How SRI Has Changed the Business Case for Environmental Investments

Published September 25, 2019

2019-09-25 10:31:32

The emergence of socially responsible investing (SRI) has changed the debt and equity landscape such that companies with fewer environmental concerns have a significantly lower cost of capital. This is a relatively new variable in making the business case for improving environmental performance with technology upgrades or other costly strategic investments.

While justifications will differ from project to project and firm to firm, return on investment (ROI) and other financial considerations will invariably be part of the mix. Now, sustainability professionals can reference peer-reviewed data showing the potential for reducing cost of capital through improved environmental performance.

The Impact on Interest Rates

For a study published in Management Science, I analyzed a comprehensive sample of bank loans made to US public companies. What I found was interest rates are significantly higher for companies with more environmental concerns.

Concerns include things like hazardous waste sites, legal emissions of toxic chemicals, and climate change liabilities. Strengths include producing a beneficial good or service, clearly communicating environmental impact and investing in pollution prevention and/or clean energy.

Companies that had more concerns than strengths were charged interest rates 20% higher than those with an even number of concerns and strengths. Hazardous waste concerns alone boosted interest rates 12% to 13%, while companies that derived their primary revenue from environmentally beneficial goods or services were charged rates 20% lower than others.

Here’s a simplified example of the first figure at work. Company X and Company Y both want to finance $10 million, best-in-class water treatment technologies for their manufacturing. But Company X has more environmental concerns than strengths, whereas Company Y is even, or weighted toward strengths. Over a 10-year term at 5%, Company X would pay more than $3.3 million in interest, while Company Y (at 4%) would pay about $500,000 less.

However, if that new wastewater technology balanced Company X’s concerns and strengths, all of the company’s future financing (for any type of project) might be done at better terms, dramatically changing the ROI of the initial environmental investment.

The Expectations of Equity Investors

In the same study, I analyzed stock market data and earning estimates to derive the implied cost of equity capital and understand how it was affected by environmental concerns.

I found that investors demanded significantly higher returns from investments in companies that are filtered out by environmental screens for the types of concerns mentioned above. On average, they expected a yearly rate of return 0.7% higher. Not surprisingly, climate change concerns had the largest impact on expectations, leading investors to demand rates 0.47% to 0.69% higher to offset risks such as future regulation, compliance costs or litigation.

In this situation, if there were two similar firms in the same industry and with the same cash flows, the firm with more environmental concerns would have a lower stock price than the firm with fewer or no environmental concerns.

Two More Significant Findings

My research also revealed that companies with an imbalance of environmental concerns had significantly fewer institutional investors, and borrowed from a smaller number of lenders. This suggests these companies have fewer options for raising capital when necessary.

Lastly, it’s important to note that the environmental profile of a company was not simply a stand-in for unaccounted default risk in this study. This was demonstrated by the fact that environmental concerns had no measurable effect on a company’s risk of bankruptcy or a credit rating downgrade.

Is There a Big Takeaway?

In his 2019 Letter to CEOs, BlackRock CEO Larry Fink wrote that the largest transfer of wealth in history is underway. Due to $24 trillion moving from baby boomers to millennials, he said, “…environmental, social, and governance issues will be increasingly material to corporate valuations.”

If there’s a big takeaway for sustainability practitioners, I would suggest it’s this: environmental performance is now more material than ever to corporate evaluations, and that’s not likely to change any time soon.

BlackRock – the world’s largest investment firm – made environmental risks and opportunities a top engagement priority for this year. Fink explained that BlackRock wants to be sure the companies it invests in have long-term environmental strategies.

The profile analyses performed by investors and lenders like BlackRock have shifted the cost structure of equity and debt capital for the foreseeable future. Sustainability practitioners who are aware of this shift can paint a bigger picture for their colleagues in justifying future environmental investments.

To explore the research further, download the Sustainability Practitioner Brief from the Ray C. Anderson Center for Sustainable Business at Scheller College of Business.

By Sudheer Chava, Alton M. Costley Chair of Finance and affiliate faculty of the Ray C. Anderson Center for Sustainable Business at the Scheller College of Business, Georgia Institute of Technology

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