Is Environmental Performance a Determinant of Bond Pricing? Evidence from the U.S. Pulp and Paper and Chemical Industries*

Abstract

In this study I provide evidence that there is an economically significant relation between a firm’s environmental performance and its bond yields. Firms that have poor environmental performance will face future environmental liabilities related to compliance and clean-up costs due to increasingly strict environmental laws and regulations. These liabilities are large enough to drive polluting firms into bankruptcy and can leave bondholders’ claims subordinate to environmental liabilities. I also find evidence that the relation between environmental performance and bond yields fades as bond quality increases, which is consistent with the non-linear pay-off structure of bonds. This study focuses on two of the most polluting industries in the U.S., chemical and pulp and paper. The paper’s findings support ongoing calls for greater cooperation between the Securities and Exchange Commission (SEC) and the U.S. Environmental Protection Agency (EPA), which would allow for the reporting of quantifiable environmental information in firms’ disclosures. It also provides evidence of environmental performance as a determinant of bankruptcy risk. Bankruptcy due to a history of poor environmental performance often leaves the related environmental liabilities underfunded. Many regulators are required to ensure adequate funds are available for remediation to match ongoing environmental degradation. Thus, the interplay between a firm’s bankruptcy risk and its environmental performance has broad implications.