CARACTERÍSTICAS GEOMORFOLÓGICAS DEL RIO CAUCA

Prior research on the relation between corporate disclosures of ESG activities and the cost of capital focuses on self-constructed ESG disclosure variables and the implied cost of equity capital (See e.g. Chava, 2011; Dhaliwal et al., 2011; El Ghoul et al., 2011; Plumlee et al., 2010). The consensus appears to be a negative relationship between ESG disclosure and the cost of equity capital. Surprisingly, only very few studies investigate such effects on the cost of debt (Bauer and Hann, 2010; Oikonomou et al., 2014). However, the few studies that do, also report a negative relationship between companies' ESG activities and the cost of debt.

For example, Dhaliwal et al. (2011) empirically show that companies enjoy lower cost of equities after the initiation of increased ESG disclosure. Their findings are based on a large sample of 1,300 US companies, on average, and over the sample period from 1993 to 2007. In line with Dhaliwal et al.'s (2011) findings, El Ghoul et al. (2014) also report a negative relation between a company's environmental performance and the implied cost of equity for global manufacturing companies and high polluting sectors in the US.

Although the available evidence on the relationship between a company's ESG activities and the cost of debt is rather scarce, the empirical evidence is similar to prior findings related to the cost of equity. While Oikonomou et al. (2014) empirically establish that several dimensions of ESG concerns are negatively related to the cost of debt, Bauer and Hann (2010) corroborate these findings by focussing on one sub-dimensions of ESG, namely corporate environmental practices and its potential effects on a company's cost of debt capital. More specifically, using environmental management strengths and weaknesses, Bauer and Hann (2010) show that companies with better corporate environmental management enjoy lower cost of debt financing relative to companies with environmental concerns. Oikonomou et al. (2014) extend the analysis to a comprehensive list of several ESG dimensions and report that several fine-grained ESG themes such as sustainable community, employment, environment, and product safety and quality initiatives are negatively related to the cost of debt. In contrast, ESG controversies related to community and employment tend to increase the cost of debt (Oikonomou et al., 2014).

In the following chapter, my aim is to discuss theoretical arguments that could motivate a negative relation between the cost of capital and ESG disclosure, all else being equal. Drawing from Merton's (1987) model of market equilibrium with incomplete information, my theoretical arguments are related to the depths of a companies' investor base,

reductions in companies' beta (systematic risk), and reductions in companies' future litigation and reputational risks.

7.2.1.1 Depth of Companies' investor base

According to the Efficient Market Theory, when companies immediately materialise on profitable investment strategies they rapidly eliminate market abnormalities and inefficiencies93 (Fama, 1970; Jensen, 1968). This mechanism only works under the perfect market assumption that companies can immediately raise sufficient capital to trade on profitable investment strategies (Merton, 1987). However, as Merton (1987) and others (see e.g. Grossman and Stiglitz, 1980) highlight, "the dealer business is neither costless nor instantaneous" (Merton, 1987:485). Investment professionals have to follow regulatory capital requirements that could restrict the pursuit of every profitable investment strategy (Merton, 1987). Similarly, the assumption that any type of publicly available information will reach all investors immediately and that investors act on it instantly, may be somewhat simple (Merton, 1987:484).94

As a result, Merton (1987) developed a capital market equilibrium model with incomplete information by departing from the complete and instantaneous information assumptions. The key assumption in Merton's theoretical framework is that "an investor uses security k in constructing his optimal portfolio only if the investor knows about security k" (Merton, 1987:488). He argues that the information exchange between firm k and the investor only occurs after considerable "set-up" costs95 have been incurred. If investors have to pay considerable set-up costs for any company they wish to follow, then they will likely only follow a subset of all traded companies in the market (Merton, 1987).

With respect to a company's cost of capital, this implies that according to Merton's (1987) capital market equilibrium model with incomplete information, companies have an incentive to disclose more information as this increases investors' awarness of a company's existence and expands the investor base, which will reduce the firm's cost of capital and increase the market value of the company (Merton, 1987). In other words, to increase the depth of a company's investor base (and thereby reduce the cost of capital), management is

93 _{For example, through arbitrage.}

94 _{For example, while some information such as companies' earnings or dividend announcements could be} readily analysed by investors, other information such as published empirical discoveries (including the size anomaly) could take some time to be properly assessed by investors (Merton, 1987).

95 _{Set-up costs are fixed costs incurred by the investor for setting up a company's information exchange (Merton,} 1987). If an investor has to pay a significant set-up cost for each company, then any investor will likely only

encouraged to disclose more information to attract new investors who are not currently shareholders to incur the set-up costs that allow for a seamless information exchange between the investor and security k 96 (Merton, 1987).

