How ESG Optimizes The Cost of Capital
Sustainable Corporate Finance
How much return on capital employed a company achieves and how much it has to pay for equity and debt capital is an important aspect for entrepreneurs and executives: if the return is not sufficient to cover at least the cost of capital, the company works in a value-destroying manner. Sustainability can help reduce the cost of debt capital.
destroying manner. Sustainability can help reduce the cost of debt capital.
Sustainability plays an incremental role in the financing of most companies. Both in the case of large capital market transactions (e.g. bond issuance) and when taking out loans, banks and investors – also due to regulatory requirements – require companies to be able to report financial key performance indicators (KPI) in terms of Environmental, Social and Governance (ESG) on a recurring basis.
Measuring sustainability
Typical ESG figures considered in loans or bonds include, but are not limited to, a company’s greenhouse gas emissions (carbon footprint), energy consumption, water consumption, and waste production. In addition, social metrics such as workforce diversity and inclusion, working conditions, and community engagement also play an important role. Governance metrics include aspects such as board independence, transparency of corporate governance, and compliance with ethical business practices. In the lending market, two to three ESG figures are commonly used.
More favourable conditions for loans and bonds
Regardless of recent political developments, ESG remains relevant in corporate finance. This is because various studies show that companies with better sustainability indicators have a lower cost of capital. In short, they can get capital more cheaply and have to pay less interest on loans or bonds. For example, reports from e.g. the NYU Stern School of Business and Chava have shown that sustainable companies receive relatively more favorable interest rates or benefit from lower credit and credit default spreads. The difference is said to be about 20 percent with regard to interest rates for loans.
Agreement on ESG Covenants
In practice, this works in such a way that when liabilities are accepted, it is agreed which key figures (“ESG covenants”) the company must comply with. For example, in the issuance of a € 250 million promissory note loan from the German real estate group Branicks (formerly DIC Asset) in 2021, the share of “green buildings” in the real estate portfolio was relevant. The target: to increase the share to more than 20% by 2023 from 11.6% at that time. If the target was achieved, the interest rate should fall by 5 basis points, if the share is 15-20%, nothing changes, and if the share is less than 15%, the interest rate should rise by 5 basis points.
Entire credit market requires ESG
An evaluation by Commerzbank for the period from 2020 to 2023 has shown that all transactions in the syndicated loan market had at least one environmental KPI. About 77% of the transactions were equipped with a CO2 indicator. It was also found that social metrics were more common in the credit market than in the bond market. Sustainability in the supply chain is somewhat less relevant (12%) (e.g. CO2, ESG ratings, purchase of raw materials and intermediate products from organic farming). So far, key figures on biodiversity and the EU taxonomy have rarely been seen in the market; however, this is likely to become more important in the future, the Commerzbank experts estimate.
Measures to reduce CO2 emissions
Against this background, the need for sustainable business practices and their recurring measurability based on key figures also comes from the corporate finance sphere. For entrepreneurs and managers, therefore, finance and operations should organize for close networking – in order to achieve a positive effect on the cost of capital through targeted investments in decarbonization. A key aspect of improving the ESG rating is the reduction of CO2 emissions by:
1.) Optimize energy efficiency
– Conversion to LED lighting
– Use of energy-efficient machines
– Automation and intelligent control systems
2.) Use renewable energies
– Installation of photovoltaic systems
– Purchase of green electricity
– Use of geothermal energy or biomass
3.) Promote sustainable mobility
– Switching to electric vehicles
– Bicycle and public transport promotion
– Reduction of business travel through digital meetings
4.) Promote CO2 offsetting and circular economy
– Support reforestation projects
– Recycling and resource conservation
– Efficient waste management
Energy savings in buildings: key to sustainability
Buildings in particular are responsible for a significant proportion of companies’ energy consumption. Optimising building efficiency can bring significant CO2 savings. Key measures include
- Insulation: Better building insulation reduces the energy required for heating and cooling.
- Smart heating, ventilation and air conditioning (HVAC) systems: Automated controls and modern circulation pumps help to minimise electricity consumption.
- Optimize lighting: Motion sensors and LED technology can save up to 80% on energy costs.
- Use energy storage: Batteries and other storage technologies help to use renewable energies more efficiently.
- Green roofs and facade greening: These improve thermal insulation and can contribute to air pollution control.
Improving the ESG rating and reducing CO2 emissions are crucial for companies to gain better access to capital, achieve financial benefits with regard to loans or bonds, and at the same time make a positive contribution to climate protection. Energy savings in buildings play a central role in this. With the right measures, companies can improve their ESG performance, reduce costs and increase their resilience to market fluctuations.