Invest in ESG practices to lower the cost of capital

December 4, 2023

In recent years, Environmental, Social, and Governance (ESG) factors have become increasingly integral to corporate decision-making and investment strategies. Companies are recognizing that strong ESG performance not only contributes to a more sustainable and ethical business model but can also have a significant impact on financial metrics. One key area where ESG excellence is believed to make a difference is in the cost of capital. What drives this assumption and does it hold true? More importantly, are there any other financial benefits?

Comprehending ESG Performance

Investors assess a company's operations and global effect using a set of criteria known as ESG. Governance examines the company's internal controls, ethics, and leadership; environmental considerations review the company's impact on the environment; and social aspects address the company's interactions with customers, employees, and communities.

Businesses that exhibit a dedication to social responsibility, sustainable practices, and sound corporate governance are those that do well in terms of environmental, social, and governance. This dedication can take many different forms, like lowering carbon emissions, encouraging inclusiveness and diversity, and upholding honest and moral corporate practices.

The Connection Between Cost of Capital and ESG compliance

1. Risk Mitigation:

Organizations with robust ESG policies are frequently better able to recognize and manage a range of risks, such as those related to the environment, society, and governance. Investing in these companies is thought to carry a lower risk due to investors' perception that they are less likely to encounter legal challenges, reputational damage, or regulatory issues.

2. Access to Funds:

Businesses that demonstrate strong ESG performance may find it easier to raise finance as the market for ethical and sustainable investments expands. ESG considerations are becoming more important to investors when making decisions, and businesses that share these values are likely to attract a larger investor base.

According to SEBI data on green debt securities, between 2017 and September 2022, 15 Indian corporates issued green bonds worth ₹4,539 crore. Most of these are related to renewable energy generation, while one is slated to be used for the tertiary treatment of waste water. The Hindu Business Line

3. Cost of Debt:

Businesses that perform well in environmental sustainability may pay less for loans. Because these businesses are less likely to be involved in social unrest, environmental liabilities, or governance issues, lenders view them as more creditworthy. Bond and loan interest rates may drop as a result of this.

4. Investor Preference:

More and more institutional investors are incorporating environmental, social, and governance factors into their investment choices. Businesses with strong ESG performance are more likely to draw and keep these investors, which might raise stock price and decrease equity cost.

About 85percent of the chief investment officers surveyed stated that ESG is an important factor in their investment decisions. Sixty percent of respondents review their overall portfolio for ESG considerations, and about 80 percent assess individual company positions in the context of how ESG affects forecasted cash flows. McKinsey

5. Long-Term Value Creation:

Strong ESG performance frequently reflects a company's commitment to creating long-term wealth. Companies that put sustainability and ethical business practices first are valued by investors, who believe that these companies have a higher chance of producing steady returns in the long run.

A rising amount of research points to a favourable association between improved ESG performance and a lower cost of capital, even though this relationship is neither absolute or direct. In addition to making the world a more ethical and sustainable place, businesses who actively adopt and promote ESG principles may also see a decrease in capital costs. Businesses that disregard ESG factors may find it more difficult to attract investors as the financial sector develops and prioritizes sustainable investing.

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