Increased stakeholder awareness and concern for the environment as well as the tighter environmental laws and regulations have led to corporate environmental issues becoming a topic of both theoretical and empirical research (Al-Tuwaijri, Christensen & Hughes 2004; Case 1999, p.1; Charter & Polonsky 1999; Connors & Sliva-Gao 2009; EPA 2000; Ernst & Young 2003; Jenkins 2002, p.3; Klassen & Whybark 1999). This study will investigate the impacts of corporate environmental performance on the cost of bank loans and covenants included in bank loan contracts for Australian firms.
Regarding the impact of corporate environmental performance on the cost of debt, Schneider (2008) indicates that corporate environmental performance in the U.S pulp and paper industry is negatively related to the cost of public debt. There are also some other studies relevant to this topic (Goss & Roberts 2008; Sharfman & Fernando 2008; Webb 2005). However, these studies are all based in the United States. Little research has been done regarding the impact of corporate environmental performance on the cost of debt for Australian firms. To fill this gap, this study will examine how and to what extent corporate environmental performance impacts on the cost of debt in the context of Australia. In Australia, bank loans are the main source of firms' finance rather than public debt (Cotter 1998b). As such this study will focus on the cost of bank loans for Australian firms.
There has been little research about covenants in bank loan contracts in Australia and the relationship between corporate environmental performance and the loan covenants (Booth & Chua 1995; Cotter 1998a; Mather 1999). This study will explore how corporate environmental performance impacts on the covenants in bank loan contracts in Australia.
Clarkson, Overell & Chapple (2008) employ the emissions data in the National Pollutant Inventory(NPI) as the measurement for Australian firms' environmental performance. This study will follow Clarkson, Overell & Chapple (2008) in employing the NPI to measure corporate environmental performance for Australian firms.
The cost of bank loans is determined by the overall quantification of risk (Coulson & Monks 1999). Thus for the cost of bank loans, this study expects to measure it with drawn All-in-Spread (AIS) in basis point which is the yield spread paid in basis point over London Interbank Offer Rate(LIBOR) for each dollar drawn down under loan agreements.
The research problem to be addressed is:
How does corporate environmental performance impact on the cost of bank loans and the loan covenants for Australian firms?
To answer the research problem three research questions have been developed:
- How do banks evaluate corporate environmental performance and assess environmental risks?
- How does corporate environmental performance influence the bank loan covenants?
- To what extent does corporate environmental performance impact on the cost of bank loans?
The following proposition and hypothesis stem from the research questions above:
Proposition: There are environmental covenants in bank loan contracts responding to corporate environmental performance.
Hypothesis: Firms with superior environmental performance are rewarded by lower cost of bank loans.
This study will use a mixed methods approach of both qualitative and quantitative methods. A qualitative approach will be used in the first phase of this study to interview senior managers of the five banks in Australia who are responsible for corporate lending policies and practices. It is expected that the findings from the interviews in the initial qualitative phase will lead to the development of further hypotheses for the quantitative stage of the study.
Background and Motivations for the Study
Corporate environmental issues are fundamental part of corporate sustainability considerations and have been the subject of wide ranging research (Connors & Sliva-Gao 2009; EPA 2000; Feldman, Soyka & Ameer 1996; WBCSD 1999). It is now widely accepted that the corporate environmental issues affect a firm's profitability as well as its strategic direction (Hoffman 2000, p.3).
Stakeholders of firms are becoming more environmentally aware and as such environmental issues have become common concerns in the debate about sustainability in the corporate world (Bansal & Howard 1997, p.2). As a consequence of these concerns, there has been an increase in the breadth of environmental regulations in an attempt to mitigate some of the negative impacts and improve the environmental sustainability of business (Case 1999, p.1; Jenkins 2002, p. 3).(See Figure 1)
As Figure 1 shows, firms are motivated to be good environmental performers in order to meet expectations of stakeholders as well as comply with environmental laws and regulations (Elijido-Ten 2007; Watson et al. 2004). Godfrey (2005) argues that improved environmental performance results in less business failure risk from environmental penalties, remediation costs and/or legal sanctions. Therefore, falling behind on environmental sustainability impedes the long-term development of the firms, due to obstacles such as reduced choices in sources of financing and poor public perception of the firms' products and services (Charter & Polonsky 1999; WBCSD 1999). Therefore, corporate environmental performance is a high-priority issue (Charter & Polonsky 1999).
