It’s cheaper being green
It may not be easy being green (at least not if you are a frog) but if you ask corporate decision makers, it certainly is cheaper. There are more and more studies that try to estimate if green projects benefit from a lower cost of capital, either through lower debt costs or a smaller equity premium. Most of these studies try to estimate any difference from financial market data or econometric models, but few have so far bothered to ask executives themselves.
The chart below shows the results of recent papers on the subject. For each study, the chart shows the difference in cost of capital between ‘brown’ and ‘green’ projects. As you can see some studies show a cost advantage for green projects, while others show the reverse.
Studies on the cost of capital difference between green and brown projects
Source: Gormsen et al. (2024)
The chart is taken from a study by Niels Joachim Gormsen and others that mined earnings calls for information provided by companies about the cost of capita they use for green and sustainable projects vs. other projects. They find that green projects benefit from a perceived cost of capital that is about 1% below that of brown projects. Emphasis is on the word ‘perceived’.
The interesting thing about the survey is that it elucidates the cost of capital company executives use in practice to make capital allocation decisions, whether this is the empirically correct cost of capital or not. If companies use a lower cost of capital for sustainable projects than for traditional ones, they will allocate more capital to these sustainable projects and starve traditional ones. And that is exactly what happens in practice. The study finds that capital allocation has increasingly shifted towards green projects as the perceived cost of capital advantage increased.
How can you know? Well, the perceived advantage in cost of capital only started to emerge after 2016 when ESG investing became mainstream. Which can explain the mixed messages we get from different studies on the subject. If a study uses more data from before 2016, the cost of capital estimates will be closer to showing no difference between green and brown projects. If it uses more recent data, the likelihood is that it will show at least some advantage for green projects.
Green project cost advantage emerges after 2016
Source: Gormsen et al. (2024)
One wonders how much of this phenomenon is a result of recency bias. Governments lately have been closing down brown industries, hence corroding capital, while at once subventioning greenness. Maga intends to do the opposite, so will similar analyses arrive at quite different results in 2034?
This is more compelling evidence, however, it seems to require long term thinking which is at odds with short-term bottom-line thinking that dominates.