The Impact of a Firm’s ESG Score on Its Cost of Capital: Can a High ESG Score Serve as a Substitute for a Weaker Legal Environment?

Abstract

This article analyses the relationship between the ESG score and the cost of capital of 600 large, mid and small capitalization companies across 17 countries of the European region being a component of the EURO STOXX 600 Index. The article further examines whether the effect is due to the environmental, social, and/or governance component and whether these specifically impact the cost of equity, the cost of debt, the beta, or the leverage ratio of the companies. Furthermore, this article analyses whether a high ESG score can substitute for a weaker legal environment. We find significant evidence that companies having a higher ESG score have a lower cost of capital, but this relationship holds only for firms domiciled in countries having a weaker legal environment, thereby providing evidence for the substitution effect. The ESG score does not seem to have a significant impact on the cost of equity and the beta, although the ESG score has a significant positive impact on the cost of debt, which can be explained by the fact that firms having a high ESG score can significantly obtain more leverage. In countries with weaker legal institutions, the impact of the ESG score on the cost of debt is even significantly negative. In terms of the ESG component, the environmental and social factors have a significantly negative impact on the cost of capital, only in countries having a weaker legal environment, while the governance component positively impacts the cost of capital by allowing firms to borrow more.

Keywords: ESG, cost of capital, sustainable finance, capital structures

JEL Classification: G3, G31, Q5