Addressing environmental issues has never been more pressing. Yet when it comes to environmental risk management, companies feel conflicted. Take climate change: Organizations need to consider stakeholder engagement, as well as their reputation, yet they also need to maximize shareholder value. So what should organizations do?
In fact, it turns out that practicing environmental risk management lowers companies' overall capital costs. Two business professors, Mark P. Sharfman and Chitru S. Fernando, both of the University of Oklahoma, studied 267 of the Standard & Poor's 500 companies that reported data on their emissions and toxic substance disposal to the U.S. Environmental Protection Agency. These companies also received rankings by KLD Research & Analytics Inc. on their environmental performance. The authors looked at the environmental risk management data that affected their 2002 capital costs.
Sharfman and Fernando, calculating debt and equity financing costs, determined that being green isn't just a feel-good activity. Companies that had better environmental risk management practices—those with lower emissions and higher KLD environmental rankings—had overall lower capital costs and thus an advantage over their competition.
Cost of capital has both debt and equity components. And the cost of debt capital was actually higher for the more environmentally conscious companies. Debt investors watch cash flows and current risks, so they may have considered investing in environmental risk management as an inefficient use of resources. Debt markets tended to allow higher leverage for the greener companies, so this wasn't wholly bad news.
Equity investors placed great value on environmental risk management. The lower cost of equity capital associated with environmental risk management practices outweighed the higher debt capital costs. And the cost-of-capital advantage held true even after controlling for company size and industry.
It's possible that those companies with better environmental risk management were simply better at all risk management—including issues like product safety and corporate governance. But the authors found that environmental risk management still stood out as an advantage even when controlling for an overall ability to manage risk.
The authors did not measure, however, the investments companies made in order to improve their environmental risk management. These initiatives could have been very costly—perhaps even outweighing the benefits of lower capital costs. So the business case for environmental management is still no slam dunk.
"The reality is major corporations are spending millions or tens of millions of dollars convincing the world how green they are," says Sharfman. "Changing the perception of the financial markets [requires] major investments in green technology or managing your firm from a green perspective. Switching over to compact fluorescents in your corporate offices isn't going to do that." Improving environmental risk management, then, is far more than a public relations exercise. Which isn't to say that public relations aren't important. Companies need to display their efforts. One way to do so? Sustainability reporting helps ensure that investors know what organizations are doing.
In fact, the authors contend that the key driver is the relationship with individual investors. They tested for this idea and found improving environmental risk management significantly increases the number of individual shareholders. Given that this study examined companies before concerns about global climate change were mainstream, the number of shareholders who consider a company's environmental decisions when investing could be even larger today.