Environmental Externalities and Cost of Capital

TLDR

The study analyzes how a firm’s environmental profile affects its cost of equity and debt capital. The study finds that firms with environmental concerns face higher expected equity returns and higher loan rates, lower institutional ownership, fewer syndicate banks, and that these costs are not merely due to default risk, indicating that exclusionary socially responsible investing and environmentally sensitive lending materially raise capital costs. The paper was accepted by Brad Barber in Finance.

Abstract

Ianalyze the impact of a firm's environmental profile on its cost of equity and debt capital. Using implied cost of capital derived from analysts' earnings estimates, I find that investors demand significantly higher expected returns on stocks excluded by environmental screens (such as hazardous chemical, substantial emissions, and climate change concerns) compared to firms without such environmental concerns. Lenders also charge a significantly higher interest rate on the bank loans issued to firms with these environmental concerns. I provide evidence that the environmental profile of a firm is not simply proxying for an omitted component of its default risk. Further, firms with these environmental concerns have lower institutional ownership and fewer banks participate in their loan syndicate than firms without such environmental concerns. These results suggest that exclusionary socially responsible investing and environmentally sensitive lending can have a material impact on the cost of equity and debt capital of affected firms. This paper was accepted by Brad Barber, finance.