Sébastien Pouget, Co-Director of the Initiative for Effective Corporate Climate Action questions the impact of corporate climate action on their cost of capital. He shared some food for thought on this topic at an event organized by Getlink in Paris on October 11, 2023.
Climate action, a new determinant of the cost of capital
Climate change is forcing companies to review their business models in order to reduce greenhouse gas emissions and adapt to the consequences of global warming. But this transition to a low-carbon economy comes at a cost, corresponding to the investments needed to achieve carbon neutrality. These financing requirements impact corporate profitability via the cost of capital, i.e. the rate of return required by investors to finance projects. The cost of capital is determined by the financial market, and incorporates the expectations, preferences and risks of economic agents. It therefore depends on investors' perception of the profitability, risk and societal impact of climate action projects.
Several theoretical studies have analyzed the impact of climate action by companies on their cost of capital. Climate action can affect corporate risk as perceived by investors. When it comes to climate, two risks are prominent: transition risk, linked to the regulatory, technological, economic or social changes that accompany the transition to a low-carbon economy, and physical risk, linked to the damage caused by extreme or gradual climatic events, such as droughts, floods, storms or rising sea levels. These risks can affect the value and correlation with macroeconomic cycles of the activities of companies that are exposed to fossil fuels, have a high carbon intensity or are located in high-risk areas. Under the standard model for valuing financial assets, the cost of capital will therefore be influenced by climate risks.
But the standard model needs to be enriched to incorporate the specificities of climate challenge. For example, climate action by companies can also influence their cost of capital via investor preferences, by modifying the demand and price of their financial securities. These preferences reflect their values in relation to ethical, social or environmental issues. For example, if investors have an aversion to polluting or fossil fuel companies, they will demand a higher rate of return to hold their shares or bonds (or will avoid these assets altogether), which will increase their cost of capital; on this subject, see the theoretical work of Heinkel, Kraus and Zechner (2001), Pastor, Stambaugh and Taylor (2021), Zerbib (2022) and Gollier and Pouget (2022). Uncertainty surrounding the intensity of investors' climate preferences may nevertheless mitigate this phenomenon (Avramov, Cheng, Lioui, and Tarelli, 2022).
Realized returns, expected returns: keys to empirical analysis
To the extent that ambitious climate action is associated with lower corporate risk and attracts responsible financiers and investors, it can be expected to translate into a lower cost of capital. Various empirical studies have attempted to investigate this question. The results of these studies are, at first glance, mixed.
Some studies find, as expected, a positive effect of carbon footprint on realized returns on equity markets, both at the US and global level; see Bolton and Kacperczik (2021, 2023). For example, on a sample of nearly 14,400 companies in 77 countries from 2005 to 2018, a one-standard-deviation increase in carbon emissions is associated with an increase in realized returns of 2.34% per year. But other studies qualify these results; see Aswani, Raghunandan, and Rajgopal (2023) and Zhang (2023). Indeed, there are various empirical challenges. For example, during certain market phases, green companies can record high returns: over the period from 2013 to 2020, in the USA, an outperformance of almost 10% per year was observed; see Pastor, Stambaugh and Taylor (2022). Using realized returns to measure the returns required by investors can introduce biases, for example linked to changes in preferences over the study periods or the impact of media news on climate change; see Pastor, Stambaugh and Taylor (2022) and Ardia, Bluteau, Boudt, and Inghelbrecht (2022). It is then useful to turn to an alternative methodology based on expected returns as inferred from asset values and expectations of future cash flows.
Empirical studies show that investors' expected returns for companies with ambitious climate action, and therefore their cost of capital, are lower than for other companies; see Chava (2014), Pastor, Stambaugh and Taylor (2022) and Hege, Pouget and Zhang (2022). This result confirms the first theoretical analyses discussed earlier. For example, a recent study of US bond markets shows that companies whose carbon intensity (ratio of emissions to sales) is one standard deviation above the mean have a cost of debt that is 2 to 17 basis points higher (Kim and Pouget, 2023).
Finally, other empirical studies highlight the difficulty for investors to identify companies' climate commitment, whether the information is lacking or inconsistent - despite the presence of extra-financial rating agencies - or whether this information is subject to manipulation and greenwashing; see Berg, Kölbel, Pavlova and Rigobon (2023) and Hege, Pouget and Zhang (2022).
Implications for companies and regulators
What can private and public decision-makers learn from these analyses? Companies could improve their transparency and communication on their environmental performance, in order to credibly signal their commitment to climate action and reduce information asymmetry with investors. This could involve the introduction of environmental accounting or economic performance ratios that take environmental performance into account. The use of certification bodies for climate performance should be developed. Regulators could encourage the design and use of climate standards and labels, to facilitate the comparison and verification of information provided by companies. From this point of view, the creation of the Green Taxonomy at European level is a step in the right direction but much remains to be done.
References
- Ardia, D., K. Bluteau, K. Boudt, and K. Inghelbrecht (2022). Climate change concerns and the performance of green versus brown stocks. Management Science.
- Aswani, J., A. Raghunandan, and S. Rajgopal (2023). Are carbon emissions associated with stock returns? Review of Finance.
- Avramov, D., A. Lioui, Y. Liu, and A. Tarelli (2022). Dynamic ESG equilibrium, Working papers available on SSRN.
- Berg, F., J. F. Kölbel, A. Pavlova, and R. Rigobon (2023). ESG Confusion and Stock Returns: Tackling the Problem of Noise, Working Paper available on SSRN.
- Bolton, P. and M. Kacperczyk (2021). Do investors care about carbon risk?", Journal of Financial Economics, 142, pp. 517-549.
- Bolton, P. and M. Kacperczyk (2023). Global pricing of carbon-transition risk, Journal of Finance, forthcoming.
Replay of the event organized by Getlink on November 11, 2023:
"Les Rencontres du Climat" - Deuxième édition (in French)
Photo: name_ gravity sur Unsplash
