The Green Capital Advantage

Companies with better environmental risk management have a lower cost of capital.

The moral imperative to address environmental issues like global climate change has never been stronger in the zeitgeist. Yet making the business case for environmental risk management has long been a tug of war between softer concepts such as “reputation risk” and “stakeholder engagement” on the one side and the cold, hard need to maximize shareholder value on the other.

Two professors have taken steps to bridge that gap. Their article, “Environmental Risk Management and the Cost of Capital,” published in the June 2008 issue of Strategic Management Journal, establishes that environmental risk management practices lower the overall cost of capital for companies.

Mark P. Sharfman and Chitru S. Fernando, professor of strategic management and Michael F. Price Professor of Finance, respectively, at the University of Oklahoma’s Michael F. Price College of Business, studied Standard & Poor’s 500 companies that reported data to the U.S. Environmental Protection Agency on their emissions and disposal of toxic substances and that also were ranked by Massachusetts-based KLD Research & Analytics Inc. on their environmental performance. In all, 267 companies were studied, and the authors looked at environmental risk management data that had an impact on the cost of capital for the 267 companies in 2002.

By calculating the costs of debt and equity financing, Sharfman and Fernando determined that tree hugging isn’t just a feel-good activity. Rather, companies that had better environmental risk management practices — those with lower emissions and higher KLD environmental rankings — had a lower overall cost of capital and thus gained an advantage over their competition.

The cost of capital has both debt and equity components, of course. And the cost of debt capital was actually higher for the more environmentally conscious companies. Debt investors tend to keep a keen eye on cash flows and current risks, so it’s possible they discounted investments in environmental risk management beyond what’s necessary for compliance as an inefficient use of resources. Debt markets did tend to allow higher leverage for the greener companies, however, so the news wasn’t wholly bad.

Equity investors, for their part, placed great value on environmental risk management. What’s more, the lower cost of equity capital associated with environmental risk management practices more than outweighed the higher cost of debt capital. The cost-of-capital advantage held true even after controlling for company size and industry.

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