Using ESG analysis to improve the business of lending

CORPORATE credit with terms pegged to companies' environmental, social, and governance (ESG) ratings has taken hold. In South-east Asia, Singaporean banks are leading the way in linking ESG risk assessment to their credit and pricing decisions for corporate clients, with a sharp focus on sustainable financing. DBS, for example, has more than doubled its sustainable financing target to reach S$50 billion by 2024.

Recent developments in capital markets also indicate a relationship between sustainability and share price performance. Stocks with higher ESG ratings have outperformed the market and shown greater resilience, a correlation that has persisted throughout the Covid-19 pandemic.

While investment performance of public companies is well researched, analysis of the credit risk of private companies has been thin.

Recently, however, Bain & Company applied statistical analysis to a large, representative sample of commercial customers in Dutch multinational Rabobank's loan portfolio.

The analysis confirms a strong relationship between customers' sustainability practices and lower risk of being in arrears.

THE ESG-RISK CONNECTION

Rabobank gathered ESG information from its 20,000 small and medium-sized enterprise clients, using questions specific to their particular industries. Manufacturers, for instance, were asked whether they reused or cleaned waste and water, and which energy-saving measures they took. Agricultural clients were asked about land management and animal welfare. External data such as eco-certifications corroborated the account manager assessment.

Using this data, Bain analysed the differences between the top ESG performers and the bottom ones. We controlled for factors that can confound results, such as company size, profitability, and levels of debt.

Our analysis found that clients with low ESG performance were about twice as likely to be in arrears as the high ESG performers, all else equal. Separately, we investigated the ESG-risk relationship over time. We found that low ESG performers were about twice as likely as high performers to move into arrears over the year, even when they started from the same risk rating.

These results indicate a correlation between higher ESG performance and lower credit risk across different geographies and industries.

THE ROLE OF MANAGEMENT

Exactly why sustainability correlates with lower risk is difficult to prove statistically, because of 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-calibre management establishes business models that foster financial stability and sustainability. Such investments can lead to greater operational efficiency, by reducing by-products and waste and by more efficiently allocating resources. In turn, efficient resource allocation improves a firm's financial health and lowers its default risk.

For example, Rabobank sees that Dutch organic grocery chain Ekoplaza actively focuses on reducing food waste by optimising its supply chain and donating produce that is almost out of date. ESG-focused clients tend to have more efficient, long-term-oriented operations and thus pose a lower credit risk for the bank.

IMPROVING THE BUSINESS OF LENDING

Given the durable connection between sustainability and risk, banks have an opportunity to improve their lending business through client management, risk assessments, loan pricing, and funding.

• Advanced client management. Client dialogues should expand to cover how performance on ESG dimensions affects the risk of default or falling into arrears, as well as the long-term benefits.
• Enhanced risk assessment. Adding in-depth analysis of ESG variables will increase the accuracy of risk models, enabling banks to make more informed judgments about each client's risk profile.
• Adjusted loan pricing. Financial incentives will help motivate clients to invest in sustainability.
• Improved funding cost. Funds have already been made available for ESG investment from sources such as Europe's central banks. Investor demand for sustainable assets currently outstrips supply, so a bank that can securitise and sell its ESG-intensive loans will be able to obtain cheaper funding.

Many banks clearly want to further ESG goals in their own and their clients' activities. Rabobank's experience should give banks confidence that they can help attain these ambitions, and improve their economics in the bargain, by analysing and working with the private companies in their own portfolios.

• The writers are partners in Bain. Avishek Nandy is based in Singapore; Edy Widjaja is in Jakarta, and Christian Graf is in Munich.