Risky Business: Lenders Charge Premiums to Finance Risky Firms

Environmentally risky firms must pay higher interest rates to banks and higher returns to shareholders.

Lenders, like investors, charge premiums to finance risky firms.

Environmentally risky firms must pay higher interest rates to banks and higher returns to shareholders.

This was the finding of researcher Sudheer Chava from the Scheller College of Business at the Georgia Institute of Technology. Chava examined the relationship between environmental performance and cost of capital for over 13,000 firms during a 15-year period.

Socially Responsible Investing Up 300%

Socially responsible investing (SRI) has become an increasingly important facet of shareholders’ investment philosophies. The annual amount of money devoted to SRI has increased more than 300% since 1995. The Social Investing Forum estimates one in every eight dollars (US) of equity financing is invested in socially responsible portfolios.

As ethical investors become more selective, firms with poor environmental performance risk either divestment (shareholders selling their stocks) or having to pay shareholders higher returns. Both outcomes directly affect the company’s equity financing.

But cost of capital includes more than just equity. It also includes debt.

Lenders refuse risky firms – or charge higher interest.

Banks representing nearly 80% of worldwide lending now consider borrowers’ environmental profiles when they make financing decisions. Many of them have adopted the Equator Principles – a framework for assessing and managing projects’ environmental and social risk (see also Start Here Guide) – and are signatories to the United Nations Environment Programme (UNEP) Statement by Financial Institutions.

Lenders get penalized for issuing loans to irresponsible clients. They risk losing their reputation as a responsible lender, and liability laws threaten to tie banks up in litigation. For environmentally risky firms, banks either refuse to issue loans or price the risk by charging higher interest rates.

Debt & Equity: Two Elements of Capital

Restructuring financing or finding alternative sources of capital affects borrowing firms’ Weighted Average Cost of Capital (WACC) by changing the percent of capital financed by debt.

Using a modified capital asset pricing model, bank spread data, and KLD indicators to categorize firms’ environmental behaviours, Chava conducted several tests to find out exactly how debt and equity structures change under specific corporate conditions.

Reports and Articles

MSCI KLD Scores

Lauren Turner

KLD data define environmental performance.

Chava used KLD data to code firms’ environmental profiles. Companies received scores for “Environmental Concerns” if:

• They received fines or penalties for hazardous waste;

• Operations and/or sales relied heavily on coal, oil, or fossil fuel derivatives, or;

• Chemical emissions exceeded air and water safety thresholds.

Similarly, Chava assigned firms scores for “Environmental Strength” if:

• They actively worked to reduce pollution;

• Substantial revenues were derived from environmentally beneficial services or products;

• They had instituted clean energy initiatives to reduce their footprint, or;

• The firm had implemented or committed to rigorous environmental reporting standards.

Stock estimates and Dealscan database provide financial data.

Chava used the internal cost of capital (ICC), taken from analysts’ stock estimates, as a proxy for expected returns. Using the internal cost of capital (as opposed to the Weight Average Cost of Capital) ensures the present value of Free Cash Flows to Equity exactly equals the company’s current stock price. Using the analyst data, Chava had ICC estimates for every firm in the data set from 1992-2007.

Chava collected bank data from the Loan Pricing Corporation’s Dealscan database.

After merging the environmental performance and cost of capital information, Chava had data for more than 5,800 firm bank loans of more than 13,000 stock return observations over fifteen years, including their varying environmental profiles, interest rates, and lending and investing profiles.

Banks and shareholders demand premiums for environmental risk.

Chava found lenders charged firms with greater environmental risk almost 20% higher interest – about 25 basis points – on their bank loans.

Similarly, investors required 1.38% higher annual stock returns from firms with environmental concerns as compared to firms without these concerns. Shareholders were particularly punitive to firms that gained significant revenue from the sale or combustion of coal, oil, and other fossil fuels, demanding 0.96% per annum higher than other firms.

Investors are not driven towards environmentally friendly firms.

Chava found no significant relationship between strong environmental performance and expected stock returns. This finding suggests investors don’t necessarily expect lower stock returns from environmentally friendly firms.

This finding is similar to a study on third-party CSR ratings that found being named to a sustainability index fails to drive shareholder interest – but being delisted from an index can significantly drop stock price.

Banks reward firms with environmental products and services.

Lenders reduced loan spread significantly for firms with environmental products or services. Companies that derived substantial revenue from environmental products or services enjoyed approximately 20% lower loan interest, and in turn, a lower cost of debt.

Lenders were not as generous, however, to firms with other environmental strengths. Banks did not offer equally low interest rates to firms that reduced their pollution or reported on environmental performance.