Do Debt Investors Care about ESG Ratings?

🚨 New Paper Alert 🚨

Do debt investors care about ESG rating? Together with my co-authors, Kornelia Fabisik and Larissa Schaefer, I investigate this question using a methodology change of an ESG rating provider that introduces plausibly exogenous variation in firms’ ESG ratings. Virtually all ratings have been downgraded or upgraded (which happened far less often). We analyze whether these rating changes, and downgrades in particular, had a measurable impact on the cost of debt of US publicly listed firms using daily prices of loans traded in the secondary corporate loan market.

These are our initial key results:

• We find that loans spreads of downgraded ESG-rated firms in the secondary corporate loan market increase by about 12.5% compared to non-downgraded ESG-rated firms and compared to before the rating downgrade.

• We decompose loan spreads into a “predicted” spread reflecting fundamental default risk of the firms and a “premium” demanded by investors in addition to compensation for default risk. We find that ESG rating downgrades do not increase fundamental default risk of the firm but the premium charged by lenders.

• We find that the effect is stronger for firms that are more financially constrained and firms that are more exposed to ESG and, particularly, climate risk concerns. We measure ESG / climate risk exposure using a simple NLP algorithm on firms’ earnings calls but also more advanced measures.

• We also took a closer look at private firms. These firms are usually not rated by ESG rating providers and lack the earnings calls or reports researchers usually use to construct ESG related proxies. An important question thus is: Are there spillovers to these firms when public firms experience downgrades? Yes! We find that also loan spreads of private (unrated) firms in industries especially affected by ESG rating downgrades increased after the methodology change.

We do not yet have a draft of the paper to circulate, but I hope these initial results are already interesting and please reach out if you have comments or questions.