Lesson 7 of 7 · 11 min
Evaluating ESG risks and opportunities
Debt and equity analysts use the same process to quantify material ESG effects on cash flows and discount rates, but equity usually reacts first and hardest, while debt suffers mainly when repayment is threatened, and more so at long maturities.
In short
- Debt and equity are claims on the same cash flows, so the ESG analysis process is similar for both.
- Step one: quantify how material ESG factors change the firm's discounted future cash flows.
- Severe adverse ESG events usually hit equity first and hardest (residual claim).
- Debt is hit less, unless the ability to pay interest and principal is threatened: then expect higher borrowing costs and rating downgrades, in extreme cases bankruptcy.
- Long-term ESG risks (such as stranded assets) hurt long-maturity debt more than short-term debt.
- Analysts adjust forecasts (costs, revenues), discount rates and use sensitivity or scenario analysis.
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