Institutional investors divesting polluting firms' bonds: ISF working paper

Toxic spills into the air, land and water are significant threats to the environment and human health, and a substantial risk for investors. New research supported by the Institute for Sustainable Finance at Smith School of Business, Queen’s University, shows that institutional investors are divesting from corporate bonds in response to significant pollution events, restricting access to capital by polluting firms.

In a working paper titled “Toxic Assets: Divestment of polluting firms’ bonds by institutional investors”, authors Evan Dudley, PhD, and Minkang (Michael) Kim show that because large investors such as pension funds, insurance firms and mutual funds have long investment horizons, often over human lifetimes to fund retirements, they are sensitive to the risk of stranded assets. Asset stranding is when otherwise productive facilities like factories become unviable due to harmful effects on society.

Download the working paper here.

“We know that for corporate managers, cost of capital is a first order concern. In an extreme scenario, the corporate bond market can be closed for firms that are judged as too risky,” said Evan Dudley. “Should a firm be involved in a large toxic release, for example, the value of its bonds will decrease dramatically, and it may be unable to issue new debt to replace the old debt, thus precipitating the firm into bankruptcy.”

The authors studied firms regulated by the U.S. Clean Air Act and found that:

• Institutional investors react to significant toxic release events, divesting their holdings of polluters’ corporate bonds. More concentrated toxin releases have greater potential to be harmful to humans or to create environmental damage, exposing the firm to greater stranded asset risk.
• Depending on the type of investor, corporate bond sales vary between 7% and 40% of the investor’s holdings of the polluting firm’s bonds over the four calendar quarters following a pollution event. These sales are not subsequently reversed.
• Bonds sold by more informed investors experience a permanent -1.3% cumulative abnormal price decline over the year following divestment. This is similar in magnitude to the impact of fire-sales by institutional investors around significant credit downgrades from above to below investment grade.
• The decline in price is considerable, particularly given the average bond issue size in the authors’ sample is $US13.1-billion. Turnover in a firm’s investors through exit by informed investors will increase a firm’s cost of capital.
• While the effects of pollution on humans and the environment may be indirect and take time to manifest, and thus take time for regulators to enforce, capital markets penalize firms almost immediately for excessive pollution. Polluting firms need to adapt to a changing regulatory environment by reducing their pollution levels accordingly.
• Pollution has a direct effect on health outcomes ranging from increased infant mortality rates, illness including higher childhood brain tumours, and economic effects including lower labour earnings and labour-force participation. Reducing pollution should be an important consideration for responsible investing.

In the U.S., on which the study data is based, there are over $US10-trillion of corporate bonds outstanding, many of them issued by large polluting firms and owned by large institutional investors. Because of its size and importance, the corporate bond market can play a significant role in reducing pollution by limiting the financing of pollution.

This research is presented in a working paper, a work in progress that has not yet been peer reviewed or published in an academic journal, to raise awareness of important new research and to receive feedback and build on this work. It has been supported by ISF and the Canadian Sustainable Finance Network through the CSFN Research Grant.

About the authors

Dr. Evan Dudley is an Associate Professor & Distinguished Faculty Fellow of Finance at Smith School of Business (evan.dudley@queensu.ca)

Minkang (Michael) Kim is a PhD candidate at Smith School of Business (21mk52@queensu.ca)

 

The Institute for Sustainable Finance was launched in 2019 as the first-ever cross-cutting and collaborative hub in Canada that fuses academia, the private sector, and government with the singular focus of increasing Canada’s sustainable finance capacity. The institute's mission is to align mainstream financial markets with Canada’s transition to a prosperous sustainable economy.