Developing a Sustainability Credit Score System
Rodrigo Zeidan, Claudio Boechat, Angela Fleury
Received: 21 May 2013 / Accepted: 19 December 2013 / Published online: 7 January 2014

Abstract Within the banking community, the argument about sustainability and profitability tends to be inversely related. Our research suggests this does not need to be strictly the case. We present a credit score system based on sustainability issues, which is used as criteria to improve financial institutions’ lending policies. The Sustainability Credit Score System (SCSS) is based on the analytic hierarchy process methodology. Its first implementation is on the agricultural industry in Brazil. Three different firm development paths are identified: business as usual, sustainable business, and future sustainable business. The following six dimensions are present in the SCSS: economic growth, environmental protection, social progress, socio-economic development, eco-efficiency, and socio-environmental development. The results suggest that sustainability is not inversely related to profit either from a short- or long-term perspective. The SCSS is related to the Equator Principles, but its application is not driven to project financing. It also deals with short- and long-term risks and opportunities, instead of short-term sustainability impacts.

The current trend in the literature on sustainability and finance is shifting from the idea that sustainability is a constraint on the profit function of firms toward a vision that financial markets can promote sustainability because of its many linkages with the rest of the economy. Scholtens (2006, 2009), for instance, argues that finance can promote socially and environmentally desirable activities through the credit channel and private equity activities. Adams and Frost (2008) find that companies are increasingly incorporating social and environmental KPIs into their strategic planning, but the issues raised by management and the way that they are integrated into operations vary considerably within their sample.

There are two major trends in the literature relating to sustainability and the banking industry: external and internal practices. The external practices strand analyzes the relevance of sustainability to the bank’s communication with shareholders and other stakeholders, and how investors use it as a measure to help achieve optimal portfolio allocation (e.g., Herzel et al. 2012; Konar and Cohen 2001; Weber 2005; Wright 2012). The internal practices literature, more relevant to the present work, studies how sustainability criteria are integrated into risk management models and lending practices. Weber et al. (2008, 2010) use sustainability as a predictor of future financial performance and contend that banks should apply it in their credit risk models. Another example is Thoumy and Vachon (2012), who show the relevance
of sustainability to project finance in Canada.

We focus, as do Singh et al. (2007), on the credit score as a decision tool for financial institutions and present a case study in which a multinational bank applies the methodology to the sugar and ethanol industry in Brazil. The main goal of this paper is to present a new way to incorporate sustainability into banking practices by focusing on a credit rating score system to improve financial institutions’ lending policies.

Many banks now use the Equator Principles (EPs) as a framework for assessing environmental and social risks into project finance, but few integrate sustainability into more widespread credit products. In the present paper, we analyze the case of a multinational bank that creates a sustainability credit score (based on the AHP methodology) to be used in loans to the agricultural industry in Brazil. We find no evidence of a similar approach to determine reputational risk based on sustainability issues. We contribute to the literature by discussing the implications of voluntary sustainability practices in a commercial bank’s lending
practices. There is a growing literature on the relationship between regulation and sustainability in the banking industry; for instance, Richardson (2009) argues that regulation must target the financial sector because it profits from unsustainable practices. However, if there is an ecopremium (e.g., Lubin and Esty 2010), market mechanisms may complement regulation in integrating sustainability and management practices.

The Sustainability Credit Score System (SCSS) is developed through the following stages:
• Selecting the industry;
• Analyzing the industry: economic outlook, product lifecycle analysis, value chain, legislation and public policy, industry self-regulation, and innovation.
• Developing paths for the average firm: business as usual (BAU); sustainable business (SB); and future sustainable business (FSB).
• Defining variables related to individual firms, in each of six sustainability dimensions: economic growth (EG), environmental protection (EP), social progress (SP), socio-economic development (SD), eco-efficiency (EE), and socio-environmental development (SE).
• Unveiling the materiality issues pertaining to the average firm, plus vulnerabilities and opportunities regarding the sustainability of the industry.
• Combining the information on the steps above to obtain questions for the composition of the score system.
• Defining the weights for the analytical hierarchy process.

