Incorporating ESG into the cost of equity and debt in a company valuation

published on 20 February 2024 | reading time approx. 4 minutes

ESG factors are becoming increasingly important due to growing regulatory re­quire­ments, changing customer, investor and employee preferences, and the growing demand for their consideration in corporate valuation. This article shows how ESG issues can be incorporated into the cost of capital.

In recent years, numerous studies have found a positive correlation between a company's financial per­for­mance and its ESG ratings. There are two possible explanations for this observation, namely that a company's sustainability is the cause of its financial success, as such companies can manage their risks better than their competitors and thus receive a higher rating, and that companies with a high rating are financially healthier, which allows them to invest more in sustainability and ultimately receive a higher ESG rating. Although the concepts of sustainability and ESG have been around for some time, the topic has recently become in­crea­sing­ly important. This is largely due to the fact that ESG challenges have become more visible, tangible, and global in recent years. However, increasing regulatory requirements, customer and investor preferences, competitive demands, and the goal of being an attractive employer also give ESG not only global relevance, but also sig­ni­fi­cance at the level of individual companies and in their valuation.

In order to incorporate environmental, social and governance factors into the valuation of a company, ESG-related adjustments can be made to the cost of capital in addition to cash flow components and long-term growth rate. In their studies, Gregory et al. and Giese et al. found that companies that received an upgrade in their ESG rating experienced a decrease in systematic risk and an increase in value, while downgraded com­pa­nies experienced an increase in both systematic and company-specific risk, confirming the positive correlation between a company's sustainability and its value. This translates into lower costs and risks and higher returns over the long term, making more sustainable companies more stable and resilient overall than less sustainable companies. As a result, companies with a strong ESG profile are less vulnerable to systematic market shocks ^[1][2]. the discount rate reflects the risk compensation of equity and debt investors, sustainable companies should have lower systematic risk and beta, and thus lower overall cost of capital and higher firm value.

However, as systematic risks affect the whole market or specific sectors, market- and sector-related ESG risks should by definition be priced in. This could either be done through the expected market return (r_M) or through beta. If ESG issues have a global impact on the economy, an adjustment in market expectations (r_M) would be required. However, to the extent that a particular sector is more sensitive to certain ESG issues, such as energy-intensive sectors to carbon emissions, the increased volatility would be reflected in the beta factor. However, it is difficult to assess the specific change in market expectations and volatility of a sector that can be attributed solely to an ESG effect.

However, there are approaches to actively incorporate ESG issues that are not covered by expected market return or β. ESG can be incorporated into the cost of capital through a flat rate adjustment, peer group selec­tion for beta calculation, unsystematic risk, cost of debt and modified beta calculation.

Zerbib has developed the Sustainable CAPM (SCAPM) to incorporate ESG into the beta calculation, which takes into account investors' preferences for socially responsible companies. By incorporating different invest­ment styles, it has the advantage of working in a non-homogeneous market. When applied to US equities for the period 1999-2019, investors' sustainability preferences led to an average exclusionary effect of 3 per cent for sin stocks ^[3]. In addition, Petersen, Fitzgibbons and Pomorski developed an ESG efficient frontier and an ESG-adjusted CAPM based on Markowitz theory and the introduction of an additional optimisation constraint by the ESG score. Tested on S&P 500 stocks and various ESG proxy indices, they also identified a sin premium in the form of a negative alpha estimate ^[4].

ESG issues can also be taken into account in the peer group selection process for determining beta. The tra­di­tional selection process is supplemented by new screening criteria that explicitly take ESG criteria into account, such as a company's ESG rating or CO2 emissions. This method can also be used to map ESG-related risks and differences within a given sector, which tend to be less quantifiable and significant.

Another way of incorporating ESG into the cost of capital is to make a general adjustment using ESG ratings. This involves clustering companies in an industry into Leaders, Averages and Laggards according to their ESG rating, and then determining the average beta factors of each cluster. These average beta factors are used as a benchmark for the company being evaluated, which is also assessed for sustainability and then assigned to a cluster. Lodh provides a first indication of an appropriate flat rate adjustment, which amounts to a difference of 0.4 percentage points (5 per cent of the cost of equity) for developed market companies and a difference of 2 percentage points (18 per cent of the cost of equity) for emerging market companies between high and low ESG performers ^[5]. However, it should be emphasised that flat rate adjustments are subject to statistical noise and may also be influenced by non-ESG-related issues.
 
In addition to the cost of equity, ESG influences the cost of debt, which can also be lower for sustainable companies due to their stability and resilience. As a result, sustainable companies receive more favourable financing options, such as lower interest payments, but also lower credit and default spreads. For example, Chava shows that companies with significant environmental problems pay almost 20 per cent higher interest rates on loans than comparable companies ^[6]. Furthermore, the issuance of preferential loans and green bonds also means a reduction in financing costs for such companies. Green or social bonds are environmental, sustainability-related bonds that are currently used by a number of listed companies, mainly to obtain more favourable financing. However, it should be noted that issuing green bonds can also lead to higher costs for the company due to stricter requirements. A company's corporate governance structure and compliance with ESG criteria are also increasingly important to lenders in order to reduce financing costs. For example, some lenders use ESG margin ratchets in loan agreements, where the interest rate is linked to meeting or achieving certain ESG criteria, such as a certain level of CO2 emissions. In addition, some lenders exclude entire industries, making it much more difficult for companies with poor ESG ratings to obtain credit. In addition to more favourable terms, sustainable companies may also have a higher leverage ratio because they appear more reliable and resilient. Although Lodh gives an initial indication of a difference in the cost of debt between high and low ESG rated companies of around 0.75 percentage points (around 30 per cent of the cost of debt), this effect is difficult to quantify, similar to the cost of equity.

When adjusting the cost of capital for ESG effects, it should be borne in mind that these can have a significant impact on the overall valuation of the company and are much more difficult to quantify and understand. For this reason, Le Meaux advises basing the adjustment on a past or peer case that can be accurately quantified. He also emphasises that the total WACC adjustment should not exceed ±100 basis points ^[7]. This is supported by Singh, who identifies a downward adjustment of 25 to 100 basis points for ESG-friendly companies ^[8]. In addition, the level of adjustment should be based on the materiality of the ESG issue under consideration. For example, a significant issue might warrant an adjustment of ±50 bps, while an insignificant or remote issue might only warrant an adjustment of ±10 bps ^[7].