How ESG Is Being Used to Distort Credit Risk

A new fad has taken root in political and investing circles: Environmental, Social, and Governance (ESG). ESG calls for investors to consider non-financial factors when making investments.  

Leaving aside the ungrammatical mix of nouns and adjectives inherent to ESG, this concept of governance was not an elevation of risk assessment and investment management but an outright denigration.  ESG not only adds nothing of value to risk assessments or investment management, but it can have significant perverse effects by exposing investors to more risk than they expected – or shunning good investment opportunities that are not favorably scored by a political agenda.

The word “governance” as applied to credit assessments, whether municipal or corporate, seems to have been hijacked with the advent of ESG around 2017. Suddenly, “governance” was elevated to a separate category of analysis that, along with “environmental” and “social”, would be applied to a credit judgement a posteriori: a finger on the scale after the base credit assessment had been determined.  

Get Woke, Go Broke  

Longtime skeptics of ESG’s inherent subjectivity and political agenda may perhaps be forgiven their schadenfreude given its comeuppance over the past months.  

Following an overdue regulatory focus on greenwashing and the broader investor flight to actual return on investment, the recent implosion of Silicon Valley Bank (SVB) and Signature Bank has been illuminating given that both institutions were certainly not shy about their “diversity, equity and inclusion” (DEI) and ESG bona fides.

Many are now wondering if wokeness has replaced competence and merit across the banking sector, questions that are also being directed at its regulators. Signature Bank’s cringeworthy employee music videos and comedy sketches are certainly an embarrassment now. SVB was unable to hire a risk manager from April 2022 until January 2023, yet managed to onboard "a Chief Diversity, Equity and Inclusion Officer, an executive-led DEI Steering Committee, and Employee Resource Groups with executive sponsors focused on these objectives."  

Financial experts who have been through more than a few financial cycles know the full story of these debacles only emerges over time.¹ Even at this early stage, however, it appears that SVB failed some core elements of Banking 101: managing interest rate risk and its liquidity. The bank’s long Treasuries lost value with inflation-driven rates hikes and its depositors were highly concentrated.  

On the lending side, there is some argument that SVB’s virtue-signaling bent gave it undue exposure to money losing but narrative-approved venture capital tech startups, climate change related projects and activist groups. Perhaps SVB and its regulators truly believed the official narrative that inflation was “transitory”, despite the compelling contradictory evidence of massive national debt, money printing and deficit spending, compounded by the destruction of cheap energy.

The more recent debacle of Anheuser-Busch’s failed Bud Light marketing strategy suggests other reasons why corporations go “woke”, even to their apparent detriment.  Large companies are put under immense pressure to earn a high Corporate Equity Index score, else be publicly shamed as “discriminatory,” “racist,” or some other nasty label that translates to “not woke enough.”² There may also be a more cynical reason—to placate (left-leaning) regulators, who wield enormous power over acquisitions and mergers, as well as examinations. ³  

Is Governance Really a Separate Credit Factor?

In a word, no.  

Neither SVB’s collapse, nor Anheuser-Busch's unforced loss of 5% of its market value is ameliorated just because these events resulted from what some perceive as good social intentions. These errors and missteps are core to their credit quality.  

The idea that an entity’s underlying credit characteristics could be fully evaluated and then, somehow, after-the-fact further-adjusted based on “governance” was always intellectual nonsense.  

By mid-2020, it was already apparent that COVD-19 was a manageable respiratory virus, yet some governments persisted with societal shutdowns, creating an economic and social crisis whose destructive waves will afflict us for many years.  

But where are the ESG “governance” scores distinguishing those entities that continued to damage their economies and residents, as opposed to those like Sweden and Florida who took another course and reaped the economic and social benefits? On the flip side, what about those states and local governments that seem to be driving away residents and investments with high taxes, regulation, and crime?  

ESG is so subjective as to have no standards and no useful meaning, it seems. Who pays any attention to ESG assessments, I wonder, other than those who have been hired at financial firms specifically to do just that?  

Governance and Municipal Credit

A municipal entity’s credit is determined by several elements that are given, and other elements over which it has more control. The “given” elements here are three:  

• the economic base, over which the entity has some influence but typically only gradually, through policies related to taxation, development, or public services;  
• a revenue structure, which is also broadly immutable and often set by the state, but which can change over time; and
• a governing framework that establishes the rules of the game: what the municipality can or can’t do in terms of services and functions, how freely it can raise taxes within its revenue structure, and its limitations upon issuing debt

Within this given structure, the municipality goes about its daily business of providing essential services (or perhaps less-essential services) as permitted by its governance framework. In so carrying out its daily operations, it manages its financial accounts and balances, and issues debt as it deems necessary. The factors over which it has control then, are:

• financial operations, including levying, budgeting, spending, and maintaining reserves, and;
• debt issuance and management

The creditworthiness of the municipality, then, is the total expression of how manages its financial health and debt within the limits imposed by its economic base, revenue structure, and overall operating framework.  

In terms of a credit assessment—the willingness and ability to repay debt—this is necessarily the fullest expression of governance itself. If “governance” is then tacked on atop this, that “governance’ relates to something else entirely. It has become a different measure, of something other than credit.

Governance and Corporate Credit

This analytic construction broadly applies to corporates as well: “economic base” becomes “market sector” or “customer base” and revenue structure becomes “pricing margin”. The main difference is that unlike the municipality—which, after all, “can’t leave town”—the corporate can physically move and buy or sell into and out of different businesses with much flexibility.

The fact that the corporate credit typically has greater ability to define itself makes the point even more obvious: there are few Aaa/AAA or even Aa/AA corporate credits because corporates choose to live with more debtor risk; there is simply insufficient advantage to the enterprise or to shareholders to tie up reserves necessary for a higher rating, particularly when yield spreads are relatively tight.

This begs the question as to why US municipal bonds don’t choose a similar path; lower reserves and narrower revenue margins would likely benefit taxpayers and incentivize economic growth. Ultimately, however, the taxpayers may not be the true shareholders in the municipal world.

Nevertheless, the key point remains: a credit assessment should measure debt repayment, and intrinsic to that measurement is how an entity governs itself with regard to credit.  ESG perverts this simple task and exposes investors and the public to greater risk than they should be exposed to.  

As such, rating agencies and anyone with an interest in the assessment of credit quality should disregard ESG distortions.  

Al Medioli is a seasoned veteran of the capital markets, and investor, and Senior Fellow at The Transparency Foundation.

¹ One element to watch for is any evidence that Signature Bank in particular was the target of anti-crypto sentiment.

² https://nypost.com/2023/04/07/inside-the-woke-scoring-system-guiding-american-companies/

³ https://www.zerohedge.com/news/2023-04-17/why-anheuser-busch-went-woke