Capital Structure and ESG Integration

Abstract

We analyze how borrowers’ capital structure affects their incentives to integrate ESG. Borrowers may make socially valuable but financially underperforming investments to reduce expected payments to outside investors. These financial gains increase as the expected payoffs of securities issued for borrowers’ investments sensitively change with financial profitability. ESG-focused investors may accept financial losses to fund ESG investments, particularly when borrowers have relatively weak social preferences. However, low capital costs can shift borrowers’ focus back to financial profits, although investors hold strongly sensitive securities to ensure ESG integration. This incentive misalignment is mitigated when all competing investors bid with equities.

Keywords: capital structure, ESG, greenwashing, moral hazard, security design

JEL Classification: D82, D86, G32, G38