The final result is a credit score system that rates companies and is composed of six matrices for the six sustainability dimensions. For each dimension, Ai is composed of five questions, and a final questionnaire of 30 questions is developed from the analytical model, giving us a final sustainability credit score that ranges from 0 to 1 and is used as a tool to assess the sustainability of a company in the selected industry.

Incorporating Sustainability into Commercial Practices in the Banking Industry

The CSR literature can be divided into external and internal practices. External practices relate to mitigating corporate externalities and the value of reporting it to stakeholders. Internal practices and CSR relate to how
management practices change regarding sustainability issues and is the subject of our research from both lender and borrower perspectives. Research suggests that CSR plays a role in financial institution strategies (Jeucken 2001; Jeucken and Bouma 2001). As a result, Weber (2005) divides financial institutions approaches to integrating sustainability into five models: event-related integration of sustainability, sustainability as a new banking strategy, sustainability as a value driver, sustainability as a public mission, and sustainability as a requirement of clients.

His research contends that sustainability events usually prompt new management practices into the banking industry. Hu and Scholtens’ (2012) analyze 402 banks from 44 developing countries and conclude that commercial banks in developing countries perform relatively well on social issues but are rather poor performers regarding environmental management, codes, and responsible products. Thus sustainability variables may provide incentives for financial institutions to develop new strategies such as the eco-premium (Lubin and Esty 2010), creating positive change in which companies conduct business (Conley and
Williams 2011; San-Jose et al. 2011).

The CSR literature also suggests that CSR variables affect the cost of capital (Ghoul et al. 2011) and that lenders react positively to CSR practices. Goss and Roberts (2011) demonstrate that firms with social responsibility concerns pay between 7 and 18 basis points more than firms that are more responsible. However, this effect disappears for high quality borrowers. But Scholtens and Dam (2007) analyze banks using the EPs on projects over US$10 million and find different policies regarding social, ethical, and environmental issues from non-adopters. They conclude that adoption of the EPs is used to signal responsible
conduct. Going further than the EPs, then, should also provide more signals of responsible conduct to the market.

The EPs are a risk management framework, adopted and managed by financial institutions, to determine, assess, and manage environmental and social risk in project finance. The EPs apply to four financial products: project finance advisory services, project finance, project-related corporate loans, and bridge loans. Thresholds are high: project capital costs should be US$10 million or more, and for project related corporate loans; the total aggregate amount should be at least US$100 million. As of 2013, 78 financial institutions in 35 countries have officially adopted the EPs.

Financial institutions commit to implementing the EPs in their internal environmental and social policies, procedures, and standards for financing projects and should not provide project finance or project-related corporate loans to projects in which the client is unable to comply with the EPs.

Signaling theory (see Connelly et al. 2011) provides an explanation to added incentives for commercial banks to promote sustainable management practices, environmental management practices (Hofer et al. 2012), or CSR disclosure (Dhaliwal et al. 2011). Signaling theory is concerned with information asymmetry between senders and receivers. Reducing information asymmetry can generate competitive
advantages by showing stakehold engagement on the part of firms. Sustainable management and participation in the EPs by financial institutions can emerge as a response to either sustainability as a value driver, an ecopremium, or signaling through enlightened self-interest (Pitelis 2013). All are constructs that are closely related theoretically and relevant to the present case. However, signaling theory is more related to external management practices, while the eco-premium and the sustainability as a value driver are closely related to internal management practices. We follow the latest, as the SCSS is developed for a multinational commercial bank to change its lending policies. While institutions adopt EPs as a signal to shareholders and stakeholders, the SCSS is a regular score system to determine the credit score of potential clients.

