The benefits of going green: Lower your firm’s cost of capital by managing
environmental risks
EXECUTIVE SUMMARY
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.
BACKGROUND
IMPLICATIONS FOR RESEARCHERS
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.
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.
METHODS
FINDINGS


Firms that implement an environmental risk
management strategy reduce their weighted
average cost of capital.
Higher levels of environmental risk management
lead to:
o Greater willingness of debt markets to
provide debt financing
o Higher tax benefits that partially offset the
cost of debt capital
o Reduced cost of equity capital from a
decrease in systematic risk
o Reduced cost of equity capital from an
increased dispersion of shares
IMPLICATIONS FOR MANAGERS
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 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.
CITATION
Sharfman, Mark P., & Fernando, Chitru S. (2008).
Environmental Risk Management and the Cost of
Capital. Strategic Management Journal, 29: 569–592.
Full article source.
SUMMARIZED BY
Tirath Sandhu & The Network Team
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