Developing A Z‐ESG Score Model for Assessing Corporate ESG Performance

ABSTRACT

In this study we develop a novel, unique ESG rating model that exploits the logic of the Z‐score by Altman (1968) to discriminate between ESG performing and non‐ESG performing firms using indicators of ESG performance for each of the three pillars (Environmental, Social, Governance) in place of financial ratios. We name our model the Z‐ESG rating model. Based on a sample of 325 European listed firms, we build a multiple discriminant analysis model to estimate the Z‐ESG score for each firm and confirm these results by employing a logistic regression to determine respective probabilities of being ESG performing. Z‐ESG scores are then converted into agency‐equivalent rating classes through a Z‐ESG rating matrix. Multiple implications can be envisaged for researchers and practitioners: asset managers may use the Z‐ESG rating model to identify new investment opportunities and build appropriate ESG‐performing portfolios; risk managers may exploit the Z‐ESG metrics to assess the current ESG positioning of a firm and monitor its evolving path; credit risk managers can link the Z‐ESG score of a firm to its Z‐score to measure the impact of its ESG performance on its probability of default; bank managers may better price green (or ordinary) loans based on the Z‐ESG score of the borrowers; chief sustainability officers of companies can self‐assess the degree of their ESG performance and design a sustainability strategy that targets a desired Z‐ESG rating; corporate boards may include the Z‐ESG metrics as an additional element of their executive compensation policy.