Our research is an offshoot of Chih et al. (2010) and Nandy and Lodh (2012). In the first, the authors investigate a total of 520 financial firms in 34 countries and find that larger firms are more CSR minded, even though financial performance and CSR are not related; firms act in more socially responsible ways to enhance their competitive advantages when the market competitiveness is more intense, and firms in countries with stronger shareholder rights tend to engage in fewer CSR activities. In the present case, the SCSS is developed for an institution that closely resembles the characteristics reported by Chih et al. (2010):
it is a commercial bank in a country with weak shareholder rights, and it is a large institution that faces intense market competition. Hence, it is poised to have the proper incentives to develop innovative CSR policies. These policies should generate competitive advantage not only by reducing information asymmetry between the company and its stakeholders but by increasing profits related to its core business. In the case of commercial banks, lower probability of defaults (PDs) should be the result of introducing rating systems like the present SCSS.

Nandy and Lodh (2012) use 3,000 lending transactions by banks in the US and find that eco-friendly firms obtain more favorable loan contracts than firms with a lower environmental score. They argue that banks can reduce their default risk by considering firms’ environment-consciousness when determining loan contracts. However, most models (e.g., Goss and Roberts 2011) usually assume that banks are socially neutral and are concerned solely with credit repayment.

The SCSS may reduce information asymmetry by engaging stakeholders, but its main purpose is to reduce banks risks by lowering default rates. Rating scales are commonly used in the financial industry [e.g., Grunert et al. (2005) and Duffie and Singleton (2012)]. We follow the standard approach for developing a credit score based on the analytic hierarchy process (AHP) methodology. There are always important issues related to the development of scale measures (Churchill and Peter 1984). Recent developments outline the desirable characteristics of scales (Sanjeev 2003). The SCSS is supposed to follow the desirable characteristics of Sanjeev (2003). However, it is still being implemented, and there is no data available to measure its reliability and validity. We come back to this issue in a later section, when we discuss the implementation of the SCSS.

Methodology for the Sustainability Credit Score System

Lending practices by commercial banks rely on credit score systems, developed to estimate risk against default by borrowers. New regulatory standards under the heading Basel III mean that banks need to estimate the loss parameters: probability of default, loss given default, and exposure at default. Usually banks rely on credit-worthiness as the main criteria, and all information for the decision making is related to financial information or qualitative data on how likely is that borrowers can repay their loans.

In the present case, the SCSS would complement regular credit rating models by yielding qualitative and quantitative information that would lead to improved decision making. For example, let’s assume that companies would be rated in the same way as in regular credit models, with sustainability worthiness ranging from triple A (prime borrowers) to D (default). Assume a company with a low sustainability rating, below investment grade (usually in the BB range or lower). This could mean increased interest rates or denial of credit by the, even if the company is otherwise credit worthy. Conversely, companies with high
sustainability ratings could get preferred treatment, either in terms of costs or access to capital.

The Brazilian banking industry uses the same criteria as in most countries, based on Basel standards. In the present case, the Brazilian branch of the bank is chosen, because it has the most advanced sustainability department among the subsidiaries of the bank. The idea is that the SCSS is tested in Brazil and, if it improves the lending ability of the bank, is going to be introduced to the other branches of the bank around the world.

The SCSS is different than EPs which establish that projects over US$10 million should be analyzed through short-term sustainability impacts. Here the SCSS measures most companies in the industry, even small companies, and it focuses on both risks and opportunities for future sustainability. The goal of the SCSS is to measure each firm’s potential contribution to sustainable economic production, given the industry’s sustainability factors. Because sustainability is multidimensional and dynamic, there is no unique way to measure the impact of a single firm. For the present work, Fig. 1 below summarizes the whole analytical
process that generates questions for the score system.

The methodology is based on a bottom-up approach. First is the industry analysis, followed by the definition of critical issues regarding the industry and its long-term sustainable path. We then distil these issues into their environmental, economic, and social aspects and relate them to the three main paths for sustainable development: BAU, SB, and FSB. Due to the inherent uncertainty of dealing with forecasting, we adopt a generic conception of these development stages.

• BAU refers to the present stage in which the industry practices are directly related to past practices, which may or may not be sustainable.

• SB is a future stage (mid-term, around 2020), resulting from the adoption of new sustainable practices by firms. These are mainly derived from emerging technologies, new commercial practices, and evolving legislation.

• FSB is a future stage (long-term, around 2050) marked by the foreseen role of the industry in a sustainable path that would allow continuing economic, social, and environmental development (WBCSD 2010).

