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Ashish Lodh

Ashish Lodh

Executive Director, MSCI Research

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ESG and the cost of capital

  • Companies with high ESG scores, on average, experienced lower costs of capital compared to companies with poor ESG scores in both developed and emerging markets during a four-year study period. The cost of equity and debt followed the same relationship.
  • Companies with lower ESG scores exhibited a stronger relationship to the cost of capital than did those with higher scores. In developed markets, companies with lower ESG scores, upon improving their MSCI ESG Rating, experienced reduced costs of capital.
  • Corporate management may wish to consider that strong management of financially relevant ESG risks has been aligned with investor interests.

Over the past few years, integrating environmental, social and governance (ESG) criteria into portfolios has shifted from an exercise involving a relative handful of investors to a mainstream focus.1 In our recent Principles of Sustainable Investing framework, we asserted that ESG risks, and in particular the transition to a low-carbon economy, may lead to significant reallocation of capital over time.


What has this change meant for publicly held companies? Have we seen any relationship between cost of capital and ESG scores? While an emerging body of research has studied the relationship between a company's ESG characteristics and financial performance,2 little light has been shed on how ESG has affected the cost of capital.


Companies’ ESG profiles correlated with cost of capital

We obtained monthly industry-adjusted ESG scores that underlie the MSCI ESG Ratings and classified the companies in the MSCI World Index (comprised of developed-market constituents) and MSCI Emerging Markets (MSCI EM) Index into two sets of ESG-score quintiles, each with the same number of companies.3 Our study period was from Dec. 31, 2015, through Nov. 29, 2019.4

In the MSCI World Index, the average cost of capital5 of the highest-ESG-scored quintile was 6.16%, compared to 6.55% for the lowest-ESG-scored quintile; the differential was even higher for MSCI EM. Previously, we have found that high-ESG-rated companies have been less exposed to systematic risks — i.e., risks that affect the broad equity market or market-like sectors or industries — than low-ESG-rated companies. This finding is consistent with the capital asset pricing model (CAPM), where lower systematic risk (beta) implies lower cost of equity. Similarly, we found that the average cost of debt of high-ESG-rated companies was lower than that of low-ESG-rated companies. This was in line with expectations, as the corporate-governance standard, one of the pillars of ESG, is known to reduce a firm's default risk, which directly impacts its cost of debt.6


ESG scores were related to companies’ cost of capital

Monthly averages were reported over the period from Dec. 31, 2015, to Nov. 29, 2019. The average number of companies in the MSCI World Index and MSCI Emerging Markets Index over the analysis period was 1,552 and 960, respectively.


Regional differences were present albeit minor

Since developed-market regions differ from each other in terms of investors’ ESG awareness and regulatory regimes, we repeated the quintile analysis for companies in the U.S., Europe and Japan individually. The relationship between ESG scores and the cost of capital was the strongest in the U.S., where the lowest-ESG-scored companies faced significantly higher cost of capital than the highest-ESG-scored companies. In Europe and Japan, the relationship was not entirely consistent, although the cost of capital for the lowest-rated companies remained significantly higher than for the best-rated ones. Also, across all regions, ESG scores bore a stronger relationship to the cost of capital for low-rated companies, as shown by the sharp increase from quintiles Q3 to Q1 (low ESG).


Relation between ESG scores and cost of capital differed within developed regions

Monthly averages were reported over the period from Dec. 31, 2015, to Nov. 29, 2019. The average numbers of companies in the U.S., Europe and Japan over the analysis period were 538, 452 and 319, respectively.


ESG materiality was sector-agnostic

In the MSCI ESG Ratings methodology, companies in each industry are assessed only on industry-specific ESG key issues, which are deemed financially relevant by its Global Industry Classification Standard (GICS®)7 subindustry.8 Low-scoring companies exhibited significantly higher costs of capital than high-scoring companies within most GICS sectors — and not just in the sectors traditionally viewed as more exposed to environmental risks (energy and utilities) or governance risks (financials). This remained true for both developed and emerging markets.


Difference in cost of capital (in %) between high- and low-scoring (Q1 – Q5) companies by GICS sector

GICS Sectors MSCI World MSCI Emerging Markets
Energy 0.38 0.59
Materials 0.23 0.90
Industrials 0.39 1.03
Consumer discretionary 0.43 1.00
Consumer staples 0.39 0.69
Health care 0.35 0.61
Financials 0.39 1.06
Information technology 0.46 1.14
Telecommunication services 0.41 0.75
Utilities 0.55 0.73
Real estate 0.43 0.46


Improving MSCI ESG Ratings carried some benefits

To analyze whether the correlation we observed between ESG and cost of capital was more than a statistical accident, we looked at the evolution of the average cost of capital around MSCI ESG Ratings upgrades of companies.9 Markets appeared to reward MSCI ESG Ratings upgrades in developed markets, while the effect was not present in emerging markets. This was particularly significant for developed-market companies whose initial MSCI ESG Ratings were at the lower end of the spectrum — a pattern consistent with the results reported earlier. While causality is empirically hard to establish with limited data history, the results suggested the companies that had weak MSCI ESG Ratings could potentially benefit by taking steps to marginally improve their ESG profile.