According to Salzmann, Ionescu-somers & Steger (2005), corporate environmental performance has not been fully explored in the literature. Prior studies on the influence of corporate environmental issues on capital markets have been primarily concerned with the cost of equity capital, with little attention been given to the impact of corporate environmental performance on the cost of debt (Connors & Sliva-Gao 2009; Feldman, Soyka & Ameer 1996; Koehler 2006; Schneider 2008). Debt financing is also an important part of the capital structure of firms and the cost of debt influence firms' accessibility to debt (Elijido-Ten 2007; Ruf et al. 2001). Debt financing is quite different from equity financing in that creditors bear a firm's downside risk but do not share in its upside growth and as a consequence creditors and shareholders may evaluate a firm's status from different perspectives (Deegan, C 2007; John (Xuefeng) 2007).
The work that has been done on the relationships between corporate environmental performance and the cost of debt are mainly based in United States due to the availability of a wide range of data of sources relating to environmental performance and debt issuance (Koehler 2006; Schneider 2008; Sengupta 1998; Sharfman & Fernando 2008). Schneider (2008) suggests that research on the relationship between corporate environmental performance and the cost of debt needs to be undertaken outside United States to expand the scope of this topic.
In Australia, environmental concerns have stimulated significant debate and as a result businesses are faced with ever increasing environmental accountability and regulations (Ramsay & Rowe 1995, p.101 & p.475). There are mandatory requirements for Australian firms to report the impacts of their activities on the environment such as Section 299(1)(f) of the Corporation Law and the NPI reporting requirements (Ernst & Young 2003; Frost & English 2002, p.476; Ramsay & Rowe 1995). While the environmental regulatory situation in Australia is quite different from that in United States (Jenkins 2002, p. 4). Ernst & Young (2003) indicates that there is some doubt about the level of enforcement of environmental laws in Australia as the environmental disclosure regulations are less developed when compared to United States. Furthermore, the Australian debt market is also much smaller than that in United States (The Allen Consulting Group Pty Ltd 1996, P6; Valentine, Ford & Copp 2003, P74). As such there is a clear need for this research to be undertaken in Australia to gain new insights into the relationship between environmental performance and the cost of debt.
Cotter (1998b) argues that Australian firms use bank loans as the main source of financing rather than public debt. Valentine et al.(2003, p19) also indicate that bank loans rather than bonds weigh more in the financing structure of non-financial firms in Australia. Although it seems that there is little effect of environmental issues on banks, the bank loans for firms are increasingly exposing banks to environmental risks in forms of direct risk, indirect risk and reputational risk, with legal compliance being the main driver (Case 1999, p.9; Ernst & Young 2003; Sarokin & Schulkin 1991; Thompson 1998). To succeed, the lending banks have to ensure that the loan contract terms such as the cost of bank loans and covenants finely accord with their overall risk exposure (Coulson & Monks 1999; Glantz 2003, p.1). Consequently, the exposure to the environmental risks gives banks incentives to incorporate environmental issues into their lending activities (Coulson & Monks 1999; Thompson 1998; Weber, Fenchel & Scholz 2005). Coulson & Monks (1999) indicate that firms with superior environmental performance are rewarded by their lending banks and the benefit may be in the way of lower cost of bank loans. For example, the Co-operative Bank in the United Kingdom (UK) rewards good environmental performers with lower interest rates on loans (Coulson & Monks 1999).
The report to Environment Australia by Ernst & Young (2003) points out that the financial institutions including banks in Australia have conducted environmental risk analysis in their lending processes. Ernst & Young (2003) also demonstrates that there is a growing significance of environmental risks towards financial institutions of Australia, with 57 percent of them considering environmental risks as "business as usual" and another 30 percent taking them as occasional considerations. Australia and New Zealand Banking Group Limited (ANZ) has developed policies for managing environmental risks (ANZ 2009). However, limited research has been done to examine the impact of corporate environmental performance on the cost of bank loans for Australian firms.
It is not surprising that banks need to consider corporate environmental performance in their lending processes. There is evidence that banks integrate environmental issues with lending processes mainly through environmental risk management (Coulson & Dixon 1995; Fineman 2000, p.79; Thompson & Cowton 2004). However, the knowledge on how banks assess environmental risks and integrate environmental risks with their lending decisions in Australia is still scarce (Ernst & Young 2003). There is suggestion that further research is needed to develop approaches to environmental risks measurement and expand the knowledge on the ways banks integrate environmental issues with their lending processes (Ernst & Young 2003; Thompson 1998; Thompson & Cowton 2004).
