3.

Methodology

The main goal of our paper is to explore if affiliation to a sensitive industry influences a company's
sensitivity to the cost of debt, concerning the various domains of its ESG score compared to firms in
different sectors.

3.1 Data description

The analysis for this research is based on financial and bond data from the sample period of January
1st, 2010, to December 31st, 2019. As pointed out by Kotsantonis & Serafeim (2019), ESG scores do
not follow a consistent pattern. Subsequently, the rating companies’ efforts to signal positive ESG
activities are hindered.

Data for our analysis includes solely recently issued unsecured fixed-rate corporate bonds,
with reported yield spread and bond rating. We exclude bonds that include options or non-standard
elements. As a result, a total of 1542 bonds from 160 companies are included in our sample. Table 1
displays our sample with respect to the number of bonds per company. After looking at our sample,
we exclude missing observations for ESG ratings and values of 0, due to no measure, following
Apergis’ (2022) approach. Relevant for our analysis, we divide the bonds in our sample into industry
sectors. Table 2 presents these industry sectors.

Table 1: Number of bonds per firm

no. of bonds per firm no. of firms % of firms
1-3 101 63.1%
4-6 32 20.0%
7-10 10 6.3%
11-20 8 5.0%
21-99 6 3.8%
100+ 3 1.9%
Total 160 100.0%

3.2 Dependent variable

The dependent variable for our research is the market quoted yield spread of newly issued bonds,
which expresses the firm's cost of debt. The yield spread equals the difference between the offering
yield to maturity of a bond at issue date and the yield to maturity of a corresponding treasury bond.
It reflects the premium that the market charges to borrowers above the risk-free rate for the risk that
they may default on their debt obligations.
Table 2: Number of bonds per industry

SIC Codes Division Amount Percentage

1000-1499 Mining 2 0.130%
1500-1799 Construction 1 0.065%
2000-3999 Manufacturing 459 29.767%
Transportation, Communications, Electric,
4000-4999 Gas and Sanitary service 130 8.431%
5000-5199 Wholesale Trade 3 0.195%
5200-5999 Retail Trade 24 1.556%
6000-6799 Finance, Insurance and Real Estate 825 53.502%
7000-8999 Services 98 6.355%
Total 1542 100.000%

We analyze the cost of debt in its log form, ln(Spread), because of the significant positive
skewness in the yield spread distribution.

The model we use to analyze is:

𝑌!,# = 𝛽0 + 𝛽1 𝐸𝑆𝐺!,# + 𝐵2 𝐼𝑠𝑠𝑢𝑒𝑟 𝑐ℎ𝑎𝑟𝑎𝑐𝑡𝑒𝑟𝑖𝑠𝑡𝑖𝑐𝑠!,# + 𝛽3 𝐵𝑜𝑛𝑑 𝑐ℎ𝑎𝑟𝑎𝑐𝑡𝑒𝑟𝑖𝑠𝑡𝑖𝑐𝑠!,# + 𝑠(𝑖) + 𝑦(𝑡) + 𝛿(𝑗) + 𝜀!,#

Where:
- 𝑌!,# = yield spread - Issuer char. = vector of ind. variables
- i = bond - Bond char. = vector of ind. variables
- t = period - s(i) = industry sector fixed effects
- ESG = ESG Score - y(t) = time fixed effects
- δ(j) = country of issue fixed effects

3.3 Independent variables

The ESG pillar scores are used, which outline a company’s ESG performance in a single E,
S or G pillar provided by Refinitiv, in order to identify ESG performance. The company’s ESG
combined score evaluates a company’s ESG performance based on the ESG pillars separately. We
integrate companies’ financial performance as issuer characteristics. These explanatory variables are
presumed to capture the risk factors for the yield spreads in the primary corporate bonds market. Also
at the bond ratings at issue dates.
 Table 3: Descriptive statistics on bonds in sample

Variable Observations Mean Std. Dev Min Max Median Kurtosis Skewness
Yield spread (bps) 1540 123.288 65.261 0.300 539.220 136.920 2.138 0.425

ESG Score 1529 67.366 12.324 13.297 92.987 67.563 1.417 -0.762
ESG [E] Pillar 1521 78.698 18.153 1.034 97.637 85.006 2.697 -1.698
ESG [S] Pillar 1529 72.833 12.463 18.807 97.782 73.957 3.317 -1.485
ESG [G] Pillar 1529 59.303 18.186 7.310 97.094 57.782 -1.109 0.041