How cost of capital changed for companies that experienced MSCI ESG Ratings upgrades

Companies with MSCI ESG Ratings upgrades in the period from Dec. 31, 2015, to Nov. 29, 2019, with data available from t-3 months to t+9 months were used. We observed 691 upgrades in the MSCI World Index and 248 upgrades in MSCI EM.


High-rated companies exhibited above-market valuation and profitability

So why did high-ESG-scoring companies experience lower costs of equity? These lower costs could come from being less susceptible to systematic market risks. In a discounted-cash-flow model, with all other things equal, companies with a lower cost of capital would also likely have a higher valuation. The valuation ratio of the MSCI ACWI ESG Leaders Index and MSCI SRI Index10 — which each take a best-in-class approach to selecting high-ESG-scoring stocks — was higher than the traditional market-cap-weighted MSCI ACWI Index over the analysis period from June 30, 2011, through Nov. 29, 2019.11 Besides having a lower financing cost, high-ESG-scoring companies could also have benefited from the competitive advantage that stems from better management of resources, human capital and company-specific operational risks.


Valuation and profitability of MSCI ACWI ESG Leaders Index and MSCI ACWI SRI Index

Monthly numbers are reported over the period from June 30, 2011, to Nov. 29, 2019.

Although incorporating financially relevant ESG criteria in a business strategy could incur a short-term fixed cost, the market seemed to reward companies that took steps to improve ESG practices, over the study period. High-ESG-scored companies faced lower costs of capital, and low-ESG-scored companies benefited from improving their ESG profile. This relationship between ESG and cost of capital might have provided some empirical validation for recent innovations in ESG-linked corporate lending, whereby lenders have tied the terms of lending to the achievement of specified ESG criteria by corporate borrowers.12

In this study, we have shown that the cost-of-capital channel was one way that firms’ ESG profiles (as measured by MSCI ESG Ratings) could have been linked to corporate financing and investment decisions. Going forward, these linkages could provide more explicit criteria for financing, as investors, lenders and companies improve their understanding of how management of ESG risks can translate into long-term financial performance.


The author thanks Sebastien Lieblich, Linda-Eling Lee, Laura Nishikawa and Stuart Doole for their contributions to this post.



1 “2018 Global Sustainable Investment Review.” Global Sustainable Investment Alliance, March 28, 2018.

2A recent meta-study that reviewed about 2,200 empirical papers reported a positive link between ESG and corporate financial performance. Friede, G., Busch, T., and Bassen, A. 2015. "ESG and financial performance: Aggregated evidence from more than 2000 empirical studies." Journal of Sustainable Finance & Investment.

3We controlled for size bias in ESG scores by using the residuals obtained from the cross-sectional regression of industry-adjusted ESG scores on size scores.

4The study period of analysis is limited by data availability on the cost of capital.

5The data on cost of capital was obtained from Thomson Reuters. It is the weighted average of the cost of equity, debt (after tax) and preferred stock. Cost of equity was derived from CAPM using the risk-free rate and equity risk premium of the company’s country and beta with respect to the country’s primary index. Cost of debt took into account both short- and long-term debt, which is 1- and 10-year yield on the credit curve of the company. Cost of preferred stock was the current dividend yield on preferred stock.

6Switzer, L. N., Tu, Q., and Wang, J. 2018. “Corporate governance and default risk in financial firms over the post-financial crisis period: International evidence.” Journal of International Financial Markets, Institutions and Money.

7GICS is the global industry classification standard jointly developed by MSCI and Standard & Poor’s.

8Please refer to the MSCI ESG Ratings Methodology for more details on industry-specific key issues.

9Industry-adjusted ESG scores were converted to ESG Ratings that ranged from “AAA” (highest ESG scores) to “CCC” (lowest ESG scores). A rating upgrade refers to an improvement in the letter rating by at least one step. For more details, please refer to the MSCI ESG Ratings Methodology. Because the cost of capital showed a systematic uptrend during the analysis period, we standardized the cost of capital by creating z-scores for the cross section of companies.

10The MSCI ESG Leaders Indexes select the top 50% ESG-rated stocks in each GICS sector. MSCI SRI indexes select top 25% ESG-rated stocks in each GICS sector. For more information, please refer to MSCI ESG Leaders Methodology document. This analysis excludes MSCI ESG indexes that were optimized using tight tracking-error constraints.

11We are able to use a longer period here because cost of capital data is not required. The study period of analysis is limited by data availability for the MSCI ACWI SRI Index.

12Please see 2020 ESG Trends to Watch for a discussion of in ESG-linked loans.



Further Reading

Weighing the evidence: ESG and equity returns

ESG investing in emerging markets

Foundations of ESG investing