Incorporating environmental covenants into bank loan contracts may be one of the ways factoring environmental risks into lending activities (Case 1999, p.104). Covenants are one of the common features of bank loan contracts which put restrictions or requirements on borrowing firms (Rajan & Winton 1995). The covenants in bank loan contracts have the function of reducing the risk exposures of lending banks and the agency cost of debt, which further lowers the cost of bank loans (Deegan, C 2007; Paglia 2002). Case (1999, p.104) indicates that the incorporation of environmental covenants into bank loan contracts responding to corporate environmental performance may be particularly effective in protecting banks from default risk exposure. As for the number and tightness of bank loan covenants, El-Gazzar & Pastena (1991) indicate that the loan characteristics and firms' status have effects on the number and the tightness of loan covenants, with corporate environmental performance not been considered.
Little evidence has been provided for the influence of corporate environmental performance on the bank loan covenants in Australia. The Equator Principles provide a framework for banks to manage environmental issues in project financing which include incorporating environmental covenants into loan agreements (EPFI Best Practice Working Group 2009). However, when adopting the Equator Principals banks find necessary and are allowed for changes (Cornwell, Spargo & Millhouse 2005; EPFI Best Practice Working Group 2009; Thomas 2004). As such conclusion can not be drawn on whether the banks include environmental covenants into their environmental management for project financing. In addition, the Equator Principals are for project financing rather than traditional corporate lending. Therefore, to fill the gaps identified above, this study will investigate the impacts of corporate environmental performance on the cost of bank loans and the loan covenants for Australian firms.
Scope of the study
This study focuses on firms' underlying environmental performance rather than their environmental disclosures. While there has been an increase in environmental disclosures for Australian firms in recent years, the positive information being disclosed exceeds the negative information suggesting that it is self-laudatory in nature rather than being objective (Clarkson, Overell & Chapple 2008; Deegan, Craig & Gordon 1996; Deegan, C & Rankin 1996; Frost & English 2002). As a consequence environmental disclosure is not necessarily an accurate reflection of firms' underlying environmental performance (Clarkson, Overell & Chapple 2008).
A key issue in this research is the measurement of corporate environmental performance. In the United States environmental performance is routinely measured using the data from Toxic Release Inventory (TRI) of EPA whose validity has already been tested and widely accepted (Connors & Sliva-Gao 2009; Schneider 2008). In Australia the National Pollutant Inventory (NPI) has been used by Clarkson, Overell & Chapple (2008) to measure firms' environmental performance. The NPI and TRI have similar basis and thus Clarkson, Overell & Chapple (2008) conclude that the measurement of corporate environmental performance based on NPI is an acceptable measure for Australian future research. As such this research will follow the methodology of Clarkson, Overell & Chapple (2008) in using the NPI to measure corporate environmental performance. This measurement is the quantity of hazardous emissions rather than financial ratios and qualitative rankings.
Given that the majority of corporate debt in Australia is bank loans rather than public debt, this study will investigate the impact of corporate environmental performance on the cost of bank loans for Australian firms. Both secured and unsecured bank loans are expected to be included in this study. Syndicated loans, project financing and relationship banking are expected to be beyond the scope of this study.
When referring to the impact of corporate environmental performance on the covenants in bank loan contracts, the key focus of this study is on the environmental covenants associated with bank lending arrangements. It is important to note that banks are able to leverage more information from corporate borrowers during the lending appraisal process than firms make available for public debt issues resulting in lower risk of information asymmetry in private lending arrangements (Goss & Roberts 2006). As a consequence, the information requirements sought by banks will be an important aspect in determining how they evaluate corporate environmental performance and assess environmental risks and in turn how those affect the cost of bank loans. This study will conduct interviews to explore the information requirements.
In summary this research will be limited to Australian firms listed on the Australian Stock Exchange (ASX). The following section sets out the relevant literature of this research in more details.
Given stakeholders' significant concerns about environmental issues as well as Australian firms' dependence on bank loans (Cotter 1998b; Elijido-Ten 2007), this study will explore how corporate environmental performance impacts on the cost of bank loans and loan covenants for Australian firms. Given agency relationships that exist between firms and lenders this study will be approached from the perspective of agency theory.
Corporate Environmental Performance
Corporate environmental performance is a multidimensional and complex concept which leads to difficulties in figuring out an agreed-upon definition and measurement of corporate environmental performance (Bennett, James & Klinkers 1999; Epstein 1996; Ilinitch, Soderstrom & Thomas 1998; Klassen & McLaughlin 1996; Lober 1996; Talbot et al. 2001).
Although various definitions of environmental performance can be found in the literature, Klassen & McLaughlin(1996) conclude that the ill-defined environmental performance in the industry remains an issue. According to International Organization for Standardization (ISO)'s ISO 14001:2004 (cited by Perotto et al. 2008), the definition of environmental performance is:
"Measurable results of an organisation's management of its environmental aspects".
