By James Cardamone, Product Manager, ESG Integration at Truvalue Labs
A new study, “ESG, Material Credit Events, and Credit Risk,” by Professor Witold J. Henisz and Doctoral Student James McGlinch of the University of Pennsylvania’s Wharton School published in the Journal of Applied Corporate Finance illustrates the connection between ESG performance and credit risk. 
“Our study is the first large-sample empirical study of the mechanisms that link ESG performance to credit risk, said Henisz, “We found that Truvalue Labs’ ESG scores capture timely and material events such as regulatory inquiries, investigations and lawsuits, which are correlated with credit risk and the likelihood of default.”
The study, “leverages Truvalue Labs’ data to uncover and analyze cases of companies with relatively weak ESG performance that subsequently experience high-profile negative ESG events leading to measurable increases in credit risk.” Below is a summary of some of the highlights we found in the study.
Empirical Evidence of Heightened Material Risks Due to Weak ESG Performance
While previous studies have attempted to tie ESG performance directly to credit risk and others have analyzed the correlations between ESG performance and financial performance (outsized stock return), Professor Henisz and Doctoral Student McGlinch of the Wharton School use multiple studies to show empirical evidence of specific material risks that are heightened due to weak ESG performance and link them to credit risk.
Key Areas of Analysis:
- Touchstone cases of companies with poor ESG performance undergoing material events further impacting ESG performance, stock performance, and credit spreads.
- Sector-level projects (Infrastructure & Commodity Value chains) showing a correlation between specific ESG measures & credit risk.
- Multi-industry study using 342 non-financial services firms creating a bivariate relationship based on TruValue Labs ESG prior-year performance and reported material events from RavenPack News Analytics (15 Positive & 15 Negative groups).
Quantifying the Negative Impact of Major Credit Events on Poor ESG Performers
Starting with the touchstone cases, the examples help quantify the negative impact major credit events have on poor ESG performers from both a legal perspective and financial impact.
Using the Volkswagen (VW) Emissions Scandal as an example, we see that VW had been installing software to help pass emissions tests on diesel vehicles from 2009-2015. The following ensued, according to Henisz and McGlinch:
- September 18, 2015 the US EPA announces VW violated the Clean Air Act.
- Post-violation announcement, VW saw its share price fall 37% over 3 days and credit default swap (CDS) spreads widened 187% to 216bps.
- October 16, 2016, a $15 billion settlement deal included a buyback program, $2.7 billion for environmental mitigation, and $2 billion for clean-emission infrastructure.
In each of the study’s examples, a material credit event causes drastic stock price depreciation and significant CDS widening post announcement. In most cases the events result in lawsuits, significant fines, stock price decline, and irreparable damage to the public image.
Spotlight on Infrastructure Projects of Publicly-Traded Companies
The second section of the study evaluates infrastructure projects of publicly-traded companies. The authors used a dataset of 4,642 infrastructure projects and narrowed it to 255 that were geocoded with latitude and longitude, and also attributable to financing secured by publicly-traded parent companies.
The authors then examined reported incidents such as halted operations, lawsuits, labor-related issues, and conflicts due to indigenous peoples’ land claims. The study finds a strong correlation between proximity to indigenous land claims and material events: As much as a 500% increase for projects within 10 km, versus within 500 km.
After this initial linkage ESG vendor data (MSCI, RepRisk, Sustainalytics, and Truvalue Labs) is used to overlay ratings specific to indigenous land claims.
That analysis “found a strong moderating role for sponsors’ indigenous rights management capability,” meaning that for companies with poor ratings from ESG vendors in related areas:
“Incidence of these material events was anywhere from three to 66 times higher, depending on the event type and risk measure. In most cases where companies do a reasonably good job of managing indigenous rights issues, the incidence of these material risks increases less prominently.”
Examining Commodity Value Chains
In the second sector study, the authors analyzed commodity value chains by evaluating financed projects across a large group of companies covered by various ESG providers. The analysis began with 4,352 “commodities-based” companies, which were narrowed to a smaller subset with daily bond trading data. The initial analysis concludes that superior environmental stewardship significantly reduces the likelihood of material credit events (i.e., halts of operations, regulatory inquiry, lawsuits or legal actions).
Further testing the link between ESG performance and credit risk, the trades of corporate bonds by the parent company post issuance of an agricultural finance facility displayed signs of a built-in risk premium. Controlling for fundamental measures of risk, top quartile biodiversity scores as measured by Truvalue Labs exhibited credit yield spreads 20bps below peers in the bottom quartile. Again, a promising correlation, however it needs to be noted that only 13-19 companies were able to be analyzed due to the linkages and data limitations. In a similar analysis from the perspective of the creditor, using 26 banks but only data from 8-12% of borrowers, higher environmental or biodiversity scores from the borrower led to significantly less risk for the banks as witnessed by tighter CDS spreads.
Broader Analysis on Non-Financial Services Industries and Materiality
With the sample size increased to 342 companies, with data from 2009-2017, in a broader analysis performed on 13 non-financial services industries, the authors stated that only Truvalue Labs’ data enabled the study to delve into the bivariate relationship of material ESG criteria as defined by SASB to find correlations between prior year ESG performance and reported material events from RavenPack:
“At this level of analysis, the ability of Truvalue Labs data to take into account relative performance within industry and the materiality of the ESG criteria was critical. No other ESG data series to which we have access—including MSCI-KLD, Sustainalytics, RepRisk, or ASSET4—displayed evidence of positive bivariate correlations in our full sample of firms.”
The study concludes that higher-performing ESG firms experience lower incidence of material adverse events and firms with below peer industry performance on material ESG criteria experience a higher incidence of adverse events. In a table that highlights the correlations based on material ESG factors from Truvalue Labs and both positive and negative events from RavenPack, higher-performing ESG companies had fewer incidents, either positive or negative, suggesting less volatility by these stronger firms.
Henisz, Witold and McGlinch, James, “ESG, Material Credit Events, and Credit Risk,” Journal of Applied Corporate Finance, Volume 31, Number 2, Spring 2019.