The default risk of a company could be negatively affected by a lack of environmental sustainability via four interconnected transmission channels. First, companies with a higher environmental sustainability have less regulatory risks because they have a lower probability of being fined for environmental misconduct and they are better prepared to adopt any regulatory changes regarding environmental issues. For example, the US Environmental Protection Agency (EPA) enforced private parties to spend over USD 450 million to cleanup Superfund sites in fiscal year 2018 (EPA 2019). Similar to the US Superfund, the EU put the Environmental Liability Directive (ELD) into force to prevent and remedy environmental damage based on the “polluter-pays” principle. This directive, which is enforced by the particular member states, is one European regulation that makes companies liable for the environmental damage they have caused (European Union 2006). Additionally, stricter regulations can be expected based on the Sustainable Development Strategy (SDS) of the European Union (European Union 2019). The implementation of these new regulations could pose a major challenge to environmental sinners and increase their compliance costs. In summary, the companies with lower environmental sustainability have a higher regulatory risk due to potentially higher fines as well as a slower and more costly adaption of upcoming regulatory changes which are expected to increase their default risk.
Second, companies with a lower environmental sustainability face higher stakeholder and reputational risks. The perception of environmental issues has changed leading to an increased public awareness and media coverage (Leiserowitz et al. 2018). Hence, many customers have become more sensitive to ecological issues and punish environmental misconduct by avoiding products from environmentally unfriendly companies, which can lead to a severe reduction in sales and harm profits. Additionally, other companies do not want to be associated with environmental sinners and thus are likely to cut off business dealings with polluters, which could have a negative impact on the whole supply chain. Bauer and Hann (2010) demonstrate that a deterioration of stakeholder relationships directly affects the cash flow, which influences both the firm value and the default risk.
Third, companies, which are involved in environmental issues, have a higher financial risk, because many investors start to integrate sustainability criteria in the investment process and thus either refuse to invest in those companies or demand a higher risk compensation. The EU plans to reinforce this development by introducing the EU taxonomy,Footnote 1 sustainability-related disclosure for investment products and alternative sustainable benchmarks (European Union 2019). This is likely to redirect capital to more sustainable firms and thus lead to a further increase in refinancing costs for less sustainable companies. Additionally, banks and credit rating agencies start to incorporate sustainability criteria in their credit risk assessment process (Fitch Ratings 2019; Goss and Roberts 2011; Weber et al. 2008, 2010). Hence, less sustainable companies are likely to face higher refinancing costs for both loans and bonds if they receive lower credit ratings from banks and rating agencies, respectively. This will not only increase funding costs but also constrain access to sufficient funding sources in times of financial distress.
Fourth, companies, which are less sustainable, in particular in regard to environmental factors, have higher event risks. The Exxon Valdez (1985), BP (2010), Tepco (2011) and Vale (2019) catastrophes are a few examples that highlight the effect of environmental disasters on the creditworthiness of a company. For instance, the most recent disaster was the burst of Vale’s dam in Brazil which led to the death of at least 248 people. Besides destroying the surrounding area, the whole ecosystem is now contaminated by metals which were released after the dam burst. As a result, Vale’s stock price fell 24 percent after the catastrophe and their credit rating was reduced by Fitch to BBB. Furthermore, it significantly deteriorated their relationship with many stakeholders and will probably lead to stricter regulations. Vale could have prevented a decline in their creditworthiness, the deterioration of its stakeholder relationships and stricter regulations by better managing their environmental risks. The event risks that emerge from questionable business practices can lead to immense liabilities, which often question the continuation of the business and thus increase the default risk.
In summary, the higher regulatory, reputational, financial and event risk of companies with a lower environmental sustainability score is expected to negatively affect the creditworthiness of the respective company. Hence, our first hypothesis is as follows:
Companies with higher environmental sustainability have lower credit risk premiums.
The previously outlined risk-mitigation view, which states that higher sustainability leads to lower default risk, is widely held by researchers and investment professionals (e.g. Bauer and Hann 2010; Dorfleitner et al. 2019; Schneider 2011). However, some argue that investments in sustainability are a waste of scarce resources, which could be better spent by investing in the expansion of the firm or paying dividends. In accordance with this overinvestment view, the credit risk premia for more sustainable companies should be higher (e.g. Menz 2010). We hypothesize that companies with a high creditworthiness have more financial scope and are thus able to afford being “green.” For them, the risk reduction effect from being sustainable overcompensates the additional costs. Furthermore, companies with a low creditworthiness have less financial scope, which makes it more difficult for them to direct their few resources towards sustainable development. Moderating effects could provide a link between the risk-mitigation view and the overinvestment view, as shown by Stellner et al. (2015) for the moderating effect of country sustainability on the relationship between credit risk and sustainability on company level. Based on these considerations, our second hypothesis is as follows:
Only companies with a high creditworthiness profit from a high environmental sustainability.
The first study regarding the effect of environmental sustainability on credit risk was conducted by Graham et al. (2001), who show that off-balance-sheet environmental obligations have a negative impact on bond ratings. Graham and Maher (2006) confirm these results and extend the previous work by investigating the impact of environmental liability information on bond yields. Their findings indicate that environmental obligations are accounted for in bond yields. However, the environmental liability information has no additional explanatory power if bond ratings are also considered in the model. The study from Schneider (2011) focusses on firms in the pulp and paper as well as chemical industry and highlights that poor environmental performance has a negative impact on bond pricing. Additionally, Bauer and Hann (2010) confirm the positive impact of good environmental management on bond ratings and yield spreads. However, their results indicate that there is no general industry or sector level effect moderating the effect of sustainability on credit risk due to the high heterogeneity of firms within these sectors. The most recent study in this field of research was conducted by Dorfleitner et al. (2019) which concludes that considering social and environmental criteria improves the prediction of credit ratings and that firms with a higher social or environmental sustainability receive better credit ratings. Additionally, we review the literature on green bonds, which are attracting growing investor interest. Hachenberg and Schiereck (2018) show that green bonds have a lower credit risk premium, which could be economically important, even though their results are often not statistically significant. In summary, the current literature regarding the impact of environmental sustainability on credit risk supports our first hypothesis.
In contrast, the moderating effect of creditworthiness on the impact of sustainability on credit risk is hardly analyzed by academics. Moreover, the few existing studies contradict each other. For instance, the findings of Schneider (2011) highlight that the effect of environmental sustainability on credit risk is more positive for U.S. companies from the pulp and paper as well as chemical industry if they have lower credit ratings. Goss and Roberts (2011) analyze loans from U.S. banks and investigate the impact a firm’s investment in corporate social responsibility (CSR) has on its loan spreads. Their results contradict the findings from Schneider (2011), when they conclude that low-quality borrowers face higher refinancing costs if they invest in discretionary CSR.
To the best of our knowledge, this is the first study that analyzes the impact of environmental sustainability on credit risk for European companies using CDS spreads and investigates the moderating effect of creditworthiness while incorporating all industry sectors, except the financial sector, with an extensive sample ranging from 2006 to 2017.