From this relationship, we deduce risks and opportunities, which are the source of the credit score system. The main contribution of this methodology is that the resulting credit score system can help to develop proactive short- and long-term commercial practices. We turn to this later, but a simple example of long-term commercial practices follows. By conducting a long-term analysis, we try to establish the possible future sustainability of the industry itself. For instance, let us assume that our analysis of the sugar industry shows that its long-term yield productivity is going to be low and that the only way for the industry to survive is to expand geographically into protected environments and/or displace other cultures, generating negative benefits for society. In this case, the FSB analysis would show that firms would only be able to achieve FSB practices if they change their core business by focusing on more sustainability-promising products. This could result in the development of credit strategies in which loans are given to companies investing in changing
their business model toward a more sustainable one. On the other hand, it may be that the FSB is one in which firms are technological leaders and would be able to obtain much

The Industry in 2012
The SCSS is tested through an application to the Brazilian sugar and ethanol industry (referred to as the sugar industry from now on), which combines two main characteristics that make it suitable as a first adopter: it presents environmental, social, and economic pressing issues (ethanol is considered a relatively clean source of energy) and is large enough to warrant a sustainability analysis by a commercial bank.

The sugar industry output in Brazil totalled U$32 billion in the 2011/2012 crop season, approximately 2% of the Brazilian GDP, representing 50% growth compared with 2005. The industry employs about 4.5 million people and processes around 700 million tons of sugar cane to produce 38 million tons of sugar and 27 billion litres of ethanol annually. Table 1 below reveals some data on the industry for the Brazilian economy. Relevant to the present work is the fact that the industry is composed of dozens of thousands of small producers and hundreds of industrial mills, which makes it costly to collect information to develop rating systems.

Brazil is the world’s largest sugar cane producer. In the 2011/2012 crop season, sugar cane crops occupy an area of 8.1 million hectares: 0.95 % of Brazil’s territory and 2.5 % of the country’s cultivable land. Recently, it has added the generation of bioelectricity from sugar cane bagasse. Of the total 2011 industry output, 45 % was used to produce sugar and 55 % to produce ethanol. Roughly two-thirds of the refined sugar output is exported. Sugar cane-related activities employ 3.85 million people, and formal labor relations reach 79.6 % of the workforce.

Industry Analysis
The industry analysis methodology combines an in-depth examination of the industry practices with an analysis of the global challenges (WBCSD 2010). It forms the basis for all the subsequent analyses. Relating it to the global challenge allows us to decide on the major issues that firms—and consequently the sugar industry—have to address in the coming decades.

The variables that determine environmental, social, and economic changes are many, and the relationships among them are dynamic and complex. From the countless challenges and issues regarding sustainability (e.g., KPMG 2012; OECD 2012; United Nations 2012; United Nations Environment Programme 2011; WBCSD 2010), among many others, thirteen are selected, either because of their global comprehensiveness (such as water and climate change issues) or because of their relevance to the industry (such as transportation and mobility). For each one, we identify possible sources of sustainability risks, but also opportunities for the dynamic development of the industry. Table 2 shows the selected global challenges for the sugar industry in Brazil.

The next step is to relate these challenges to the sugar industry. We achieve this by dividing the analysis into six topics: economic outlook, value chain, life cycle, public policies and legislation, industry self-regulation and programs, and innovation.

Critical Issues
The industry has, in the last 5 years, established some important self-regulatory measures. These measures can be subdivided into programs, initiatives, and formal commitments. They attempt to mitigate some of the negative externalities generated by the industry.

Some of the initiatives are related to labor issues, such as labor productivity and minimum prices paid to producers. There is also an initiative for an international environmental standard, called Bonsucro Certification.
This attempt to gain acceptance among international market players is especially important for ethanol, because commoditization breeds market penetration. Innovation is a key to the development of the sugar
industry, whichever development path it should take. There are many R&D initiatives regarding the development of new sugar cane varieties, but also relevant is innovation in terms of industrial flexibility in ethanol and sugar production.

