Corporate environmental performance and financing decisions

• Author: Mohammed Benlemlih,Li Cai
• DOI: http://doi.org/10.1111/beer.12257
• Date: 01 April 2020
• Published date: 01 April 2020

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  wileyonlinelibrary.com/journal/beer Business Ethics: A Eur Rev. 2020;29:248–265.© 2019 John Wiley & Sons Ltd

1 | INTRODUCTION

In recent decad es, a growing numb er of top corporate e xecutives

allocate a consid erable amount of t ime and resource s to corporate

environmenta l responsibility (CER) str ategies—that is, the voluntar y

integration of environmental concerns into company operations.

Gregory-Smith, Manika, and Demirel (2017) find that consumers are

willing to pay more fo r environmenta l products . The rise of corpo-

rate environmen talism is also attribut able to the lobbying effor ts of

independent environmental groups, as well as the promotion of var-

ious governmental and nongovernmental organizations.1  As a result,

corporate environmentalism is much more common. According to

Harvard Political Review, each company in the Dow Jone s Industrial

Average today makes so me reference to sustainab le practices on its

website, and the ma jority of thes e companies have webp ages de-

voted entirely to sustainable environmental practices.2 

Effective ca pital struc ture and fina ncing decisions ar e neces-

sary for strong operational performance. Inferior capital structure

choices may lead to f inancial distress and even to ba nkruptcy. How

firms make finan cing decisions is a central quest ion in modern cor-

porate finance . For example, they can acquire ou tside financi ng, at

a cost, from eit her debt instruments or equ ity issues. The potential

tax savings as sociated with bor rowing may encour age debt; how-

ever, the costs of bank ruptcy or finan cial distress may d iscourage

borrowing. In th e trade-off model, f irms determine optimal l everage

by weighing the cost s and benefits of an addition al dollar of debt.3 

Quantifyi ng those costs a nd benefits is a d aunting task, h owever,

even in a highly fric tionless capital market . Moreover, the real cap-

ital market is loa ded with additi onal frictio n, including info rmation

asymmetr y and agency costs, which make a uni form financing the-

ory nonexistent.4 

In this paper, we investi gate how environme ntally respon sible

firms choose their optimal capital structures and make incremental

financing dec isions. There are several rea sons for which a firm's en-

vironmental p erformance may affe ct these financing d ecisions. First

of all, as outside m onitors of a firm, potential len ders and investors

may discriminate b etween firms with su perior CER performa nce and

those with less i mpressive CER per formance. For e xample, Hong

and Kacperc zyk (2009) prov ide evidence of soc ietal norms aga inst

funding operations that promote certain vices. Similarly, Sharfman

and Fernando (2008) propose that environmental management af-

fects the cos t of capital, including t he cost of equity and the cost of

debt.5  More recently, Mar tinez-Ferrero a nd Garcia-Sanche z (2017)

find that even sus tainability assura nce affects the cost of c apital.

Second, a firm's e nvironmental investment s can be viewed from

a risk management p erspective. A fi rm with better CER per formance

could have lower futu re risk (Cai, Cui, & J o, 2016). Furthermore ,

Diamond (1991) emphasizes th at firms with posi tive private infor-

mation about th eir future risk and credi t ratings will signal tha t infor-

mation to the marke t by renegotiating th e conditions of short-term

Received: 20 Jan uary 2018 

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  Revised: 1 Novembe r 2019 

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  Accepted: 4 Novemb er 2019

DOI: 10 .1111/bee r.12257

ORIGINAL ARTICLE

Corporate environmental performance and financing decisions

Mohammed Benlemlih1,2  | Li Cai3

1Centre for Rese arch in Economics an d

Management, University of Luxembourg,

Luxembourg, Luxembourg

2PricewaterhouseCoopers, PWC

Luxembourg, Luxembourg, Luxembourg

3IIT Stuart Sc hool of Business, I llinois

Institute of Technology, Chicago, Illinois

Correspondence

Mohammed Benlemlih,

PricewaterhouseCoopers, PWC

Luxembourg, 2 Rue Gerhard Mercator,

Luxembourg L-2182, Luxembourg.

Email: mohammed.benlemlih@lu.pwc.com

Abstract

We investigate the financi ng strategies of environ mentally responsi ble firms to

understand h ow they set target cap ital struct ures and make increment al financing

decisions. Literat ure shows that firms wit h better environmen tal performa nce have

lower risk and better a ccess to financing. However, it is not obvious how these fir ms

choose to finance the ir investments. Using an exte nsive data set of U.S. firms, we f ind

that firms with supe rior environmenta l performance have sign ificantly lower deb t

ratios and use most ly short-term debt for temporary f inancing needs. In doing so, en-

vironmentally re sponsible firms are able to achieve more t ax savings and experience

lower costs of financ ial distress. Our results provide ne w empirical facts about envi-

ronmental per formance and financing decisions, an d they help explain the observed

relationship between environmental performance and economic performance.

    

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loans. As such , environment ally responsibl e firms are likely to u se

short-term loans fre quently to signal qualit y.