The environmental aspects are "elements of an organization's activities or products or services that can interact with the environment".
The ISO 14000 series definition is ambiguous due to the consensus-orientated definition process (Schaltegger & Wagner 2005, p.54). It is ambiguous in that it doesn't solve the following points: (1) What are the environmental aspects on? (2) When are the impacts happening (dynamic issues)?
Schaltegger & Wagner (2005, p.54) define environmental performance as:
"Environmental performance is the change of a firm's environmental impact over time."
This definition solves the dynamic points while has the problems regarding to the issues that whether the change is measurable and what the environmental impact is on. In addition, environmental impacts are already the changes resulting from environmental aspects (Perotto et al. 2008).
As mentioned in previous part, the main drivers for corporate environmental concerns are environmental laws and regulations as well as stakeholders' environmental awareness (Al-Tuwaijri, Christensen & Hughes 2004; Case 1999, p.1; Charter & Polonsky 1999; Connors & Sliva-Gao 2009; EPA 2000; Ernst & Young 2003). This study will explore banks' respondence for borrowing firms' corporate environmental performance. To fit in this study, the definition of corporate environmental performance needs to include the impacts of firms' environmental performance on stakeholder (banks) relations. In addition, in terms of banks' environmental risks exposure with legal compliance been the main driver, the definition is supposed to incorporate the firms' compliance with environmental laws and regulations.
Based on the examination of the literature on corporate environmental performance and the context of this study, the definition of corporate environmental performance in this study is presented as follows:
Corporate environmental performance measures a firm's environmental impacts on stakeholder relations and the firm's compliance with regulations and laws over time.
In this study, stakeholder relations refer to the interaction between firms and their lending banks. Compliance refers to "the degree to which companies meet minimum standards required by laws and regulations" (Ilinitch, Soderstrom & Thomas 1998). Emissions to land, air and water are included in the environmental impacts being significant importance for banks and also under tight scrutiny of Australian laws which are quantifiable (Ernst & Young 2003).
Bank Loan Covenants and Environmental Risk
Bank loans usually have tight covenants imposing restrictions on borrowing firms (Carey et al. 1994, p.32). They provide frameworks for the agreed-upon financial plans between lending banks and firms (Glantz 2003, p.42). Generally, the covenants in bank loan contracts include affirmative covenants and negative covenants (Booth & Chua 1995; Paglia 2002; Strahan 1999). Affirmative covenants are requirements and obligations that the borrowing firms have to meet while negative covenants are used to restrain borrowing firms from dissipating their assets which impairs the banks' interest (Booth & Chua 1995; Glantz 2003, p.42-43; Paglia 2002; Strahan 1999). In bank loan contracts, the negative covenants are usually financial covenants which are in the form of financial ratios (Booth & Chua 1995). Leverage ratios, interest coverage ratios, current ratios and prior charges ratios are the most widely accepted financial covenants in bank loan contracts for listed Australian firms (Cotter 1998b).
Consistent with Smith & Warner (1979), the moral hazard problems inherent in lending banks-firms relationships are dividend payout, claim dilution, asset substitution and underinvestment which induce the agency cost of debt. As such banks have incentive to demand high interest rate for the loans (El-Gazzar & Pastena 1991). Covenants provide a mechanism which is both ex ante and ex post for controlling these sources and thus avoiding the higher interest rate than it otherwise is (Carey et al. 1994, p.34; El-Gazzar & Pastena 1991; Smith & Warner 1979). Covenants put restrictions on borrowing firms' activities which are anticipated to erode lending banks' wealth. Also, the lending banks may have rights to force firms into bankruptcy, renegotiate the contracts terms or put more restrictions on firms when there are violations on covenants (Carey et al. 1994, p.34; Paglia 2002). In addition, through the mechanism of covenants for controlling asset substitution and underinvestment, the covenants in bank loans can also enhance the firm value which protects lending banks' claim on firms' assets (Carey et al. 1994, p.35; Smith & Warner 1979).
Covenants play significant role in bank loan contracts to protect banks from risk exposure and have been incorporated into banks' risk management (Glantz 2003, p.25; Paglia 2002). To succeed, the lending banks have to ensure that the loan contracts terms finely accord with the risk exposure of banks (Glantz 2003, p.1). Corporate environmental issues expose lending banks to environmental risks via banks' lending activities (Thompson 1998). Case (1999, p.9) identifies that environmental risks impact on lending banks through three ways:
- Direct risk: Collateral is a common feature of a bank loan which is in the form of specific assets of borrowing firms such as land (Rajan & Winton 1995). When the loans are secured by collateral, banks are likely to be liable for the legal environmental liabilities because of borrowing firms' pollution on the collaterals (Case 1999, p.9; Coulson & Monks 1999).
