Credit to companies with conditions linked to the environmental, social and governance (ESG) ratings of companies has become essential. In Southeast Asia, Singapore banks are leading the way in linking ESG risk assessment to their credit and pricing decisions for corporate clients, with an emphasis on sustainable financing. DBS, for example, has more than doubled its sustainable funding target to reach S $ 50 billion by 2024.
Recent developments in capital markets also indicate a relationship between sustainability and stock price performance. Stocks with higher ESG ratings outperformed the market and showed greater resilience, a correlation that persisted throughout the Covid-19 pandemic.
While the performance of public company investments is well documented, the analysis of private company credit risk has been thin. Recently, however, Bain & Company applied statistical analysis to a large representative sample of business clients from the loan portfolio of the Dutch multinational Rabobank. The analysis confirms a strong relationship between clients’ sustainable development practices and a lower risk of arrears.
The ESG-risk link
Rabobank collected ESG information from its 20,000 small and medium-sized business clients, using questions specific to their particular industries. For example, manufacturers were asked whether they reused or cleaned waste and water, and what energy saving measures they were taking. Farm customers were asked about land management and animal welfare. External data such as eco-certifications corroborated the assessment of the account manager.
Using this data, Bain analyzed the differences between the best ESG performance and the worst. We controlled for factors that can skew results, such as company size, profitability and debt levels.
Our analysis found that clients with poor ESG performance were roughly twice as likely to be in arrears as clients with the highest ESG performance, all other things being equal. Separately, we have studied the ESG-risk relationship over time. We found that underperforming companies on ESGs were about twice as likely as top performers to be in arrears during the year, even when starting from the same risk rating.
These results indicate a correlation between higher ESG performance and lower credit risk in different geographies and industries.
The role of management
It is difficult to statistically prove why sustainability correlates with lower risk due to the qualitative factors involved. Interviews with account managers, combined with our experience working with other banks on ESG-related initiatives, suggest that the quality of management plays an important role.
Higher caliber management establishes business models that promote financial stability and sustainability. Such investments can lead to greater operational efficiency, reducing by-products and waste and allocating resources more efficiently. In turn, efficient allocation of resources improves a company’s financial health and reduces its risk of default.
For example, Rabobank finds that Dutch organic grocery chain Ekoplaza is actively focusing on reducing food waste by optimizing its supply chain and donating nearly obsolete products. ESG-focused clients tend to have more efficient and long-term operations and therefore present a lower credit risk to the bank.
Use ESG analysis to improve lending activity
Given the lasting link between sustainability and risk, banks have the opportunity to improve their lending activities through customer management, risk assessment, loan pricing and financing.
Advanced customer management. Dialogs with clients should expand to cover how performance on ESG dimensions affects the risk of default or late payments, as well as long-term benefits.
Improved risk assessment. Adding in-depth analysis of ESG variables will increase the accuracy of risk models, allowing banks to make more informed judgments about each client’s risk profile.
Adjusted loan pricing. Financial incentives will help motivate customers to invest in sustainability.
Improved financing cost. Funds have already been made available for ESG investments from sources such as European central banks. Investor demand for sustainable assets is currently outstripping supply, so that a bank that can securitize and sell its ESG-intensive loans will be able to obtain cheaper financing.
Many banks clearly want to promote ESG objectives in their own activities and those of their clients. Rabobank’s experience should give banks confidence that they can help achieve these ambitions, and thereby improve their economy, by analyzing and working with private companies from their own portfolios.
Shazrul Asari is a partner at Bain & Company, based in Kuala Lumpur; Avishek Nandy is a partner in Singapore; and Dr Christian Graf is a Munich-based partner.