For years, investors concerned about climate change have poured money into greener companies and projects. The logic is simple: if greener companies can access capital more cheaply than heavy polluters, businesses have a financial incentive to invest in cleaner technologies. But does green investing actually work in this way?
New research from Professor Sangmin Oh of Columbia Business School — in collaboration with Niels Joachim Gormsen and Kilian Huber of the University of Chicago — suggests that, at least for a time, it did. Between 2016 and 2023, greener companies (those with more eco-friendly business policies) perceived their cost of capital to be about one percentage point lower than that of browner companies (those that rely more heavily on fossil fuels and high-emission operations). The researchers also found evidence that some major energy companies applied lower costs of capital to their greener divisions, potentially tilting investment decisions toward renewable energy.
The findings suggest that financial markets can influence the transition to a greener economy through a mechanism that works somewhat like a carbon tax. “When investors care about green stocks, that pushes up valuations and lowers the opportunity cost of doing green projects,” Oh says. “We think this channel could be a valid complement to a lot of the other efforts to build a low-carbon economy.”
Putting a price on green capital
When a company considers building a factory, developing a wind farm, or making another long-term investment, it must decide whether the expected payoff justifies committing money to that project rather than putting the capital elsewhere. To make that call, the company first needs to know the return its investors require on the debt and equity that fund the firm. In finance terminology, that opportunity cost is the cost of capital.
However, what ultimately matters for corporate decisions isn't necessarily the cost of capital calculated from financial-market data. Instead, it's the cost that corporate decision-makers believe they face — the perceived cost of capital. Rather than estimating those figures from measures such as stock returns and bond yields, Oh and his team collected companies' own cost-of-capital estimates from corporate conference calls.
Before 2016, the researchers found little difference between the perceived costs of capital of greener and browner companies. After 2016, however, they began to diverge. From 2016 through 2023, green companies perceived their cost of capital to be about one percentage point lower on average. That might sound small, but corporate investments frequently generate returns over 10 or 20 years, meaning relatively modest differences in the cost of capital can compound into substantial differences in how attractive projects appear.
One possible explanation for the findings is the dramatic growth of sustainable investing beginning around 2016. As more investors sought out environmentally friendly companies, they could bid up those companies' valuations and accept lower expected returns. For the companies themselves, that translated into a lower perceived cost of capital. Suddenly, a green project that previously failed to clear a company's required return could become more attractive.
The mechanism appears to operate not only between companies but within them. After examining investor materials from the world's 200 largest energy and utility companies, the researchers identified 51 that disclosed different costs of capital or discount rates for individual divisions. Since 2016, green divisions such as renewable energy had an average cost of capital roughly one percentage point below brown divisions such as fossil fuels.
That matters because some of the world's biggest emitters operate both kinds of businesses. A company deciding how much capital to allocate to natural gas versus wind or solar can effectively make the greener investment more attractive by applying a lower discount rate.
“What these individual firms do in terms of capital budgeting makes a big difference for the overall economy,” Oh says.
A piece of the puzzle
The effect isn't large enough to solve climate change by itself. The researchers estimate that greener companies' financing advantage between 2016 and 2023 was roughly equivalent to a carbon tax of $10 to $14 per ton of CO2, well below the $50 to $100 benchmark the paper uses for an optimal carbon tax.
But unlike carbon taxes, changing investment preferences doesn't necessarily require governments to pass politically difficult legislation. That makes the cost-of-capital mechanism a potentially powerful complement to policy and technological change.
And recent developments may provide a revealing test of the researchers' theory. Their published data end in 2023. Since then, enthusiasm for ESG investing has cooled as the political and investing climate has shifted. That could mean that the cost of capital advantage has decreased or even reversed—a possibility the researchers are currently exploring by looking at more recent data.
If the evidence turns out to support this outcome, it would underscore both the power and the limits of green investing. Investor preferences can alter the financial incentives companies face — and potentially the investments they make. But when those preferences change, the incentives can change with them.