7.2.1.2 Reductions in companies' beta

Another mechanism through which corporate disclosures on ESG activities could affect the cost of capital is beta or systematic risk (Dhaliwal et al., 2011). Within a framework consitent with a traditional model of market equilibrium, i.e. capital asset pricing model (CAPM), Lambert et al. (2007) investigate how better information disclosure quality or more precise firm-specific disclosures influence the cost of capital. Lambert et al. (2007) show that not only does better disclosure lower the variance of a copmany's cash flows, it also affects the covariances with other companies, which brings a company's cost of capital closer to the risk- free rate. According to Lambert et al.'s (2007) theoretical framework, these effects are nondiversifiable (systematic): "Moreover, this effect is not diversifiable because it is present for each of the firm's covariance terms and hence does not disappear in large economies." (Lambert et al., 2007:387). Lambert et al.'s (2007) study provides theoretical guidance for empirical assessments on the relationship between corporate disclosures of financial and non- financial activities and the cost of capital.

7.2.1.3 Future Litigation and Reputational Risks

Lastly, prior work suggests that socially irresponsible companies 97 are perceived as riskier investments because of potential future litigation and reputational risks (Bauer and Hann, 2010; Dhaliwal et al., 2011; El Ghoul et al., 2011; Starks, 2009).98 _{Brammer and Pavelin}

(2004) argue that ethically and socially unsound companies could face unexpected future claims based on companies' non-compliant behaviour. To give one example, if a company provides deliberately misleading information on their products and services, then this will increase the likelihood of future lawsuits against the company. Bankers Trust was involved in a controversy whereby employees of the bank had repeatedly misled customers with false valuations of their derivative contracts (Forbes, 1996). As a result, Procter and Gamble and

96 _{As mentioned in the previous section, security k refers to any security that an investor could consider when} constructing his optimal portfolio, only when he knows about a security (Merton, 1987).

97 _{Irresponsible companies are defined as companies pursuing irresponsible activities with negative} environmental and social impacts and externalities for stakeholders (Heal, 2005).

other former clients of the bank started a lawsuit against the bank, which cost the bank tens of millions of dollars in settlements (Forbes, 1996). 99

Companies that behave irresponsibly by violating environmental, social, or governance standards will likely be subject to fines, penalties, government sanctions and other associated litigation costs (Bauer and Hann, 2010; Oikonomou et al., 2014). These negative events could then manifest itself in higher cost of capital financing. As an illustration, Oikonomou et al. (2014) point out the increase of BP's bond yield spreads and downgrade of BP's credit rating from AA to BBB, immediately after the 2010 Deepwater Horizon oil spill in the Gulf of Mexico.

Furthermore, Hong and Kacperczyk (2009) provide evidence that "sin" companies' products 100 are more likely to be associated with increased litigation risks. "For example, tobacco companies faced substantial litigation risk until their settlement with state governments in 1997" (Hong and Kacperczyk, 2009:17). Similarly, Brammer and Pavelin (2004) argue that companies in the alcohol sector face increased litigation risks because they are associated with visible social issues such as crime and health related issues.

7.2.1.4 ESG Disclosure and Diversification

One could argue that these higher risks of low ESG disclosure companies (socially irresponsible companies) could be diversified away in a broad investor portfolio and not be "priced" in the cost of capital. My following arguments will explain why ESG disclosure could be "priced" in the cost of capital. First, as mentioned in Chapter 2.5.1. 'Pricing of ESG information', socially responsible investors do not have a preference for investing in companies with low ESG disclosures due to differences in tastes for certain assets (Fama and French, 2007; Galema et al., 2008; Hamilton et al., 1993; Heinkel et al., 2001). Consistent with efficient capital markets, Heinkel et al.'s (2001) capital market equilibrium model, shows that when fewer investors are available to hold the shares of irresponsible companies, then this will reduce diversification (risk-sharing) and increase companies' cost of capital. This means, if low ESG disclosure companies have a smaller investor base due to socially

99 _{My examination committee pointed out that future litigation costs could harm a company's expected cash} flows and growth opportunities only when future litigation costs exceed a certain threshold. While this is the case for "direct" costs, "indirect" long-term costs due to reputational loss could also lead to substantial financial harm (Brammer and Pavelin, 2004).

responsible investors' tastes, then their cost of capital will be higher (Merton, 1987).101 Second, according to Merton's (1987) equilibrium model "...expected returns seem to depend on both market risk and total variance", meaning that not just beta but also idiosyncratic risk matters for pricing (Hong and Kacperczyk, 2009). Ultimately, low ESG disclosure companies could have higher cost of capital due to higher non-diversifiable risks.102 Based on the beforementioned arguments and discussion, I state my hypotheses as follows:

Hypothesis 1: Companies with high Environmental, Social, and Governance (ESG) disclosure quality have lower expected cost of equity.

Hypothesis 2: Companies with high Environmental, Social, and Governance (ESG) disclosure quality have lower expected cost of debt.

In the following chapter, I will continue to describe the more technical details of my chapter including my empirical models to test the above hypotheses.

7.3 Research Design