In the context of capital markets, ESG continues to drive meaningful differences in investment behaviors, even as the bear market continues. -By Robin Byrd

ESG, the environmental, social, and governance measurements, are an increasingly influential force in the corporate space. This is especially true when it comes to financing. Many investors and analysts believe that companies that perform well on ESG factors may be better managed and have a lower risk profile, which can make them appear to be more attractive investment opportunities.

As a result, the consideration of ESG factors has become increasingly important in capital markets, and many investors now use ESG data and analysis to inform their investment decisions. Some financial institutions have also developed products, such as ESG-focused mutual funds and exchange-traded funds, which are designed to allow investors to align their investments with their values and focus on companies that perform well on ESG factors. Here, ESG and its importance to capital markets will be reviewed, with an eye toward uncovering the true importance of ESG in today’s economic climate.

ESG Strategies and Disclosures in Improving a Firm’s Cost of Capital There is evidence to suggest effective ESG strategies and disclosures can help to improve a firm's cost of capital. For instance, companies with a clear and comprehensive ESG strategy and that regularly disclose information this strategy may be seen as more attractive to investors and thus able to access capital at more favorable terms. Strong governance practices related to ESG strategies, such as independent board oversight, will also give the appearance of a lower risk profile.

Alternatively, companies that do not have strong ESG strategies can be seen as an investment risk. As an example, consider the bankruptcy of Pacific Gas and Electric Company. This was known as the first ‘climate change bankruptcy’ after the firm was penalized for, among other things, its handling of power lines and power stations during drought conditions in California. The fines, increased cost of capital, and follow up litigation showed investors the immediate consequences of failing to attend to ESG issues in a way that activists and investment analysts found meaningful.

Thus, firms need to do more than just pay lip service to ESG issues. They need to take meaningful action – and then communicate those actions to the public. Disclosures, press releases, case studies, presentations, and other corporate communications are needed to surface ESG activity in the minds of the investing public, so that the firm is immediately thought of as a potential ESG-compliant investment opportunity worthy of the best credit terms.

Debt Instruments Tied to ESG Performance Metrics

Along with making ESG a factor in the cost of capital, companies are also integrating ESG into their debt management. One prominent place this is being seen is with debt issuance in the form of ESG bonds and other ESG linked loan products. For example, companies are providing more “green” bonds, social bonds and sustainability bonds. These are bonds that issuers use to fund environmental and social projects. The issuance of social bonds reached a record high of $164 billion in 2020, which was nearly ten times the level of 2019. Further, in 2020, sustainability bonds increased to $128 billion, which was three times the levels seen in 2019, according to data from Refinitiv. On the loan side of things, ESG-linked loans are debt instruments tied to a company’s ESG performance. The interest rate or other loan terms are adjusted based on the company’s ESG performance. Often, bringing ESG into the loan issuance allows a company to access funding from major institutional investors and VC groups who are actively seeking green investments for their portfolios.

Signaling ESG Commitment to By Altering Corporate Structures

A larger step for many firms on the ESG continuum is to alter their corporate structure. When a company makes the decision to pursue positive social and environmental impacts as a matter of core doctrine, they may benefit from structuring their company as a Public Benefit Corporation, also known as B-Corps. This designation is experiencing growing popularity among companies hoping to attract investors, and Morgan Stanley notes that this matches well with the many investors who are looking for companies whose founding principles are based in sustainability. One example of this is Vital Farms, an ethical food producer who garnered interest from investors after seeking designation as a B-Corp. Many believe that the firms B-Corp status was instrumental in helping the company have a successful IPO at the height of the pandemic in October 2020. The firm was able to raise more than $200 million and became a benchmark example of the impact of ESG prioritization on a company’s bottom line.

Measuring the Impact of Corporate ESG Efforts In Today’s Economic Climate

Overall, it is now well accepted that ESG status can sway how investors view a company. However, hard metrics about ESG impact can be difficult to generalize across industries. Some companies benefit massively from fresh ESG disclosures, while others experience a more muted response. For example, an energy firm’s commitment to carbon neutrality may hold greater weight in capital markets than a beauty company’s similarly worded pledge. Still, despite notable variance, there are ways to for companies to measure ESG impact. For example, one can measure the impact of corporate ESG efforts on the cost of capital, such as interest rates on green bonds or ESG-linked loans. Or, one can analyze the performance of ESG-focused investment products. Finally, firms can also look at the market “drubbing” in stock prices and interest rates that firms with poor ESG metrics experience to get an idea of the potential costs of failing to bring ESG to the forefront of planning and strategy.

All in all, ESG continues to be a powerful force in capital markets. While the market as a whole may be in bear territory and interest rates still on the rise, firms with strong ESG reputations can still attract capital at attractive rates. Thus, one may expect to see more ESG-focused investment products and corporate restructuring going forward, as firms seek to marry up the less tangible positives of ESG with the hard dollar rewards ESG can bring.