Corporations’ liability for environmental risk is increasing in response to increased regulatory scrutiny and social activism. Investments in corporate environmental responsibility reduce ex ante equity financing costs worldwide.
How Is This Research Useful to Practitioners?
Investors are always looking for an edge to outperform the market and each other. A practitioner can use a filter for investments in corporate social responsibility (CSR) and, more specifically, the subset of corporate environmental responsibility (CER) to identify investment opportunities for outperformance.
Residual income valuation models and abnormal growth models, when used on manufacturing firms for 30 markets, provide evidence that the cost of equity is lower for firms with higher CER. Because the cost of equity is a discounting mechanism in discounted cash flow (DCF) models, a higher valuation can result, which also suggests an inverse correlation between CER and risks. Wealth managers can thus use investments in CER when designing investment policies for strategic and tactical asset allocation to manage risk tolerance exposures and to manage portfolios with socially responsible investment (SRI) mandates. As a corollary, a filter using a corporation’s breadth of investor base may also be used to screen opportunities. Firms with a narrow investor base usually have lower CER investment, and thus a higher risk profile can be identified in a negative/avoidance list.
How Did the Authors Conduct This Research?
The authors hypothesize that the perceived risk of firms with high CER (defined by a low ratio of environmental costs to total assets) is lower than that of firms with low CER (defined by a high ratio of environmental costs to total assets) because CER and wider corporate social responsibility (CSR) outlays decrease firm risk by reducing the probability and effect of adverse events. In addition, the authors investigate whether firms with low CER have a narrower investor base, which may result in higher cost of equity financing.
Using the Trucost database, which provides a firm-level assessment of environmental costs to society for firms from 30 markets, the authors test a sample of 7,122 firm-year observations representing 2,107 firms from 30 markets for the 2002–11 period. They use a multivariate regression framework that controls for firm-level characteristics as well as industry, year, and country effects. Using residual income valuation models and abnormal growth models, they find that the cost of equity capital is lower for firms with a high level of CER. This finding also suggests that shareholders perceive firms with improved environmental risk management (higher CER) as less risky and thus reduce the risk premium they require.
The authors’ finding is robust to alternative specifications, proxies, and the forecast period used for the cost of equity capital. The authors account for noise in analyst forecasts; use alternative pre-, during, and post-2008 crisis samples; and specify alternative and additional independent variables. In their supplementary analyses, the authors find that the relationship between environmental costs and equity financing costs holds across different legal, economic, and geographic settings. Taken together, the results provide consistent support for investment in CER reducing a firm’s perceived risk and, in turn, its equity financing costs globally.
Although prior research on CER focuses largely on the ex post or past relationship between environmental and corporate performance as captured by accounting or market-based measures of firm performance, the authors address investors’ ex ante or future perceptions of corporate environmental performance worldwide.
Whereas the consensus conclusions drawn from prior research generally indicate that the financial benefits of investments in CER exceed the costs, the authors identify a negative correlation between CER investments and cost of equity (i.e., higher CER investment leads to lower equity financing cost). The resulting difference in cost of equity is not quantified because of differential investments in CER. If the expected return based on traditional analysis results in a valuation that exceeds the valuation obtained by the marginally higher cost of equity owing to lower CER investments, then an investment is warranted. Moreover, using only corporate data for environmental costs based on six areas of direct and indirect emissions—greenhouse gases (GHGs), water, waste, land and water pollutants, air pollutants, and natural resource use—does not capture total operating environmental costs. For a comprehensive corporate environmental cost, further research on commuting costs may be needed.