How Do ESG Activities Affect Default Risk of Firms?

By Mete Tepe, Per Thastrom, and Robert Chang

It is an open question as to how default risk is affected by Environmental, Social, and Governance (ESG) activities. Investing in ESG activities may increase default risk because ESG activities come with a price tag, requiring cash outflows and creating uncertainty. Firms may need to make significant changes to their strategy, operations, assets, and capital structure. Conversely, investing in ESG activities may decrease default risk by addressing climate related risks, improving brand equity, attracting capital from ESG investors, improving operational efficiency, and attracting and retaining talent. This paper explores both the risk-driving and risk-mitigating impacts of ESG on default risk. It empirically models the impact of ESG activities on default risk using a sample of 240 publicly traded large U.S. firms between 2012 and 2018.

Our results support the hypothesis that firms with strong ESG, measured by their ESG rating, have a lower probability of default. In other words, strong ESG is a form of credit enhancement. However, our analysis raises several important questions for further research. First, do our results extend to a more heterogeneous portfolio that includes small and mid-size firms? Second, instead of looking at the combined ESG rating, what is the relationship between the separate E, S, and G pillars and default risk? Do the results hold when using ESG ratings from different data providers? Third, how do business cycles affect the relationship between ESG ratings and default? ESG activities seem to have a non-linear effect on default risk, and the benefits of ESG depend on the firm type, lifecycle stage, and specific type of ESG-activity being measured. And finally, how can financial institutions better manage the impact of ESG activities on their portfolios?

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