Lower Your Firms Cost of Capital by Managing Environmental Risks
This study shows that a firm's improved environmental performance reduces the firm's cost of capital. The researchers 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.
Many firms view "green" activities as a cost to be minimized. But according to recent research, a firm's environmental activities enable more efficient use of resources, resulting in better economic performance. Firms can manage their environmental risks by choosing strategic investments that reduce emissions and pollution and, in doing so, mitigate risks from litigation and reduce the potential for expensive environmental claims, settlements, and compliance.
Managers can reduce their firm's cost of capital by managing environmental risks. 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. Short-term costs of environmental improvements must be absorbed to generate longer-term gains.
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.
The researchers 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.