The results from the previous analyses indicate 70 issues relevant to the sustainability of the Brazilian Sugar Industry. On this set of issues, further analysis is carried out, and we select 34 critical issues. Those issues are organized in eight categories.

The next step is to give materiality to the groups of selected critical issues. First, we divide the issues and relate them to the dimensions of sustainability. The purpose is to provide guidelines for the intra-industry relationship between firms and relation to their stakeholders.

Business as Usual (BAU), Sustainable Business (SB) and Future Sustainable Business (FSB)

We then proceed to separate the group of critical issues into a development path represented by three categories: BAU, SB, and FSB. Each one is defined as follows: BAU—the average firm in the industry; SB—the top tier of firms regarding sustainable practices; FSB—the average sustainable future firm, in which innovations shape the industry according to sustainability requirements. There are two main paths for development: the dissemination of sustainable practices, in which the average firm turns to sustainable practices (from BAU to SB); and the innovation path, which leads firms from their present sustainable practices to future sustainable practices (from SB to FSB). We establish SB practices for the sugar industry, which form the basis of the credit score in the next section.

The last informational step is to determine which of the many potential risks and opportunities would be relevant to the strategies of a commercial bank. We filter the information through two development paths—from BAU to SB and from SB to FSB. The risks and opportunities are divided into credit and reputational categories and can be found in ‘‘Appendix 2.’’

Weights, Iteration, and Measurements

For the final measurements, we need to assign weights to the different development paths and the different sustainability dimensions. We use subjective criteria. The subjective criteria are going to be validated through the testing of the questionnaire in the field through successive iterations of the process. After testing it with a few companies, the final measurements should be evaluated and then the criteria can be refined. There is no inherent problem with qualitative and subjective criteria in credit risk modeling in general, which has a long tradition. Agencies today are calling for more subjectivity in their credit risk models, a
point that is contentious in the financial literature—Griffin and Tang (2012) are skeptical of allowing subjectivity in such models. Model validation is paramount to risk modeling using subjective criteria (Jones and Mingo 1999), and in the present case, the absence of extensive quantitative data makes the validation process even more important. The central idea behind the validation process is that it is conducted by the research department of the bank. The SCSS is an evolving tool, with changes being incorporated to reflect the feedback from the application of the questionnaires.

Sustainability Credit Score System

The analytical methodology has one main goal: to support the development of a questionnaire that, when applied to the firms in the sugar industry, reveal their credit-worthiness based on sustainability issues.

The SCSS is based on an AHP method and is divided into two parts: structuring and evaluation. In the first part, we decompose the critical issues and risks into a hierarchical structure. In the second, we define the relationship between the hierarchies. The AHP demands comparisons, in pairs, among criteria/alternatives that belong to the same hierarchical level. The next steps are:

(1) We compare the relative importance of eco-efficiency (EE), socio-environmental (SE), socio-economics (SD), environmental protection (EP), economic growth (EG), and social progress (SP). At the end of this phase, we obtain a 6 9 6 comparison matrix.
(2) Next, for each of the six previous dimensions, we compare the respective critical issues. For instance, for social progress, three questions are compared— which, in turn, result in a 3 9 3 comparison matrix.
(3) Finally, for each question, the level of development of the firm, relative to the sustainability criteria relevant to the sugar industry, is established. In this case, for each question, the possible answers are classified as
‘‘below business as usual (nBAU),’’ ‘‘business as usual (BAU),’’ ‘‘sustainable business (SB),’’ and ‘‘potential future sustainable business (FSB).’’

We present the AHP methodology in ‘‘Appendix 3.’’ The main result is that the credit score, which ranges from 0 to 1, ranks firms in terms of their sustainability and creates information to allow a bank to develop commercial strategies such as: lending practices; short-term strategies based on local branches—for instance, the funding of new projects related to R&D or the transportation of vinasse; long-term policies such as the funding of research centers and lending to companies in frontier regions; and reputational exposure to the industry and specific firms. Most of these results can be achieved by a detailed analysis of the
industry, but the advantage of the SCSS is that by distilling all the information into a questionnaire that results in a comparable number for each firm, financial institutions are free to incorporate it into their more established credit models.

