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Pricing ESG risk in credit markets

There is plenty of evidence showing that companies with poor environmental, social and governance (ESG) behaviours are likely to underperform their peers. Our research has historically included ESG analysis alongside assessments of a firm’s operating and financial risks. Until now, it has been challenging to price ESG risks in a similar way to these core credit risks. But this is changing: in order to analyse ESG risks with greater precision, we have developed a pricing model to capture the influence of these factors on credit instruments.

Key findings

To price ESG risk, we took Hermes’ proprietary measure of ESG risk – the QESG Score – for companies in four credit-default swap (CDS) indices. Drawing on external specialist research and the proprietary insights of Hermes EOS, the QESG Score combines a company’s current and future expected levels of ESG risk. We then compared each issuer’s QESG Score with the spreads on their CDS to identify persistent correlations. Our major findings are as follows:

  • Companies with the lowest QESG Scores tend to have the widest CDS spreads and broadest distributions of average annual CDS spreads (see figure 1)
  • Although there are correlations between companies’ QESG Scores and their credit ratings, there is a wide dispersion of QESG Scores within each rating band. This means that credit
    ratings do not perfectly accurately reflect ESG risks and thereby do not serve as a sufficient proxy for ESG risk
  • Given the positive relationship between QESG Scores and spreads, we created a pricing model that can be used to quantify the contribution of ESG risk to credit spreads
  • This model can be used to identify potential outperformers – firms with wide spreads and high QESG Scores – and underperformers – companies with tight spreads but poor QESG Score

 

credit-esg-fig-1-chart

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Magnus Kristensen, Director - Business Development, Nordics
Paul Voute, Head of European Business Development