The Green Capital Advantage

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

Reading Time: 4 min 

Topics

Buy
Like what you're reading?
Join our community
Member
Free

5 Free Articles per month, $6.95/article thereafter. Free newsletter.

Subscribe
$89 $44/Year

Unlimited digital content, quaterly magazine, free newsletter, entire archive.

Sign me up

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.

Better environmental risk management might indicate that the company is simply better at all risk management — including such factors as product safety and corporate governance. However, the authors found that, although general risk management practices, as represented by KLD social performance rankings, lowered the cost of capital, environmental risk management still stood out as an advantage — even when controlling for overall risk management.

To be sure, the authors did not measure the expenses or investments that enabled companies to achieve their environmental risk management improvements. It’s quite possible that those initiatives were very costly — and may well have outweighed the benefits of a lower cost of capital. So the business case for environmental risk management is still no slam dunk.

“The reality is major corporations are spending millions or tens of millions of dollars convincing the world how green they are,” says Sharfman. He explains that “changing the perception of the financial markets [requires] major investments in green technology or managing your firm from a green perspective. Switching over to compact fluorescents in your corporate offices isn’t going to do that.” Improving environmental risk management, then, is far more than a public relations exercise.

That’s not to say that public relations is not important. “The impacts of investments on environmental risk management are not just internal,” says Sharfman. “The ability to accurately and truthfully represent what you are doing is really a critical part of managing one’s environmental performance.” Sustainability reporting is one way of ensuring that investors — a key stakeholder group — are aware of a company’s efforts.

Which investors are paying attention? The lower equity cost of capital is somewhat surprising given that the equity assets held in funds that explicitly weight social and environmental concerns are relatively low. “[Socially screened funds] represent about 9% to 10%, depending on whose estimates you look at, of all invested funds,” says Sharfman. “For us, though, the key driver is the relationship with individual investors.” The authors tested for that idea and found “the improvements in environmental risk management are associated with significant increases in the number of individual shareholders,” Sharfman reports. And, given that the study’s reference year was four years before the movie An Inconvenient Truth helped bring concern about global climate change into the mainstream, the ranks of individual shareholders who explicitly factor a company’s environmental decisions in their investment decisions could well be even larger today.

The article is available for $29.95 from www3.interscience.wiley.com/journal/ 118479707/abstract, or contact Mark Sharfman at msharfman@ou.edu.

— Larry Yu

Topics

Reprint #:

50102

More Like This

Add a comment

You must to post a comment.

First time here? Sign up for a free account: Comment on articles and get access to many more articles.