A recent paper by Randy Priem and Andrew Gabellone analyses the relationship between ESG scores and the observed cost of capital of six hundred European-based companies.
The research examines the impact of the individual components of ESG on the cost of equity, beta and the leverage ratio of the firm together with the impact of the domestic legal environment.
The article provides the hypothesis that companies with a high ESG score will have a lower cost of capital and more leverage compared to their low-scoring ESG peers, because:
- investors believe they are less informationally disadvantaged due to greater discloser
- there is a lower risk of regulatory and or other stakeholder litigation
- there is a larger pool of investors and sources of debt finance; green investors are only attracted to high ESG scores
Further, the article hypothesises that companies in countries with weaker legal environments will benefit more from a high ESG score because investors are more concerned about governance issues, credibility and ecological violation risks.
The article finds evidence that companies having a higher ESG score in weak legal environments do have a lower cost of capital. The report concludes that the ESG score appears to act as a positive substitute for the weak legal environment. The paper observes that a one standard deviation change in the ESG score results in a 4.79% decrease in the cost of capital.
Companies in strong legal environments with high ESG scores were observed obtaining significantly more leverage but were not observed to have a relatively lower cost of capital.
