The Impact of Environmental, Social and Governance (ESG) Performance on Capital Constraints and the Cost of Capital: Evidence from European Countries

Environmental, social, and governance, collectively known as ESG, refers to the three key pillars of measuring the sustainability and non-financial performance of firms as well as the ethical impact of investments. In recent times, a growing number of firms around the globe have integrated ESG initiatives into their business models, policies, and organisational structures as a response to the increasing pressure from stakeholders, policymakers, and society. However, despite the significance of the relationship between ESG practices and firms' access to finance, only a few studies have investigated this relationship, and the findings are equivocal, with many documenting negative relationships and few positive relationships or no relationships. Given the gap in the literature, this study addresses three research questions. (1) To determine if a company's ESG performance can reduce capital constraints. (2) To investigate whether there is a non-linear effect of ESG performance on the cost of capital. (3) To explore how better ESG performance can mitigate capital constraints and the cost of capital during the 2007/2008 financial crisis and the COVID-19 pandemic. Using a comprehensive set of panel data of 14,000 firm-year observations comprising 1,164 firms from 20 European countries covering the period of 2003 to 2020. This study provides the following findings: Firstly, the results from the relationship between ESG and capital constraints show that superior ESG performance reduces capital constraints. Also, the nonlinear model reveals a curvilinear relationship between ESG performance and capital constraints. Secondly, the findings from the association between ESG and the cost of capital are as follows: ESG performance reduces the cost of capital. In addition, the study documents that ESG performance decreases the cost of equity and the cost of debt. These findings show that better ESG performance enhances a firm’s relationship with stakeholders and improves its access to finance. Moreover, the nonlinear model reveals a curvilinear relationship between ESG and the cost of capital, suggesting that even though it might be costly to undertake an ESG initiative at the start, there are benefits from improved stakeholder influence capacity that can offset the costs and provide financial benefit in the long run. Finally, the results from the impact of ESG performance on capital constraints and the cost of capital around the 2007/2008 financial crisis and COVID-19 are twofold. (1) The findings show a negative association between ESG performance and capital constraints and the cost of capital before and after the financial crisis and COVID-19. (2) The findings reveal that firms with high ESG performance have lower capital constraints and cost of capital during the financial and COVID-19 crises. These findings suggest that the pre-crisis and post-crisis ESG performance generates insurance-like benefits by protecting shareholders’ wealth from the negative impact of the crises. The practical implications of the findings suggest that managers should regard ESG activities as a strategic investment that promotes the long-term success of their firms. For investors and financial institutions, ESG is of utmost importance as ESG information can aid in decision-making processes or evaluate a company’s creditworthiness. Thus, by reporting ESG practices, a company can establish a trusting relationship with investors and financial institutions, reducing the information asymmetry between them. The findings can also help regulators and policymakers implement appropriate legislation, regulatory reform, and enforcement to improve ESG initiatives in Europe and the World at large. The results are robust to a battery of sensitivity tests, including alternative measures of capital constraints and cost of capital, model specifications, and alternative estimation techniques (fixed effects and instrumental variables - 2SLS and IV-GMM) to resolve the issue of endogeneity caused by omitted variable bias and reverse causality.