- Indirect risk: Indirect risk arises when the impacts of environmental issues impair the firms' ability to repay the bank loans which increases the risk exposure of banks and when there are contaminations on the collaterals for banks which erodes the value of collaterals (Case 1999, p.10).
- Reputational risk: Reputational risk results from the banks' lending activities towards firms with poor environmental performance or banks' associations with these firms, which expose lending banks to image or reputation damage (Case 1999, p.12; Thompson 1998).
Therefore, banks need to incorporate environmental issues into lending decisions to manage their environmental risks exposure and to make the cost of bank loans and the covenants more reasonable and reliable (Coulson & Monks 1999). It is widely accepted that environmental performance are incorporated into lending processes mainly through environmental risk management (Coulson & Dixon 1995; Thompson & Cowton 2004).
In June 2003, ten leading banks from seven countries adopted the Equator Principles which provide a benchmark for assessing and managing environmental risks of financial institutions in project financing, with environmental covenants being one of the principles (EPFI Best Practice Working Group 2009). The incorporation of environmental covenants is an advantage of Equator Principles (EPFIs 2006). However, the Equator Principles are general guidelines for financial institutions and voluntary-based, changes and refinements are needed and allowed when a bank adopt them for environmental risk assessment and management and thus the implementation and accountability is questionable (Thomas 2004). Therefore, although ANZ, National Australian Banks and Westpac Banking Corporations in Australia have adopted Equator Principles, little knowledge has been known regarding the environmental risk assessment of banks in Australia and whether they incorporate environmental covenants in bank loan contracts. Additionally, Equator Principles are for project financing rather than traditional corporate lending leading to even less literature on them. These lags link to the proposition of this study.
Corporate Environmental Performance and the Cost of Debt
Goss and Roberts (2008) examine if banks take the levels of corporate social responsibility as a consideration for interest rate of loans based on the data of 732 U.S firms from 1991 to 2003. For the firms with worst level of social responsibility, the banks charge 16 basis points higher yields. The conclusion by Goss and Roberts (2008) is that banks charge higher yields for firms with low levels of social responsibility but do not reward firms with higher levels of social responsibility. Goss and Roberts (2008) take corporate social responsibility as an overall concept resulting in no conclusion regarding the impact of corporate environmental performance on the cost of bank loans. Webb (2005) analyses the subsets of corporate social responsibility respectively, with corporate environmental index included. Webb (2005) develops the study employing KLD Socrates Database during the period of 1993 to 2000 which is cross-industry and U.S based. From the agency theory perspective, Webb (2005) concludes that firms with superior corporate environmental performance have lower agency cost of debt and thus have more debt financing. However, Webb (2005) does not give clear justification on the question that whether superior corporate environmental performance is rewarded by lower cost of debt and he focuses on public debt rather than bank loans.
Sharfman and Fernando (2008) also investigate the relationship between environmental performance and the cost of public debt but from the view of environmental risks management. They predict that superior environmental performance through undertaking environmental risks management merits lower cost of debt as a result of default risk reduction. However, the result from empirical examination is contrary to this prediction. Schneider (2008) also investigates the relationship between corporate environmental performance and the cost of public debt but documents opposite results to that of Sharfman and Fernando (2008). Schneider (2008) indicates that firms with superior corporate environmental performance are rewarded by lower cost of public debt.
Specified to the linkage between crporate environmental performance and the cost of bank loans, Coulson & Monks (1999) indicate that the benefit for firms with superior environmental performance may be in the way of lower cost of bank loans. They provide evidences that National Westminster Bank rewards firms with superior environmental performance with more favourable fixed rate loan and Co-operative Bank rewards lower interest rates on loans which are UK based and thus there is lack of generalization. In addition, although Thompson & Cowton (2004) indicate that lending banks screen the firms with poor environmental record, the environmental record is law/regulation-compliance based rather than corporate environmental performance based. Therefore, there is still no clear conclusion on the impact of corporate environmental performance on the cost of bank loans. Thus this study develops hypothesis to test to what extent the corporate environmental performance impacts on the cost of bank loans.
Gaps in the Literature
Based on the literature review above, this study identifies the gaps as follows:
- There is no agreed-upon definition and measurement of corporate environmental performance as a result of its multidimensional and complex characteristics.
