Research News

Financial Markets Grow 'Green' Companies

Investors see 'green' firms as less risky, charge lower interest rates

New research from the University of Oklahoma suggests that when companies go green, they can acquire funds less expensively than similar companies that do not. The finding is one of several from a study that shows improved green performance benefits corporations in ways previously not considered by economic analysts.

The ability to obtain financing at lower costs frees a company's other assets for further investment and future growth. Until now, evidence of this positive connection between a company's green practices and investments by financial markets has not been well reviewed.

Instead, researchers historically saw "green" practices as a negative or a cost to companies and argued they should be minimized whenever possible. This new study took a different view, opting to focus primarily on how investors perceive firms committed to green practices.

"The research indicates there is a longer term impact to a decision to go 'green,'" said Mark Sharfman, professor of strategic management at the University of Oklahoma's Price College of Business. "The financial markets seem to perceive firms that improve their environmental performance as less risky." The outcome is more willingness to invest in these firms.

Companies go green for any number of reasons including changes in environmental regulations, pressures from customers or because management believes it is the right thing to do. But surprisingly, not all financial markets view a firm's green initiatives in the same way.

Equity markets that trade a company's ownership shares, betting their value will either rise or fall, seem to place more confidence in firms that go green. But debt markets, which trade a company's IOUs, seem to hold an opposite view.

In general, the cost of equity is higher than the cost of debt, but here researchers associate stronger green practices with lower costs of equity and higher costs of debt. "This was our most surprising finding," said Sharfman. "We predicted that both types of capital markets would evaluate environmental investments in the same way and respond the same ways, so the fact that they did not was puzzling and deserving of additional research."

Taking equity and debt capital together, researchers find the weighted average cost of capital is significantly lower for green companies relative to non-green companies. The finding shows that any cost disadvantage on the debt side is more than offset by the cheaper cost of equity capital.

For investors, market outlays in green companies come down to managing risk. "If the market perceives improvements in resource utilization but did not perceive changes in riskiness, the cost of capital would not change," Sharfman and his coauthor Chitru Fernando, also of the University of Oklahoma, write in the June issue of the Strategic Management Journal.

But they also note that if the market perceived changes in a firm's riskiness as a result of improved green practices leading to lower costs of capital and decreases in overall cost base, then the firm's ability to make a profit correspondingly increased.

According to the researchers, several factors contribute to how investors perceive the riskiness of green companies. Green companies are seen as less likely to be subject to government penalties, catastrophic accidents or litigation.

Consequently, financial markets reward them by charging less for capital and allowing such firms to carry more debt. Both factors help explain why "greener" firms have better financial performance.

Sharfman's and Fernando's research paper, "Environmental Risk Management and the Cost of Capital," was sponsored by the National Science Foundation's Innovation and Organizational Sciences Program.