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

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.