Implications of Environmental Liabilities on Corporate Financing Decisions: An International Cross-Industries Investigation

This thesis consists of a systematic literature review and three related empirical studies that examine the key implications of environmental risk management performance, specifically pollutant emissions, on the cost of capital and capital structure, as well as its causality direction with financial performance, using an international dataset of companies from 45 countries from 2002 to 2020. In all three empirical studies, environmental risk management performance is evaluated in terms of environmental risk exposure in the form of pollutant emission intensity, with the Refinitiv environmental pillar score used to assess the overall quality of an organisation's environmental risk management performance or environmental profile.

It is motivated by the recognition that climate-related risks can have a catastrophic effect on business sustainability and by how organisations are now actively incorporating corporate environmental responsibility as an important component of their corporate sustainability strategy, thereby changing the way they conduct and operate their businesses. Furthermore, organisations are finding it increasingly difficult to make funding and investment decisions because of the trade-offs necessary to fulfil the expectations of many stakeholders for environmental action while maintaining profitability or firm value maximisation.

According to the results of a systematic literature review covering 25 years (1995–2020), the relationship between environmental performance and financial performance continues to be varied (negative, neutral, and positive) due to the causal impact and effect environmental performance can have on an organisation's strategic, operational, economic, and compliance processes. Overall, most evidence points to a positive and perhaps synergistic (simultaneous and interactive) connection, with environmental performance leading to improved financial performance, allowing for reinvestment in environmental risk management and other operational activities. While the literature on the relationship between corporate environmental responsibilities and cost of capital indicates that when implemented strategically, corporate environmental responsibility may improve an organisation's overall financial and operational performance, reduce capital market sensitivity to its risk profile, and ultimately lead to a lower cost of capital and higher firm value. On the other hand, the presence of a U-shaped or non-linear relationship between environmental performance and financial performance suggests that the benefits of responsible corporate environmental actions diminish beyond an optimal level, inferring that corporate environmental responsibility investments and financing decisions must be well-balanced to avoid compromising the organisation's long-term value.

The first empirical study in this thesis examines the effect of pollutant emissions on the cost of capital using a model that integrates the “win-win” and “win-lose” effects of corporate environmental responsibility activities to formulate environmental risk management strategy based on the theoretical underpinnings of stakeholder theory, resource-based view, and organisational institutional theories. The resulting relationship is an N-shaped curve, which first shows the cost of equity and debt increasing with initial environmental risk management activities to address the environmental risk (reactive strategy), then a negative relationship between increasing or moderate environmental risk management activities and the cost of both sources of capital, then positive at higher levels of environmental risk management pursuits.

The first empirical study in this thesis examines the effect of pollutant emissions on the cost of capital using a model that integrates the “win-win” and “win-lose” effects of corporate environmental responsibility activities to formulate environmental risk management strategy based on the theoretical underpinnings of stakeholder theory, resource-based view, and organisational institutional theories. The resulting relationship is an N-shaped curve, which first shows the cost of equity and debt increasing with initial environmental risk management activities to address the environmental risk (reactive strategy), then a negative relationship between increasing or moderate environmental risk management activities and the cost of both sources of capital, then positive at higher levels of environmental risk management pursuits. Additionally, improvements in the overall quality of their environmental risk management profile also help to moderate the effects of the N-curve. Furthermore, the disparity in inflection points between investors and debt holders reflects differences in the payoff function as well as the relative weight they place on environmental risk and environmental risk management performance. These findings provide useful information for organisations in determining the levels at which environmental risk management initiatives will be advantageous before they become a disbenefit.

The second empirical study in this thesis assessed the effect of environmental risk on capital structure. The results show that environmental risk has a differential impact on capital structure decisions, i.e., on average, high environmental risk exposure leads to lower utilisation of debt and long-term debt but increases short-term debt utilisation. Furthermore, consistent with the observation in the first study, organisations with quality environmental risk management profiles are better able to control the impact of environmental risk. Overall, the findings highlight environmental risk as a key predictor/determinant of capital structure, and a quality environmental risk management profile should assist organisations in securing access to the credit market with better borrowing terms and conditions.

The last empirical study in this thesis used the panel vector autoregression framework based on the generalised method of moments and the Granger causality Wald test to investigate the existence of bi-directional causation between environmental performance and financial performance. The findings indicated that reducing pollution emission intensity can enhance subsequent financial performance, but better financial performance need not necessarily lead to subsequent emission intensity reduction. This bi-directional causality, however, occurs only when a market-based financial performance measure (Tobin's Q ratio) is utilised in the equation. Furthermore, the variance decomposition results imply that environmental performance is critical for long-term market value generation. Overall, the findings are more consistent with the enlightened stakeholder theory (Jensen, 2002) and general business practise, where strategic environmental risk management involves executive decisions on stakeholder compromises to maximise long-run firm value.

In conclusion, the studies show that overall, environmental performance has a significant positive effect on an organisation's strategic, financing, and operational activities, ranging from the premium it pays for equity and debt capital, which influences the choice of debt and its utilisation, to its impact on the bottom line, implying that a proactive environmental risk management strategy is beneficial in improving future firm value. However, they also emphasise the importance of organisations’ assessing and prioritising their corporate environmental responsibility investments and/or expenditures in order to maintain long-term business sustainability.