Finally, Godfrey (20 05) indicates the pos sibility of an overinvest-

ment problem. T hat is, corporate insid ers (including manage rs) might

overinvest in CER to bo ost their own repu tations. Shor t-term debt

plays a monitorin g role, because s hort-term debt is exp ected to be

paid off within a ye ar. When firms roll over d ebt after shor t-term

debt expires, t hey are asked to disclo se information ab out insider

activities. Information is disclosed less frequently when long-term

debt is in use, bec ause borrowing firms have lon ger amount of time

to repay the princ iple with interes t. Accordingly, fir ms may use fi-

nancing mechanisms to manage overinvestment problems.

Our empirical examinations are based on a sample of 29,865 U.S.

firm-year observations between 1991 and 2012. After controlling for

a broad set of determinants of capital structure, as well as industry and

year fixed effects, we provide strong evidence that better CER perfor-

mance leads to significantly lower debt ratio, for example, ratio of total

debts to total assets. As a result, we show that, controlling for all exist-

ing determinants of capital structure, firms with strong environmental

track records are significantly more likely to operate with lower debt

ratios and in turn are less likely to declare bankruptcy. This main rela-

tionship is robust when we use alternative measures of environmental

performance and alternative estimation methods, as well as when we

use various approaches to address endogeneity and reverse causality.

A firm's book lever age reflects t he historica l aggregate of its

decisions. Our i nterest is not only i n target capit al structu res, but

also in incremental financing decisions. We therefore also examine

whether a firm's environmental performance affects its debt issue

and repurchase decisions.

We find that firms w ith higher environ mental scores a re more

likely to issue debt i nstead of equit y when they require external f i-

nancing. We also fin d that firms with strong envir onmental records

are less likely to rep urchase debt th an equity when t hey have a

financing sur plus. Shifti ng from equity t o debt financing g ives re-

sponsible fir ms higher tax benef its; however, this is inconsis tent with

the target cap ital stru cture of low lever age ratios. Notably, taking

on new debt does no t prevent a firm from reaching tar get leverage

levels if the debt is te mporary and short-term. Thu s, we further in -

vestigate the association between environmental score and debt

maturity. Consis tent with our expec tations, environm entally respon-

sible firms hol d significantl y less long-term deb t. The finding s hold

true for different measurements of environmental performance and

for different definitions of debt terms.

Our paper makes s everal contribu tions. First , although othe r

studies focus o n the economic or f inancial outcom es of CER, few

test CER's impac t on corporate s trategy and de cision making. We

explore the lon g-term and short-term fin ancing decision s of firms

with superior e nvironmental per formance. Our find ings enrich exist-

ing theory by s howing that firms can b enefit from improved e nviron-

mental progr ams by employing certai n financing strategies .6 

Second, our wor k contributes to the corpor ate finance literature

on capital st ructure and financing deci sions. Prior work f ocuses on

theory of fin ancing (e.g., Fama & French , 2005; Frank & Goyal, 20 03),

as well as how asymme tric informatio n and agency cost s affect fi-

nancing cost s and choices (Boot & T hakor, 1993; Fulghieri & Lukin,

2001; Gatchev, Spind t, & Tarhan, 2009; Ind erst & Mueller, 20 06).

However, whether nonfinancial metrics such as environmental per-

formance affe ct financing decisions rema ins an open question. Our

study shows tha t CER is indeed an imp ortant deter minant of both

target capital structure and incremental financing decisions.

Third, our empi rical work provides supp ort for the signaling the-

ory. High CER firms ar e more likely to enjoy low er future risk due

to a lower probabili ty of explicit cla ims from various s takeholder s

and a lower threat of la wsuits over irresponsible C ER behavior. CER

therefore gene rates moral ca pital and insur ance-like protect ion

(Godfrey, 2005). If th is is true, firms h ave incentives to issu e more

short-term debt in order to renegotiate loan terms when rolling over

debt. Empiric al evidence from our analysis pr ovides strong support

for this claim and s hows that high CER fir ms use more shor t-term

debt to signal qual ity and improve th eir financing co nditions when

renewing their debt.

Finally, our findin gs have agency the ory implic ations. Insider s

may pursue excessi vely high CER perfor mance in order to boos t their

reputations a s environmenta lly responsibl e managers. Addi tionally,

shortening d ebt maturity co uld be the monitor ing mechanism t hat

forces manager s to release more info rmation about t heir environ-

mental acti ons and activities whe n rolling over debt. Our resul ts are

in line with this ar gument and show th at high CER perfor mance is

associated with t he use of more short-term debt.

The paper proce eds as follows. Section 2 exte nds the literature

review and hypotheses development. Section 3 describes our sam-

ple selectio n and variables cons truction. Se ction 4 presents o ur main

findings on the relationship between environmental scores and capi-

tal structure. Section 5 provides supporting evidence, including sep-

arate tests of s trength and co ncern, use of alter native estimations,

and additiona l robustness test s for endogeneity. Sect ion 6 examines

the incremental financing decisions of environmentally responsible

firms. Section 7 concludes.

2 | LITERATURE RE VIEW AND

HYPOTHESES DEVELOPMENT

This study builds upon multiple dimensions of the literature, includ-

ing corporate env ironmental perfor mance and firm value, ot her per-

spectives of env ironmental p erformance, a nd capital st ructure and

financing the ory. The relation ships among relat ed theories an d no

theoretic findings are summarized in Figure 1, which guides the lit-

erature review and hypotheses development.

2.1 | Corpo rate environmental performance and

firm value

Accompanying th e promotion of CER issu es, the legitim acy of en-

vironmental i nvesting has att racted growin g attention. Th e debate