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Lower Your Firms Cost of Capital by Managing Environmental Risks

Research shows how your firm’s comprehensive environmental risk management strategy can reduce cost of capital and increase opportunity for debt financing.

Your firm may benefit from reduced cost of capital through improved sustainability performance and a sound environmental risk management strategy.

Many firms view “green” activities as a cost to be minimized. But studies say a firm’s environmental activities enable more efficient use of resources, resulting in better economic performance. Researchers Mark Sharfman and Chitru S. Fernando of the University of Oklahoma examined 267 U.S. firms from the S&P 500. The authors’ measure of environmental risk management was obtained using KLD environmental scores and the US EPA TRI data taken from the Investor Responsibility Research Center. The authors tested hypotheses by using hierarchical regression and controlling for financial leverage, firm size, and industry membership.

Stakeholder Trust and Risk Perception

The study found that investors perceive a firm’s risk more favourably when the firm actively manages its environmental risks. In turn, this improved perception leads to the willingness of financial markets to accept lower risk premiums on equity, or higher levels of leverage, both of which can result in an overall reduced cost of capital. (This is in keeping with research from Vasi and King on perceived vs. actual environmental risk, in which the authors found the perception of risk alone is enough to impact firm financials.)

The authors distilled two very important findings from their research:

1. Firms that implement an environmental risk management strategy reduce their weighted average cost of capital.

2. Higher levels of environmental risk management yield several benefits, including:

  • Greater willingness of debt markets to provide debt financing

  • Higher tax benefits that partially offset the cost of debt capital

  • Reduced cost of equity capital from a decrease in systematic risk

  • Reduced cost of equity capital from an increased dispersion of shares

The researchers looked beyond the correlation between internal environmental investments and economic performance to also consider institutional and other external factors. Future work could apply structural equations modelling to further examine the cost of debt findings of this research and assess whether the results will hold for firms under greater pressure to improve their environmental risk management. (For similar findings, see also the work of Ioannou, Cheng, and Serafeim in the NBS article Two Ways Sustainability Drives Access to Capital)

It Pays to Manage Risks

You can reduce your firm’s cost of capital by actively managing its environmental risks, for example, by choosing strategic investments that reduce emissions and pollution. In doing so, you mitigate risks from litigation and reduce the potential for expensive environmental claims, settlements, and compliance.

Firms that invest in environmental risk management incur higher costs of debt, but are able to carry higher debt loads and to reap greater tax benefits from their debt financing. You must be willing to absorb short-term costs of environmental improvements to generate longer-term gains.

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