“Leverage is indeed an important risk driver of companies and it should be picked up by the credit rating,” admits Michael Viehs, an ESG specialist at Hermes.
“However, even after controlling for credit ratings, which should pick up all relevant risks to a company, ESG performance still matters and is negatively related to CDS levels,” he added.
Investors should therefore feel compelled to consider ESG factors when deciding whether or not to invest in a prospective company.
“Credit investors must use a more precise measure of ESG risk if they aim to accurately capture its influence on spreads,” Reznick emphasised.
“By plotting spreads against ESG scores, we have been able to develop a pricing model that quantifies compensation we should receive for a given level of ESG risk.”
Viehs notes that some companies in their sample have high credit ratings, but low ESG scores.
“We would view such companies as candidates for ratings downgrades. Those companies are exposed to a higher ESG risk than companies with better ESG scores and this additional risk from ESG externalities is not necessarily reflected in credit ratings,” he says.
“Even a company with a very healthy capital structure could risk a downgrade in case of a particular ESG event or scandal at the company. Because of its low ESG score, the odds of an ESG incident at such a company is much higher than for a company with a high ESG score.”
The emissions scandal at Volkswagen is a perfect example of an ESG controversy impacting a company with a high credit rating. Following the scandal, which broke in September 2015, Fitch and Standard & Poor’s cut Volkswagen’s credit rating by several notches.