Our Approach
To analyse the impact of ESG ratings on a valuation we tested our hypothesis:
“Companies with higher ESG ratings have a lower Cost of Capital compared to
companies with lower ESG ratings”
To test our hypothesis, we investigated the relationship between ESG score and
beta to see the impact on Cost of Equity, as well as the relationship between
ESG score and credit spread to obtain the implications on Cost of Debt.
To obtain the ESG impact on Cost of Equity we performed a regression analysis,
regressing the sample of listed companiesʼ betas against the ESG score.
To obtain the ESG impact on Cost of Debt we regressed the credit spread of our
sample of listed companies against the ESG score.
For our analysis we used the data provider S&P Capital IQ with a sample of
10,318 listed companies from all around the world.
Cost of Equity - Formula
Our formula for the effects of ESG score on CoE can be summarised as follows:
CoE (Discount) Premium= ESG-adjusted CoE - Market (base) CoE
➔ ESG-adjusted CoE = (1.047265569 - 0.001651737 * ESG) * MRP + RFR
➔ Market (base) CoE = (1 * MRP + RFR)**
CoE (Discount) Premium= (1.0473 - 0.0017 x ESG score) x MRP - MRP
Where
CoE = Cost of Equity
MRP = Market Risk Premium = 4.70%
**MRP = 4.7% & RFR = 2.4% (MRP corresponding to the global historical
average MRP, and RFR corresponding to last 5 years of US bond returns)
Cost of Equity - Results
The table on the right side shows the relationship between the ESG score and Cost of Equity. It indicates that, on a market scenario with a Market Risk Premium of 4.7%, Market Beta of 1, and Risk Free Rate of 2.4%, every 10-point increase (decrease) in a companyʼs ESG score results in a 0.08% decrease (increase) in Cost of Equity.
The chart above shows the results of our regression analysis, delivering an R² of 31%, showing significance and thus forming the basis for our formula on the impact on Cost of Equity.
*The basis for our formula is derived from the standard
Capital Asset Pricing Model (CAPM).
Cost of Debt - Formula
Our formula for the effects of ESG score on CoE can be summarized as follows:
CoD (Discount) Premium= ESG-adjusted Credit Spread - AVG Credit Spread
➔ ESG-adjusted Credit Spread = 0.015609946 - 0.0000865919 * ESG
➔ Average Credit Spread of the Sample = 1.38%**
CoD (Discount) Premium= (0.0156 - 0.0001 x ESG score) - 0.0138
Where:
CoD = Cost of Debt
Avg. Credit Spread = 1.38%
**The average credit spread comes from our sample of 10,318
analysed companies
Cost of Debt - Debt
The table on the ride side shows the relationship between the ESG score and Cost of Debt discount or premium. It indicates that, given a Average Credit Spread of 1.38%, every 10-point increase (decrease) in a companyʼs ESG score results in a 0.09% decrease (increase) in Cost of Debt.
The above chart shows the results of our regression analysis, delivering an R² of 79% and therefore providing a significant statistical relationship between the impact of ESG score on the Cost of Debt.
This analysis is offering strong support for our hypothesis indicating that better ESG scores result in lower Cost of Capital (in this case Cost of Debt)