Sustainable Finance: A Journey Toward ESG and Climate Risk

Environmental, social, and governance (ESG) factors have gained significant attention and are now a common practice in corporate risk assessment. Nevertheless, the absence of universally accepted standards for measuring ESG risk and impact, along with the difficulty of identifying the materiality of ESG aspects, makes assessing ESG ratings challenging. This paper aims to review the state-of-the-art literature on studies that describe and evaluate ESG rating methodologies and the impact of ESG factors on credit risk, debt and equity costs, and sovereign bonds. We also expand on the topic of ESG research by including a literature strand that focuses on the impact of climate change on financial stability. The reviewed studies suggest that positive ESG ratings are associated with an improvement in credit ratings, a reduction in credit default swap spreads, and a decrease in the costs of equity capital and debt. Finally, we consider the literature discussing the currently predominant sustainable investment (SI) strategies (negative screening and divestment) and their real limited effectiveness, but also suggesting several potential solutions for more appropriate SI strategies, a clearer standardized definition of climate change risk, a better alignment between private profit and social welfare and mostly an ESG focus on outcomes rather than on activities. With regard to the relationship between climate change and credit risk, the literature agrees on the need for adequate scoreboards and an improved disclosure process to address the problem of insufficient data availability and data quality.