Letter number 120 of April 2019

  • NEW

News : Finance: green, sustainable and responsible? (2/2)

The first part of this article was published in the last month’ edition of this newsletter. You can read by clicking here.

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So, what are the concrete forms that all of the above are taking?

Among investors, concerns about socially responsible investment (SRI), first arose in the 18th century in religious communities (Quakers, Methodists) which forbad their members from investing in companies that produced weapons, alcohol or tobacco.

Vigeo-Eiris[1] has identified 1138 SRI funds in Europe with €158bn under management, up by 16% on 2015 and 13 times more than 2003. This is a large amount but at the same time not all that much when compared to total funds managed by French institutional investors (€2 200bn[2]), 50% of which state that they take extra-financial information into account when making their investment decisions[3].

Investors, the AFG[4] and the Forum for Socially Responsible Investment have come up with a definition of SRI: “SRI (Socially Responsible Investment) is an investment that aims to achieve a social and environmental impact by financing companies and public entities that contribute to sustainable development regardless of their sector of activity. By influencing the governance and behaviour of stakeholders, SRI encourages a responsible economy.”

In the Vernimmen we maintain that from a strictly financial point of view, the most important men and women in a company are its shareholders. SRI is an illustration of this as by overweighting or underweighting certain companies in their portfolios (or even totally eliminating them) investors, like other stakeholders, exercise pressure on these companies. Responding to a question from an investor who asked whether he was more interested in the sustainability of his company or that of the planet, Shell’s CEO replied that the group should no longer be described as an oil and gas group but as “an energy transition company”, thus confirming a shift towards a low-carbon world which is not specific to Shell. Similarly, European banks and some insurance companies (Allianz, Axa) have stopped financing coal-based electricity generation.

Parallel to this development, corporate social responsibility (CSR) has been defined, by the European Union for example as: “The voluntary integration by companies of social and environmental concerns into their business practices and relationships with their stakeholders. Being socially responsible not only means complying fully with the applicable legal obligations, but also going further and investing “more” in human capital, the environment and relationships with stakeholders”.

ESG criteria have been defined in order to enable SRI complaint investors to select companies that appear to them to be more virtuous and to enable companies to take concrete actions in terms of their CSR. Accordingly, the Best in Class strategy recommends investing in the best performing companies from an ESG point of view in any given sector. The Best Effort strategy is less radical in its selection as it includes wider coverage of companies that have made the most progress in terms of ESG.

The norm-based screening strategy establishes minimum ESG standards for including a company in a portfolio.

When it comes to financing of companies, volumes of green or sustainable financing are still marginal at this stage, but have increased sharply. Today we get green bonds, green loans and responsible bonds.

Green bonds are conventional bonds in terms of their financial flows so the innovation here is not financial! Their green status stems from the issuer’s undertaking to use the funds for investing or spending that is positive for the environment (as defined by the company which is generally assisted by an independent firm). Responsible bonds finance socially responsible projects.

Monitoring spending and allocating a source of financing to a particular use requires a specific type of organisation which financial departments are not accustomed to.  This type of organisation costs money. But because investors are not prepared to pay more for green bonds than for conventional bonds, this additional cost is borne by the company.

Standards for green, social and more generally responsible bonds are established by the ICMA[5] which publishes the Green Bonds Principles and Social Bonds Principles. This is important as investors rely on these standards in order to demonstrate that their investments are SRI compliant and that these bonds are eligible for inclusion in their funds or their asset portfolios dedicated to such investments.

Companies have another financial tool they can use for ESG policy implementation: green or responsible revolving credit facilities (RCFs[6]). Unlike bonds, these facilities do not require funds to be used for ESG projects (this would be complicated as for large groups, these facilities are mostly back-up undrawn credit lines). Their ESG aspect comes from the fact that their cost (and thus the banks’ remuneration) depends on the company achieving ESG goals. The relevance of these goals is initially validated by an independent agency and is subject to monitoring while the credit facility is active. We note that these products entail an ESG cost both for the company and the bank financing it! At this stage, the variability of the credit margin, which is dependent on whether the ESG goals are achieved or not, is still only a few basis points.

Notwithstanding the above, we note that ESG-type financing products are also used to mobilise employees internally given that ESG goals become more concrete since failing to achieve them results in a (small) financial penalty and has a psychological impact that is certainly not negligible.

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This development has brought its own problems. How do we go about assessing, rating and ranking companies on the basis of ESG criteria? What are the most relevant criteria and for whom are they relevant? Clearly, assessments should be sector-based as an agri-food business will not face the same ESG challenges as a power generating company. Agencies that rate companies on the basis of their ESG policies (Vigeo Eiris, Cicero et Sustainalytics) are emerging, the traditional rating agencies and audit firms are also seeking to get in on the act as are the certification agencies (Bureau Veritas, SGS) while standards (ISO) are soon to developed.

