How to lower your cost of capital using ESG.

A team of researchers from PanAgora Asset Management and Google Research investigated the amount of ESG data disclosed by companies and its relationship with ESG ratings and the cost of capital. As it turns out, disclosing more ESG data helps a company reduce its cost of capital and improve its ESG ratings.

On the ratings side, this is probably a bad thing, because it indicates that most ESG ratings still aren’t looking under the hood of a company but instead simply take ESG data at face value and then compare it to the data retrieved from peers of a company. If a company’s ESG data is better than that of its peers, the company gets a better rating and that’s the end of it. If a company doesn’t disclose the data but its peers do, the company will face a worse ESG rating. That many smaller companies don’t have the resources to generate this data and disclose it then creates a large cap bias in ESG investing that I have written about before. I don’t like ESG ratings for many reasons, but this simple box-ticking exercise that is all too common with ratings agencies is one key shortcoming of ESG ratings.

However, on the cost of capital side, it makes sense that companies that disclose more data have lower costs of capital. After all, an investor wants to know what is going on in a company and if a company is more transparent about non-financial risks, that should reduce uncertainty in investors and hence lower the cost of capital. There likely is also a behavioural bias at play insofar as investors who get more ESG data seem to perceive a company as greener and less risky. But there is also a fundamental component where companies that publish positive ESG news get rewarded by the market and companies with negative ESG news get punished. But whether it is a psychological or a fundamental effect, the result remains the same. Companies can actively reduce their cost of capital by becoming more transparent about their ESG risks.