Is there a relation between the cost of debt and environmental performance? An empirical investigation of the U.S. Pulp and Paper Industry, 1994-2005.*

This study shows an economically significant relation between a firm’s environmental performance and its cost of debt. Firms that have poor environmental performance will face future environmental liabilities related to compliance and clean-up costs due to increasingly strict environmental laws and regulations. Under current common-law, environmental liabilities can impair the value of fixed assets, as environmental claims often take precedence over the claims of creditors. Thus, future environmental liabilities are of particular concern to creditors. Previous accounting research has shown that a firm’s market value of equity is significantly affected by its environmental performance. However, the same has yet to be shown for a firm’s cost of debt capital. This study focuses on a sample of U.S. pulp and paper firms. The results imply that the market applies an ‘environmental risk ’ premium of eighty-eight basis points to the cost of debt capital for the average public firm in the U.S. pulp and paper industry, based on its environmental performance. Environmental performance is measured using the annual toxic release inventory of the United States Environmental Protection Agency. It is a measure of the amount of toxic chemicals released to land, air and water by a firm’s operating facilities. With the results of this paper, it has now been shown that environmental performance is a value relevant measure with regards to shareholders and creditors. Thus, recent calls for financial statement reporting that will clearly disclose a firm’s environmental performance should be addressed by regulators. *I would like to thank my thesis supervisor, Christine Wiedman, and the rest of my dissertatio