One of the problems that companies are having to face remains the lack of a uniform and dynamic method for selecting these criteria. New criteria are continually arising (sometimes in response to the latest trends or because new controversies have emerged) and companies are having to be agile if they want to hang onto their ratings or certifications.

One of the problems raised by green or social bonds is that funds raised must be used for ESG investments. This means they are easy to issue for very capital-intensive businesses (energy, real estate, etc.), but much trickier for knowledge-based industries (what sort of investment by an advertising agency could be classified as green or social?) So, in today’s world, these companies are unable to make use of this tool even if they happen to have impeccable ESG credentials.

This highlights the difference between the holistic and the targeted project approach to ESG. The former is clearly more ambitious but difficult to measure, standardise and grasp for anyone outside the company. There is the fear that companies may indulge in communication one-upmanship and greenwashing without taking any real action, all in the interests of political correctness. The latter approach is more concrete for investors, but involves a risk of financing companies that generally do not have very impressive ESG ambitions and only communicate on a few projects.

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But let’s not deceive ourselves. This is most definitely not just a passing trend to which homage should be paid for a short time, before returning to the way we used to do things in the good (or rather bad) old days!

We believe that any company that chooses to ignore these concerns is doomed to fail as a result of the dual effect of an increase in its cost of capital (since investors will gradually decline to finance it) or increasingly higher costs, which will penalise it vis-à-vis its competitors; and the growing difficulty of attracting human talent without which everything is a lot more complicated. And there is also the permanent risk of being stigmatised and suffering general social opprobrium.

The good news is that the long-term view doesn’t seem to be exclusively focused on financial performance. From the point of view of companies, the Boston Consulting Group[7] shows that, out of a sample of 343 groups in 5 sectors, companies with a high ESG score have higher margins than others. The direction of causality still needs to be determined. The fact that companies with higher ethical standards are more attractive to employees is one explanation. Other explanations also highlight better risk management as a result of ESG issues being factored in and the creation of opportunities (ArcelorMittal has just announced that a new technology for treating gas produced by its Gand plant will enable it to transform gas into bio-ethanol that it will be able to sell).

From an investor’s point of view, a number of empirical studies have shown that SRI funds achieve identical or better performances than conventional funds. A Russel Investment[8] study shows that asset managers that create the most value already have a large number of stocks that comply with ESG criteria in their portfolios. 

As for Finance Directors, they should not see this as something new that they have to deal with. On the contrary, given that one of their roles is to manage the financing of the company in order to ensure its long-term future, and another is to manage financial risks, again to ensure the long-term future. Sustainability, which lies at the heart of ESG concerns, has for a long time been a central theme for Finance Directors and so they’ve been “doing it” all along, just like Monsieur Jourdain in Molière’s Bourgeois Gentleman, who spoke in prose without even realising it…

As the spokesperson within the company for the investors that finance it, the role of the Finance Director is to ensure the sincerity of ESG commitments made because sincerity creates trust. And without trust, financing is just not possible.



[1] Green, Social and Ethical Funds in Europe 2016 release

[2] According to the French Association of Institutional Investors, Af2i.

[3] In the Af2i annual report

[4]  French Association of Financial Management, grouping of professionals managing portfolios on behalf of third parties

[5] International Capital Markets Association.

[7] Total societal impact, a new lens for strategy, October 2017.

[8] Are ESG tilts consistent with value creation in Europe? January 2015.


Statistics : French government bond yields since . . . 1752

This graph is result of the work of David le Bris and of other researchers. It is telling the economic history of France, and is a dreamy one.

What will the one we will publish in the issue 744 of Vernimmen.com NewsLetter in April 2098 look like?

Research : Spectacular deleveraging

With Simon Gueguen, Senior Lecturer at the University of Cergy-Pontoise

To what extent have companies that have reached their highest ever levels of leverage, deleveraged? The answer depends on the approach taken by researchers. Many studies show moderate deleveraging. For example, a 2012 study[1] on US companies since 1971 reports a reduction of less than 15 percentage points during the 7 years following the peak debt period (from 0.55 to around 0.40).

The results of study we look at this month[2] are much more spectacular. What distinguishes this study from others is that it adopts a longitudinal approach, observing deleveraging on a company by company basis (and not taking the sample average). Deleveraging measured is obviously much higher, in particular because the length of the period between the highest and lowest level of financial leverage differs from company to company. It is easy to protest that deleveraging measured will obviously be very high when measured company by company, from its maximum to its minimum level. Nevertheless, the results are spectacular and support theories that highlight financial flexibility as the motivation behind the choice to deleverage.

The study covers non-financial US companies over a very long period (1950 to 2012). The key variable considered is financial leverage (FL) measured as: (book value of debt) / (market value of equity + book value of debt).

In the sample studied, median financial leverage goes from a high of 0.543 to a low of 0.026. In one-third of cases, debt is paid off in full. Even more interestingly, the cash position increases significantly, so much so that for 60% of the sample, deleveraging results in negative net debt! The cash share of total assets increases from 0.050 to 0.132 over the deleveraging period.

