Environmental and social governance (ESG) has become a major factor of concern for companies, markets, consumers and investors. Consumers have given voice to their expectations and through their choices, they encourage companies to modify their behavior and improve certain aspects of their business.
Another strong influence for change is the power held by investors. In response, credit ratings, which have an important impact on financial markets and investment choices, have started to consider how ESG factors can be integrated into their evaluation of investment opportunities.
"The main idea behind our paper is that ESG is becoming very important for investors. More and more investors are keen to place their money in companies that are socially responsible or have responsible governance models. However, credit ratings are also very important and many times credit ratings are in contrast with ESG ratings," explains Florian Kiesel, an assistant professor in the department of Accounting, Law & Finance at Grenoble Ecole de Management.
A UN driven initiative
A survey by the UN PRI (Principles for Responsible Investment) initiative highlighted the fact that investors would like credit ratings to incorporate ESG factors. Such factors include social issues such as employee treatment, environmental and sustainability issues, as well as governance structures. For traditional credit rating companies, ESG factors are a challenge because such data is not explicit or easily quantified. "Despite this, the three major credit rating companies have now signed the UN PRI initiative and ESG factors are definitely growing in importance," adds Florian.
ESG ratings could have strong impact on financial markets
"To better understand this challenge, we examined how traditional credit ratings consider ESG and how this impacts the market. We found that ESG factors for downgrades or upgrades in credit ratings have a strong effect on the market. However, ESG is only marginally present in traditional credit ratings which minimizes the importance of this effect," explains Florian. "Yet, this is definitely a trend that will continue to grow in the future and the impact of ESG factors will certainly gain more weight for both investors and financial markets."