise on investor and institutional demand to raise significant amounts of equity capital.

Yet Narayanan warns that directional momentum and the shift in macro-economic conditions, and changes in government policy framework for driving energy independence, have led investors to overlook technology and execution risk in the near term in their equity investment approach. Basically that a focus on new opportunities may have obscured some traditional risk concerns.

It is the selected investment approach of the financial institution, however, that may continue to drive differences in capital cost and availability  – although it may not yet be comparable.

One element today is that if a business is not engaged in developing decarbonisation strategies, investors are less likely to want to provide finance. This is because, given current market developments, the likelihood is they’d be financing old business models and out-moded ideas.

ESG practices now a baseline for market performance

Given the level of competitiveness in most industries, a deliberate avoidance of innovation that is in tune with market trends may suggest a board, or a business model, that is out of touch and out of sync with the wider markets.

Maintaining a competitive edge means responding to the market as it evolves. At the very least, failure to effectively engage with the debate suggests a company that is out of touch with potential disruption of its current markets.

There is however robust data showing that effective ESG practices are lowering operational costs and increasing productivity, leading to better margins and profitability.

For example, in 2017 Walmart’s calculations revealed that a 5% reduction in packaging through its supply chain would translate into $11 billion in cost savings, of which it would capture $4.3 billion, and last year it pledged to reduce its use of virgin plastic by 15% by 2025.

Kainyah says that “Sound environmental and social performance can protect project budgets and schedules, reduce operating costs and contribute to the overall cost efficiency of operations. For example, finding ways to use less water and energy, reduce waste and increase recycling saves money in the medium to long term, and improvements in working conditions and employee benefits helps companies retain vital talent.”

There is also the issue of licence to operate and reputation, and she adds that “while an intangible concept, having a good reputation as a demonstrable result of good ESG practices can benefit a business in a multitude of ways – consumer preference, support for an organisation in a time of crisis or controversy, access to new market opportunities … to name a few.”

Capital inflows to ESG driven by changing markets

The last few years have seen a tremendous inflow of capital from corporates, sovereign wealth funds and institutional asset managers into renewable fuel, sustainable aviation fuel and new energy sources ranging from green ammonia to hydrogen.

Around the world new energy policies for energy independence have also driven significant equity risk capital towards green energy investments and those associated with transition. While the last few months have seen a growing backlash against a perceived lack of rigour in the ESG sector, the underlying drivers of change remain unchallenged.

What is remarkable is that there is even a question about the utility of any company being more aware of the risks it faces – from supply chain disruption, carbon pricing, insurance increases due to extreme weather, health of workers and consumers – and building a response into its operational strategy. Only be understanding the risks that it faces can it build a transition plan, a new business model that will enable resilience in the face of change.

Despite the current energy crisis and the rush of capital to fossil fuels, large-scale market trends around climate change, nature and biodiversity and resource scarcity are unlikely to go away.

That means significant amounts of capital searching for deal-flow, and the availability of capital interested in specific investment approaches (such as ESG) is going to affect the cost of that capital to companies performing well on the relevant criteria.

In the end, the long-term availability of affordable capital is going to be dependent on the equity and cash-flow performance of companies across a range of sectors with a declared focus on ESG. Given recent market volatility and concerns about inflation and recession, there is unquestionably nervousness in the market.

It does however appear that a company focused on understanding its current risks and market opportunities in the face of significant social, environmental and economic risks, on preparing for a shifting market, would be better positioned for success than any of its rivals.

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