- There has been limited research looking at the impact of corporate environmental performance on the cost of bank loans. It seems that none prior research regarding the impact of corporate environmental performance on the cost of bank loans has been done in the context of Australia.
- There is little literature about banks' environmental risk assessment in Australia and how corporate environmental performance impacts on the covenants in bank loans and how do the impacts relate to the cost of bank loans in Australia.
THEORETICAL FRAMEWORK AND HYPOTHESIS
This study contends that there are impacts of corporate environmental performance on the cost of bank loans and the loan covenants. In this section the theoretical linkage between corporate environmental performance and the cost of bank loans as well as the loan covenants are described. The literature underlying the theoretical framework is consolidated. The theoretical framework of this study consists of firm characteristics and loan characteristics, corporate environmental performance, environmental covenants in bank loan contracts and the cost of bank loans (See figure 2). Agency theory will contribute to the explanation regarding the expected impacts of corporate environmental performance on the cost of bank loans and the loan covenants.
Corporate environmental performance is considered to be linked with the cost of bank loans (Goss & Roberts 2006; Sharfman & Fernando 2008). This study posits that the corporate environmental performance being the independent variable is negatively correlated with the cost of bank loans.
With the tighter environmental laws and regulations being the main driver, banks are increasingly exposed to environmental risks resulting from the firms' environmental performance (Case 1999, p.9; Sarokin & Schulkin 1991; Thompson 1998). Therefore, banks are given incentive to integrate environmental issues into their lending processes to manage their risk exposures (Coulson & Monks 1999; Thompson 1998; Weber, Fenchel & Scholz 2005). Loan covenants have the function of controlling the problems between lending banks and firms and thus reducing the agency cost of debt and risk exposures of lending banks (Carey et al. 1994, p.34; Glantz 2003, p.25; Paglia 2002). Case (1999, p.104) also indicates that environmental covenants in bank loan contracts may be particularly effectively in protecting lending banks from the exposure to default risk. This study assumes that there are environmental covenants in bank loan contracts.
Agency Theory and Proposition as well as Hypothesis Development
Agency theory underpins the relationship between corporate environmental performance and the cost of bank loans as well as the impacts of corporate environmental performance on the covenants in bank loan contracts. Problems existing in agency relationships result from the delegation of decision-making from the principal to the agent (Davis 1995, p.92; Deegan, C 2007). As Jensen & Meckling (1976) point out, agency cost of debt and equity arise from the problems between principals and agents. Agency theory addresses two problems in agency relationships (Eisenhardt 1989; Jensen 1983; Jensen & Meckling 1976). The first problem results from divergent goals of principals and agents, related to which is the cost of monitoring the activities of agents (Bamberg, Spremann & Ballwieser 1987, p. 6, p. 39; Davis 1995; Eisenhardt 1989; Jensen & Meckling 1976). The second problem arises because of different risk attitudes between principals and agents (Eisenhardt 1989). Banks who provide loans to firms are principals and the firms are the agents. Firms have incentives to enhance wealth for their shareholders at the expense of the banks through claim dilution, dividend payout, asset substitution and underinvestment, which increase the risk exposure of banks (Davis 1995; Smith & Warner 1979). Thus the agency cost of debt is induced (Jensen & Meckling 1976).
Claim dilution, excessive dividend payout, asset substitution and underinvestment lead to reduced ability of a firm to service their bank loans, which indicates higher default risk on loans (Davis 1995; Deegan, C 2007, p.100). To compensate for the incremental default risk, banks will charge higher risk premiums for firms resulting in higher interest rates and thus higher costs of bank loans (Deegan, C 2007, p.100). Firms with superior environmental performance have less exposure to extreme negative environmental event and thus less environmental laws and regulations violations, which lead to lower excess future cash flow demand resulting from environmental liabilities and sanctions (Godfrey 2005; Goss & Roberts 2006; Sharfman & Fernando 2008). As a result, the possibility for firms to issue new debt to satisfy the excess cash flow demand is relatively lower, which may avoid incremental risk exposure to higher leverage and claim dilution for the current lending banks. Moreover, firms with superior environmental performance tend to have good reputations which can result in the alleviation of excess dividend payout, asset substitution and underinvestment as well as less monitoring imposed on firms and thus lower cost of bank loans (Diamond 1991).
