The Economic Radius of Natural Hazards: Analysing the Spillover Effects on Firms' Cost of Equity

Abstract

This paper examines the influence of natural disasters on firms' cost of equity, focusing on both direct and spillover effects across 67 countries from 2000 to 2022. The analysis reveals that firms situated in areas with high exposure to natural hazards tend to experience an increased cost of equity due to heightened perceived risks. Interestingly, the study also highlights significant spillover effects; firms located outside disaster-prone areas but economically connected to them face elevated costs following major disasters. Findings indicate that while direct effects on cost of equity are sometimes limited, neighbouring effects consistently show a negative correlation, indicating that firms near disaster zones may benefit from regional recovery efforts. The underlying mechanisms driving these effects are multifaceted. Firstly, natural disasters can alter investor perceptions, leading to behavioural biases where investors either overreact or underreact to risk, influencing the cost of equity. Firms in proximity to disaster zones may benefit from regional recovery efforts and improved risk preparedness, resulting in a reduced cost of equity. Conversely, operational disruptions and increased financial constraints can elevate costs for firms directly impacted by disasters. These results underscore the necessity for firms to reassess their capital structures in light of climate-related risks and highlight the complex interplay between environmental factors and corporate finance strategies. The findings contribute valuable insights into how natural disasters shape financial dynamics and investor behaviour in an increasingly climate-sensitive economic landscape.

Keywords: Climate change, natural disasters, climate-related financial policy index, implied cost of equity