Relationship between the Cost of Capital and Environmental, Social, and Governance Scores: Evidence from Latin America

Abstract

Environmental, social, and governance (ESG) scores play a pivotal role in the strategic design of firms. The literature has demonstrated the importance of sustainability issues in the financial performance of firms around the world. In particular, understanding the relationship between sustainability and the cost of capital is crucial for determining financial strategy and decision making. We identify an opportunity in the literature to analyze this relationship within Latin America (LatAm) firms. Thus, this study analyzes the relationship between ESG scores with the cost of capital of firms with headquarters in LatAm using a data set that includes 606 observations corresponding to information about 202 firms from 2017 to 2019. To conduct our analysis, two fixed effects panel data models were estimated. We model this relationship by taking ESG scores and each of its ESG Pillar scores—i.e., Environmental, Social, and Governance pillar scores—as independent variables and analyzing how they affect the cost of capital. According to the results, there is an inverse effect relationship between ESG scores and the cost of capital. Additionally, we did not find a relationship between the Social Pillar score and the Environmental Pillar score with the cost of capital. By contrast, the Governance Pillar score shows a negative relationship with the cost of capital. This indicates that the increase in transparency about internal processes and governance entities can be an essential driver of value creation for firms and higher financing confidence in LatAm firms. This study represents a breakthrough in explaining the impact of ESG scores on the cost of capital in LatAm. Ultimately, the current study presents the potential for further research in this field.