Does sustainability truly cut the cost of capital?
– It’s not so clear-cut whether sustainability increases or reduces the cost of capital. But it may seem that this doesn’t matter.
– It’s hard to estimate the cost of capital, at least for equity capital. The expected returns that shareholders expect when they buy a stock are unknown. We know the realized actual returns that they receive – but high returns could either result from high expected returns (the cost of capital channel) or high unexpected returns (the cash flow channel).
– Advocates of ESG argue that it reduces the cost of capital. They also say that it improves investment returns. But it can be only one or the other (in equilibrium); you can’t have both.
– Carbon risk is being underappreciated by all markets
It’s often claimed that sustainability reduces the cost of capital. But both theory and evidence show that it’s far from clear-cut, as noted by Alex Edmans in this article. Here’s an excerpt about cash flows:
But it is not actually that simple. Such arguments often confuse the effect of risk on a company’s cost of capital with its effect on a company’s expected cash flows. Let’s illustrate this distinction with an example. Airline A runs on hydrogen, and its expected cash flows are £1 million per year, forever. Its cost of capital is 10%, so its value is £10 million. Assume that airlines can raise debt of up to half their value, so Airline A can raise £5 million of debt.
Airline B runs on conventional fuel. Its expected cash flows are also £1 million per year. However, there’s a 10% chance that the government implements a carbon tax which reduces its cash flows to zero (for simplicity). Thus, its expected cash flows are £900,000 per year. Assume that its cost of capital stays at 10%, so its value is £9 million and it can raise only £4.5 million of debt.
Thus, Airline B does have ‘trouble raising financing’. But this is nothing to do with its cost of capital being higher – it is exactly the same as Airline A’s. Instead, the difficulty comes purely from a cash flow channel. Airline B has trouble raising financing because risk reduces its cash flows, not because risk increases its cost of capital.
And here’s an excerpt about the bottom line:
Overall, it is not so clear-cut whether sustainability increases or reduces the cost of capital. But it may seem that this doesn’t matter. Airline B is worth less than Airline A in every case (£9.5 million if its cost of capital is lower, £9 million if it’s the same, and £8.6 million if it’s higher – compared to £10 million for Airline A). If the punchline stays the same – sustainability is valuable – does it really matter whether it’s because of ‘higher expected cash flows’ or a ‘lower cost of capital’? Is there really any harm in statements such as “sustainable companies have lower cost of capital”? It may be academically imprecise, but practically it has the same outcome.
In fact, this confusion has important practical implications:
• It is very hard to estimate the cost of capital (at least for equity capital). The expected returns that shareholders expect when they buy a stock are unknown. We observe the realised returns that they receive ex post, but high realised returns could either result from high expected returns (the cost of capital channel) or high unexpected returns (the cash flow channel).
In Edmans (2020), I explain how several measures of sustainability are correlated with high realised returns and these seem to be at least partially unexpected, consistent with the cash flow channel. This research complements Edmans (2011), where I find that companies with high employee satisfaction generated earnings that systematically beat analyst expectations.
Alex argues this in this Vox article:
Advocates of ESG argue that it reduces the cost of capital. They also say that it improves investment returns. But it can be only one or the other (in equilibrium); you can’t have both.
And then check out this note by Laurent Babkian about carbon tax costs:
According to the Financial Times, we must pay the cost of #carbon if we are to cut it…so why don’t we fix it? A decent #carbontax (above $150) is the element that will bring all the other pieces of the #netzero2050 puzzle together to accelerate the transition to nature positive and we are collectively unable to set a political price at the international level. How come?
Answer: lobbyists of high emitting sectors simply don’t want it. It’s as simple as that!
Why? A recent analysis made by Kempen Capital Management shows that a $150 carbon tax applied to scopes1+2+3 emissions of all listed #companies would cause a 41% drop of #stock prices, destroying shareholder value. Imagine the drop if we were to apply the price of $250 recommended by International Energy Agency (IEA) to achieve net zero 2050…
What are we waiting for to set decent prices on all negative externalities so that #markets can do their job of valuing assets at their true value instead of gambling?