Technically, the reduction in the FL ratio results both from the reduction in the book value of debt and from the increase in the market value of equity. Although the direct effect of debt repayment is dominant (71%), this repayment is mainly achieved with the help of capital increases and reinvested earnings (which also increase the denominator of the ratio).

These empirical results shed light on the theoretical debate on optimal capital structure. According to the traditional trade-off theory, there is an optimal level of debt for each company, a level at which the tax benefit of debt is exactly counterbalanced by costs associated with the risk of bankruptcy[3]. Companies seek to achieve this (positive) target whenever an event drags them off course. According to this study, it seems instead that companies that have reached their maximum debt levels seek to deleverage completely in order to restore their capacity to finance future projects. These results are compatible with the idea of financial flexibility. Given that financing by issuing equity is the most difficult and most expensive way of doing this, companies prefer to adopt a flexible structure, i.e. low gearing, when they can, and then to borrow again when projects (or problems!) make this necessary[4].http://www.vernimmen.com/Vernimmen/Summaries_of_chapters/Part_4_CAPITAL_STRUCTURE_POLICIES/Chapter_35_Working_out_details:_The_design_of_the_capital_structure.html


[1] D. Denis and S. McKeon (2012), “Debt financing and financial flexibility: evidence from proactive leverage increases”, Review of Financial Studies, vol.25, pages 1897 to 1929.

[2] H. DeAngelo, A.-S. Goncalves and R.-M. Stulz (2018), “Corporate deleveraging and financial flexibility”, Review of Financial Studies, vol.31, pages 3122 to 3174.

[3] For further details, see chapter 33 of the Vernimmen.

[4] For more on financial flexibility, see chapter 35 of the Vernimmen.



Q&A : Can a growth rate to perpetuity be negative?

There is no reason why not in certain sectors or for certain companies, as although the global growth rate is 4%, some companies are growing at 20% or 30%, others necessarily have much lower growth rates, including negative rates. For example, this is currently the case for the magazine press in Europe with a general decline in distribution and sales revenue (although there are a few exceptions).

So there’s nothing shocking about a negative rate of growth to infinity when performing a business valuation using the discounted cash flow method, although there are very few sellers who would readily agree!


New : Comments posted on Facebook

Regularly on the Vernimmen.com Facebook page[1] we publish comments on financial news that we deem to be of interest. Here are some of the comments published over the last month.


Vigéo Eiris is being sold to Moody's this month. This is a sad and even distressing news.

Vigéo Eiris is an independent international research and ESG (Environment, Social and Governance) agency for investors and private, public and community organizations. It was founded by the former head of a trade union, Nicole Notat, who very early understood the importance that the ESG thematic would take. 3 years ago it merged with the London-based Eiris agency.

Vigéo Eiris is 91% owned by almost all major French asset managers (Amundi, AXA, BNP Paribas, CDC, CNP, Lazard, Natixis, etc.). It achieved a turnover of €9.7m in 2017, up 25%, with a loss reduced from €5.2m to €3.4m. Moody's posted sales of $4,442m in 2018, up 5% and net income of $1,309m. Nothing comparable of course.

Is financing for a few years a European ESG rating agency up to a few millions euros a year really out of reach of the main French institutional investors who collectively manage several trillions of euros? Are there no alternatives to selling Vigeo Eiris to a company closely identified with a country that has left the Paris Agreement on climate and whose ratings of vehicles invested in sub-prime loans have been key to spread the 2008 financial crisis all over the world?

If Moody's carries out this acquisition, it is of course because that agency has not developed an ESG expertise. As this market is taking off, Moody's wants to catch up with an acquisition. But let's not kid ourselves. Vigeo Eiris will be absorbed, crushed within Moody's, if not immediately, after a few years; and its some 150 employees will weigh little against the 12,000 employees of Moody's. It is a new normative power, whose importance will grow, that would leave the bosom of Europe to join a country whose slogan became America First.

The world changes

A few days ago, the largest sovereign wealth fund in the world, the Norwegian fund (€925bn in assets), announced that, subject to the agreement of the Parliament, it would stop its investments in exploration and production of oil and gas to contribute to the fight against global warming. Its original request was to remove all investment in the oil and gas industry, but the government did not want and the compromise was to forbid investments in the upstream part of this sector under the official pretext of risk diversification since Norway is a producer of gas and oil (which feeds the fund).

This is a new illustration of the power of investors that will result in a rise in the cost of capital for this industry to incentive it financially to leave some oil and gas where it is.

In the same vein, at Shell this time, where a shareholder asked at last year's meeting whether Shell was more interested in its own sustainability than the one of the planet, and to whom the president replied that Shell was an energy transition company, the public goal is to become the largest electric company in the world, with 30% of the turnover devoted to this energy in 2030.