Using the SCSS

Using the SCSS means developing a questionnaire to be completed by branch and account managers with private information regarding firms in the sugar industry. There are two necessary conditions for the SCSS to be effective: information gathering and incorporation into the decision making process. There is no hard evidence that the SCSS is actually efficient in classifying firms based on sustainability issues, and it can easily be discarded if an organization feels that it is not accomplishing its main goal.
Unless it has internal ramifications, the commercial bank will be stuck in its BAU mode, even though the main objective is to move toward a future SB.

However, if used well, it can change the criteria used to make loans and to establish portfolio allocation. It fits well into the framework of Weber (2005) and can bring forth concrete information on how banks value the CSR practices of borrowers [as in Ghoul et al. (2011) and Dhaliwal et al. (2011)]. There is precious little information on banks’ management practices regarding CSR, but if firms in the industry start adopting mechanisms similar to the SCSS, sustainability may be driven voluntarily instead of being forced by regulation; this scenario would generate positive externalities for society. The present case shows an example of a bank that is trying to act in a more socially responsible way to enhance its competitive advantage, which corroborates the result of Chih et al. (2010).


As late as 2008, less than one-third of banks around the world published sustainability reports. Five years later almost all of them do. However, sustainability is still not a deciding factor in risk models by commercial banks. We argue that developing a SCSS can provide value creation for a bank and positive externalities to society. We show the development of such a system for a multinational bank, which is using the system for rating companies in the sugar industry in Brazil. The development of the SCSS consists of the following stages:

• Selecting the industry, with corresponding analysis of its economic outlook, product life cycle, value chain, legislation and public policy, industry self-regulation, and innovation.
• Measuring paths for the average firm: BAU, SB, and FSB.
• Defining variables related to individual firms, in each of six sustainability dimensions: economic growth (EG), environmental protection (EP), social progress (SP), socio-economic development (SD), eco-efficiency
(EE), and socio-environmental development (SE).
• Unveiling of the materiality issues pertaining to the average firm, plus vulnerabilities and opportunities regarding the sustainability of the industry.
• Combining the information to obtain questions for the composition of the score system.
• Defining the weights for the analytical hierarchy process.

Firms that rank low on the SCSS would be denied credit, even if they are financially sound. The SCSS is a CSR policy but also tries to build a competitive advantage for a financial institution by reducing the bank’s long-term exposure to reputational risk. There is precious little evidence of internal management practices regarding sustainability. Financial products that are based on sustainability issues, like sustainable funds, abound, but the criteria for selecting companies are usually based on sustainability reports. Internalizing sustainability into everyday banking operations is a major challenge. Commercial bank has the ability to become proponents of societal changes. The implication for managers is clear: banks that take into account sustainability into their lending decisions would have less reputational risks and could build competitive advantage by having less default in the long run than the average bank. The SCSS is related to the EPs, but it focuses on companies instead of large-scale projects—it also tries to gather information on risks and
opportunities for future sustainability, instead of short-term impacts.

There is still no hard evidence that incorporating sustainability into credit score systems leads to less defaults. Future research could show if that is the case. There are plenty of other avenues for further research.
The first is to try to gain a better understanding of how new management practices that rely on CSR relate to building competitive advantage. Are market mechanisms relevant to the financial industry or should more regulation promote lending policies that are based on sustainability? Also, more direct evidence of new practices, such as the SCSS, may help us to understand how the financial industry is evolving regarding internal management practices based on sustainability.

Acknowledgments We are grateful to the Editor and three anonymous referees for providing us with helpful comments. We would also like to thank Heiko Spitzeck, Jay Rubin, and participants at the ECCE-USB Conference 2013.

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Keywords Sustainability: Risk management; Lending policies; Equator Principles; Banking industry; ESG; Sustainability Analytics; Management practices; Corporate social responsibility better yields by focusing on new crops and new techniques. In this case, directing loans to firms searching for those opportunities could be part of a proactive long-term credit policy.