Firm size 1540 679.806 586.809 3.767 2687.379 718.189 1.081 1.109
Interest coverage 1523 14.669 33.638 0.040 579.146 6.050 136.818 10.052

TTM (in years) 1540 16.784 9.588 1.997 100.066 14.000 11.054 2.127
Issue size (in mln) 1540 0.511 0.912 0.000 15.000 0.029 45.975 4.508
Subordinated 1540 0.962 0.192 0.000 1.000 1.000 21.214 -4.815

● Firm size is the explanatory variable for the financial characteristics of issuers, given as the log of
total assets. Interest Coverage denotes the interest coverage ratio. Specifically, it means the
earnings before interest, tax, depreciation, and amortization (EBITDA) divided by interest
expense.

Further, the bond-specific variables also account for yield differences across different bonds issues.
We include the following variables to research how the yield spreads are affected by credit risk, the
size/liquidity risk, bond seniority and maturity, and all together:

● TTM (time to maturity), calculated in years to avoid scale discrepancies.

● Issue size is calculated using the natural logarithm for the same reason as the time to maturity.

● Subordinated, a Boolean variable that equals one when the bond’s order of repayment is senior-
subordinated.

3.4 Methodology specific to our paper

We have considered two new dummy variables in order to investigate our hypotheses. These
are Environmental Sensitive Pillar (ESP) and Social Sensitive Pillar (SSP). A value of 1 in ESP
indicates that the industry is sensitive to the Environmental pillar, and a value of 1 in SSP indicates
that the industry is sensitive to the Social pillar. In our literature review, we were not able to find a
theoretical argument for industries sensitive to the Governance pillar. Therefore, we will not include
a variable Governance Sensitivity Pillar (GSP). We first structure all the industries in either sensitive
in Social pillar, and sensitive in Environmental pillar in order to obtain the variables SSP and ESP.
We use the database of Refinitiv Eikon in order to demarcate the different industries. According to
this database there are a total of 81 industries in the dataset.

For our definition of sensitive industries, we draw from Sagbakken & Zhang (2021), where
they define sin stocks as those operating in the alcohol, tobacco, adult entertainment, gambling, oil,
gas, metals, mining, uranium, and coal industries. Therefore, we define the following industries as
being a sensitive industry: Energy Equipment & Services, Chemicals, Oil; Gas & Consumable Fuels,
Metals & Mining, Aerospace & Defense, Tobacco. Note that Sagbakken and Zhang (2021) employed
the terminology "sin stocks", whereas our study employs the term "sensitive industries". In the
context of this research, we adopt the terminology "sensitive industries".

Additionally, it is crucial to determine the pillar that each specific industry is sensitive to.
Pacelli et al. (2022) find that the energy sector is highly sensitive especially from the environmental
point of view. Companies belonging to this sector are under intense social and environmental
vigilance due to the nature of their activities. Madison & Schiehll (2021) find that industries in the
materials sector, composed of companies producing chemicals, metals, minerals, and mining, the
study points out the high sensitivity of the sector to ESG factors, especially to the E pillar. In addition,
Miralles-Quiros et al. (2018) show that this sector is also sensitive to the S pillar. Cayón & Gutiérrez
(2021) show that firms in the Defense industry are sensitive to the social pillar of ESG. Therefore,
they will receive a value of 1 for the SSP variable. Finally, Hong & Kacperczyk (2009) define the
traditional sin stocks as alcohol, tobacco, gambling, and gaming to be sensitive to social discussion.
Therefore, we will allot a value of 1 for the SSP variable for these industries as well.

