Do Debt Investors Care About ESG Ratings?

February 8, 2024Published by European Central Bank

Downgrades to ESG ratings increase the cost of debt for US listed firms, according to this working paper for the European Central Bank. The impact of downgrades is also shown to have spillover effects on private unrated firms in the same industries as downgraded ones.

The results show the real-world financial importance of ESG ratings and as “the market for ESG data is fraught with conflicts of interest”, the results imply the field “might need world-wide regulator attention”, say the authors.

The authors – Kornelia Fabisik, Michael Ryf, Larissa Schäfer and Sascha Steffen – study how debt investors incorporate ESG ratings into investment decisions by exploring the impact of ESG downgrades on loan spreads for a sample of syndicated corporate loans on secondary markets.

They use a shock to ESG ratings, caused by a change to Refinitiv ESG’s rating methodology, as an event study, to assess abnormal returns on firm values. When Refinitiv – one of the largest ESG rating providers – previously changed their rating methodology in 2020, 87% of affected firms saw a ratings downgrade.

The results show that downgraded firms experienced a negative stock market reaction. They also saw a 10% increase compared to other firms in the same industries and ratings categories over the same period.

The authors found the effect on loan spreads increases significantly for the first two months and remains significant until the fifth month after the event.

These temporary effects are “driven by frictions among investors and not by long-term changes in firm fundamentals”. This implies investors respond to changes in ESG scores and adjust their portfolio accordingly, putting downward price pressure on downgraded firms, which in turn causes higher loan spreads.

The authors then explored the different potential channels to explain the transmission of effects from ESG downgrades on firms’ costs of debt.

They found that firms with higher ESG-related risk, in particular higher climate risk, experience stronger effects on loan spreads, as do firms with more ESG-related public commitments and firms that are invested in by more climate-concerned lenders.

The results also show that for smaller and more financially constrained firms the effect of the downgrade is especially pronounced.

Loan spreads of private unrated firms in industries affected by ESG rating downgrades experience a 9% increase in the loan spread relative to their average loan spread. The effect is especially pronounced for private firms without credit ratings for which additional information plays a larger role.

This page was last updated February 8, 2024

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