Further, there are three implications for less exposure to extreme negative environmental event and higher level of compliance to environmental laws and regulations. The first implication is that there is less hidden negative private information of firms which lowers the firms' uncertainty. The level of risk draws on the level of uncertainty inherent in firms' future activities (Miller & Bromiley 1990; Orlitzky & Benjamin 2001). Therefore, the compensation for the risk exposure to the uncertainty of firms' activities is lower, that is, lower risk premium in interest rates. Thompson & Cowton (2004) indicate that lending banks screen the firms with poor environmental record which is law/regulation-compliance based. Thus the second one is that there is easier accessibility to bank loans for the firms with superior environmental performance. Additionally, less negative private information and lower level of uncertainty of firms may enhance the credit ratings of firms which are awarded by lower cost of bank loans (Diamond 1991). Coulson, A. B. & Monks (1999) indicate that firms with superior environmental performance are equipped with minimized compliance risk and lower environmental credit risk, which may be rewarded by lower cost of bank loans.
The discussion above leads to the following Hypothesis:
Firms with superior environmental performance are rewarded by lower cost of bank loans.
The nature of bank loans is contracts between firms and their lending banks (Jensen & Meckling 1976). According to agency theory, the optimal solution to the problems inherent in bank loans is through incentives compatible and risk sharing bank loan contracts which document the agreements between banks and firms (Bamberg, Spremann & Ballwieser 1987, p.39; Jensen & Meckling 1976). As the contracts between firms' bondholders and shareholders demonstrated by Jensen & Meckling (1976), there are covenants included in bank loan contracts to prevent the wealth transfer from banks to the shareholders of firms and thus reduce the agency cost of debt.
Covenants in bank loan contracts have the function to reduce lending banks' risk exposure and the loan covenants violations carry higher cost of bank loans (Booth & Chua 1995; Deegan, C 2007, p.101; Paglia 2002). The covenants in bank loan contracts have been incorporated into banks' risk management (Paglia 2002). With environmental issues becoming more and more public concerned, lending banks are undertaking environmental risks in forms of direct risk, indirect risk and reputational risk (Case 1999, p.9; Thompson 1998). Reducing banks' default risk exposure, loan covenants have to reflect the overall risk expose of lending banks which implies a need to have covenants responded to environmental risks (Glantz 2003). Case (1999, p.104) indicates that the incorporation of environmental covenants in bank loan contracts may be particularly effective in protecting banks from default risk exposure which can be caused by environmental liabilities and reputational effects. Therefore, it is reasonable and valuable to include environmental covenants in bank loan contracts to manage environmental risks for banks and thus avoid the higher cost of bank loans than it otherwise is.
Given that banks' overall risk exposure in lending processes has influence on covenants in bank loan contracts, there is implication that the loan covenants should reflect environmental risks (Coulson & Monks 1999).
This study will be a mix of qualitative approach and quantitative approach in collecting and analysing data which facilitates the conjunction of exploratory and confirmatory, interpretive and predictive as well as validity and reliability (Leedy & Ormrod 2005, p.106). A sequential exploratory strategy will be employed in this study which can identify the variables for the subsequent quantitative approach (de Vaus 2006, p.271). The two-stage sequential exploratory strategy fits this study in that it helps explore phenomena by qualitative approach and expand the findings with subsequent quantitative approach (Creswell 2003, p.16; de Vaus 2006, p.271). This study will be conducted as follows:
Phase one: This study will firstly employ qualitative approach to obtain information about the following: (1) What are the impacts of corporate environmental performance on bank loan contracts for Australian firms? This includes the cost of bank loans and environmental covenants; (2) How do banks measure corporate environmental performance and assess environmental risks; (3)What is the nature of environmental covenants and how do lending banks customise environmental covenants to account for the varying environmental risks of firms (number, tightness and type);and (4) How do the impacts of corporate environmental performance on the covenants in bank loan contracts relate to the cost of bank loans?
Phase two: Depending on the information obtained from phase one, more hypotheses may be developed. This second phase of the research will test the current hypothesis as well as any additional hypotheses that are able to be developed. This study will use secondary quantitative data for hypotheses testing.
Data Collection and Sample
The qualitative data of this study will be obtained from the interviews conducted with the senior managers being responsible for loans lending to listed firms from five banks in Australia. The five banks in Australian are ANZ Banking Group Limited, Commonwealth Bank of Australia, National Australian Bank Limited, Westpac Banking Corporation and Macquarie Bank. This study will conduct interviews with one senior corporate lending manager in each bank. Human ethics approval will be applied from the Human Research Ethics Committee of University of Southern Queensland before conducting interviews.
The categories of quantitative data employed in this study are as follows: data on the measurement of corporate environmental performance, data on bank loan characteristics, data used to proxy firm characteristics variables and data used to construct the indicators of covenants in bank loans if necessary.