Table 4: Sensitivity to ESG pillar by industry

SIC Codes Industry ESG pillar

1000-1499 Mining E and S
1500-1799 Construction E and S
2000-3999 Manufacturing E and S
4000-4999 Transportation, Communications, Electric, Gas and Sanitary service E and S
5000-5199 Wholesale Trade E and S
5200-5999 Retail Trade E and S
6000-6799 Finance, Insurance and Real Estate S and G
7000-8999 Services E and S
 We will run multiple regressions to test our hypotheses. To test our first hypothesis, we set up the
following regressions:

1. 𝑌!,# = 𝛽0 + 𝛽1 𝐸!,# + 𝐵2 𝐼𝑠𝑠𝑢𝑒𝑟 𝑐ℎ𝑎𝑟𝑎𝑐𝑡𝑒𝑟𝑖𝑠𝑡𝑖𝑐𝑠!,# + 𝛽3 𝐵𝑜𝑛𝑑 𝑐ℎ𝑎𝑟𝑎𝑐𝑡𝑒𝑟𝑖𝑠𝑡𝑖𝑐𝑠!,# + 𝛽4 𝐸𝑆𝑃 + 𝑠(𝑖) + 𝑦(𝑡) + 𝛿(𝑗) +
𝜀!,#

2. 𝑌!,# = 𝛽0 + 𝛽1 𝑆!,# + 𝐵2 𝐼𝑠𝑠𝑢𝑒𝑟 𝑐ℎ𝑎𝑟𝑎𝑐𝑡𝑒𝑟𝑖𝑠𝑡𝑖𝑐𝑠!,# + 𝛽3 𝐵𝑜𝑛𝑑 𝑐ℎ𝑎𝑟𝑎𝑐𝑡𝑒𝑟𝑖𝑠𝑡𝑖𝑐𝑠!,# + 𝛽4 𝑆𝑆𝑃 + 𝑠(𝑖) + 𝑦(𝑡) + 𝛿(𝑗) +
𝜀!,#

The first regression tests if there is a relationship between sensitivity to the Environmental
pillar, and the effect that this pillar has on its cost of debt (yield spread). If the value of ꞵ4 𝐸𝑆𝑃 is
insignificant, then, our first hypothesis is rejected. However, if the performance of firms operating in
an environmentally sensitive industry is significantly negative (positive), it suggests that creditors
penalize (reward) them for having similar performance to firms in non-sensitive industries, ceteris
paribus.

The second regression tests if there is a relationship between sensitivity to the Social pillar,
and the effect that this pillar has on its cost of debt (yield spread). If the value of ꞵ4 𝑆𝑆𝑃 is
insignificant, then, our first hypothesis is rejected. However, if the performance of firms operating in
a socially sensitive industry is significantly negative (positive), it suggests that creditors penalize
(reward) them for having similar performance to firms in non-sensitive industries, ceteris paribus.
This regression is based on the hypothesis that firms in sensitive environmental industries will
substitute the environmental pillar with either the social or the governance pillars of ESG. We test
this based on three hypotheses, written formally:

1. 𝑆 = 𝛽1 𝐸𝑆𝐺!,# + 𝛽2 𝑆𝑆𝑃 + 𝛽3 𝐸𝑆𝑃 + 𝑠(𝑖) + 𝑦(𝑡) + 𝛿(𝑗) + 𝜀!,#

2. 𝐸 = 𝛽1 𝐸𝑆𝐺!,# + 𝛽2 𝑆𝑆𝑃 + 𝛽3 𝐸𝑆𝑃 + 𝑠(𝑖) + 𝑦(𝑡) + 𝛿(𝑗) + 𝜀!,#

3. 𝐺 = 𝛽1 𝐸𝑆𝐺!,# + 𝛽2 𝑆𝑆𝑃 + 𝛽3 𝐸𝑆𝑃 + 𝑠(𝑖) + 𝑦(𝑡) + 𝛿(𝑗) + 𝜀!,#

The value of SSP (ESP) in the first (second) equation cannot be positive and significant in
order for there to be a substitution effect in the social (environmental) pillar. Additionally, the value
of SSP (ESP) should be positive and significant in either the second (first) or third equation for there
to be a partial substitution effect. If the value of SSP (ESP) is positive and significant in both the
second (first) and third equation, then there is a full substitution effect.

3.5 Challenges
 Certain industries are sensitive to both the environmental and the social pillar. This could
result in a less significant substitution effect between the environmental and social pillar since these
firms are sensitive to both. The given regression would, therefore, underestimate the actual effect
that is present. An option is to remove the industries that are sensitive to both pillars. However, this
would reduce the total amount of observations in the dataset. It is therefore wise to employ both
methods and observe if either one yields significant results. Note that there are no industries that are
sensitive to the Governance pillar. However, a significant result here would at most suggest a partial
substitution effect, where firms find it beneficial to invest in Governance since it offers them the
highest return. It would not suggest that there is a general substitution effect present.