The impact of air pollution on the cost of debt financing: Evidence from the bond market

Abstract

This study investigates whether bond markets reflect firms' exposure to air pollution through an increased cost of debt financing; and, if so, whether firms can mitigate this air pollution penalty via effective governance and active monitoring. Using 1067 bonds issued by Chinese firms, we document a positive association between air pollution and the cost of debt financing, and this association is robust and economically meaningful. Specifically, with a one standard deviation increase in air pollution severity, a firm's bond yield spread increases approximately 16% relative to an average bond. Additional analysis suggests that credit risk and financial uncertainty are the transmission channels. Our results also confirm that strengthened corporate governance, active board and external monitoring, and a stabilized economic environment further enhance the impact of air pollution on a firm's cost of debt. Overall, air pollution has a material change in a firm's business strategy in using debt.

Air Pollution, Environmental Violation Risk, and the Cost of Debt: Evidence from China

“…Based on the existing literature, the control variables in our research models largely included the factors that may affect the cost of debt. The adjusted-R 2 value in model (2) equaled 0.3318, which was similar to the 0.334 of Tan et al [ 16 ] and the 0.373 of Zhou et al [ 18 ], and was slightly higher than the 0.283 of Jung et al [ 10 ] and the 0.105 of Chen et al [ 9 ]. It indicated that the fitting degree of the model was acceptable.…”

“…In response, creditors, including banks and other lending institutions, cannot ignore the environmental risk related to air pollution in the process of lending decision making [ 13 , 28 , 29 ] and prevent the air pollution-related default loss by revising debt contracts, such as raising the bond yields and interest rate as a response [ 10 , 12 , 30 ]. Tan et al [ 16 ] and Tan et al [ 15 ] also confirmed that firms in areas with serious air pollution face more significant debt financing constraints in the process of negotiation with banks due to a higher credit risk and financial uncertainty related to the environment. Consequently, we expect that firms located in areas with serious air pollution face a higher risk of environmental violations, and, thus, they need to afford higher debt costs in the process of debt financing.…”

“…Our empirical results confirmed a positive relationship between air pollution and the cost of debt after controlling for various firm-level and provincial-level characteristics that affected the cost of debt and implementing a series of sensitivity and endogenous tests. In addition, we attempted to use the mediating effect test to confirm that environmental violation risk was the mechanism by which air pollution affected the cost of debt, which was distinct from the insights into the mechanism of credit risk and financial uncertainty [ 16 ]. Specifically, air pollution-induced environmental violation risk caused pessimistic assessments by creditors on the default risk of firms, which prompted them to raise the interest rates in terms of the loan contract to reduce the air pollution-related default loss.…”

“…Firms’ exposure to environmental violation risk may increase the uncertainty risk in its current and future cash flows and, ultimately, increase the likelihood of the default [ 10 , 12 ]. With the increasing pressure of environmental supervision, firms’ exposure to environment-related risk has become an important factor that creditors cannot ignore in the procedure of lending decision making [ 10 , 13 , 14 ], which means that more and more firms are facing the severe challenge of financing constraints caused by air pollution [ 15 , 16 ]. Therefore, whether air pollution affects the cost of debt through its effect on environmental violation risk is worthy of exploration.…”

“…Second, our research provides deeper insights into how air pollution affects creditors’ decisions and corporate debt cost from the perspective of environmental violation risk. Although some scholars have attempted to analyze the restrictive effect of air pollution on corporate debt financing from the mechanism of credit risk and financial uncertainty [ 15 , 16 ], they ignored the mechanism of environmental violation risk, which is the fundamental mechanism by which air pollution affects the cost of debt. Additionally, few studies have comprehensively measured the environmental violation risk of listed firms.…”