Data on the measurement of corporate environmental performance will be obtained from National Pollutant Inventory (NPI) reported by Australian government. NPI is an Australian database of pollutant emissions on air, land and water which is managed by the Australian Government on behalf of the Australian States and Territories. There are pollutant emissions and transfers data from approximate 4000 industry facilities as well as diffuse data assessed by state and territory environment agencies in the NPI. NPI lists approximate 93 pollutant substances and their reporting thresholds. The industrial facilities are required to report their pollutant emissions on certain substances to NPI if the substances exceed the NPI reporting thresholds. There are consistent measurements for the emissions reported to NPI approved by Commonwealth, state and territory environment agencies which facilitate cross-sectional and longitude research by enhancing comparability (Australian Government 2009; NPI 2008).
Measurement of corporate environmental performance based on NPI is empirical and quantitative which may be well-accepted by future Australian research (Clarkson, Overell & Chapple 2008). The NPI data is available to public through Internet and has easier access than TRI data (Australian Government 2009; Howes 2001). NPI allocates a "Total Risk" score to each emission substance rather than weigh every emission substances equally which results in a risk-adjusted measurement (Clarkson, Overell & Chapple 2008).
In addition, through consultation Ernst & Young (2003) indicates that emissions on land, air and water are of significant importance to banks. Pollution and contamination of land, air and water resources is tightly regulated under Australian law which carry public concerns (Ernst & Young 2003).
This study will source the data on the cost of bank loans and bank loan characteristics, either from DealScan, which is published by Loan Pricing Corporations, or from the AXS and OSIRIS database. The DealScan database includes detailed information on both nonprice terms and price terms of loan contracts such as loan maturity, loan purpose, loan size and loan pricing (Guner 2006; Qian & Strahan 2007). Most of the previous studies relative to bank loan contracts employ DealScan database for their data collection and sample selection (Goss & Roberts 2008; Guner 2006; Qian & Strahan 2007). The sample size for the quantitative study will be around 100 firms if access can be gained to DealScan database, with about 50 firms reporting to NPI in continuous years under study and about 50 firms not reporting. However, if this study cannot get access to DealScan database, then the necessary information will need to be manually calculated with the available information from ASX and OSIRIS databases resulting in a smaller sample size which will be approximately 50, 25 of which report to NPI.
Definition of Variables
Dependent Variables and Independent Variables
Bank loans are different in the measurement of the costs, which often include various fees besides the interest rates (Dews, Hawkins & Horton 1992). As the dependent variable of this study, the cost of bank loans is expected to be measured by the drawn All-in-Spread (AIS) (in basis point) which is consistent with previous studies (Goss & Roberts 2008; Guner 2006). Drawn AIS is proxied by the yield spread paid in basis point over London Interbank Offer Rate(LIBOR) for each dollar drawn down under loan agreements, with various fees included (Goss & Roberts 2008; Guner 2006; Qian & Strahan 2007).
The independent variable of hypothesis in this study is corporate environmental performance measured by a firm's total emissions generations scaled by its domestic sales which reflects a firm's pollutant emissions per dollar of sales which is consistent with the measurement of Schneider (2008).
The rank for firms not reporting to NPI in the continuous years under study will be 0. Firms report to NPI in the continuous years under study will be ranked from 1 to 10 according to the ratio of total emissions generations/domestic, with lower rank standing for better environmental performance.
As measuring cost of bank loans in firm-level, this study is supposed to take firm characteristics and loan characteristics into account because both of them have been shown to have impacts on drawn AIS (Goss & Roberts 2008).
- Firm size (LSIZE): It is proxied by natural log of a firm's book value of total assets. Larger firms tend to have more assets and resources as well as better reputation and thus have lower default risk (El-Gazzar & Pastena 1991; Goss & Roberts 2008; Peirson 2008, p.279; Strahan 1999). Hence, larger firms are supposed to have lower cost of bank loans.
- Industry (INDUSTRY): Given the industry-specific economic and environmental factors, this study includes industry as a dummy variable (Schneider 2008). As the emissions reports to NPI are facility-based, many firms report to various Australian and New Zealand Standard Industry (ANZSIC) divisions (Clarkson, Overell & Chapple 2008). Thus to facility comparison, the industry categories are according to Global Industry Classification Standard (GICS).
- Interest coverage (ICOV): It is defined as earnings before interest and tax (EBIT) divided by interest expense. It is one reflection of a firm's cash flow which can service banks' claims on the firm (Strahan 1999). As such, this study predicts a negative relation between interest coverage and the cost of bank loans.
- Leverage ratios (LEVER): It is measured as the ratio of total liabilities to total tangible assets. Firms with higher leverage ratios are tend to have higher default risk in that the higher the ratio the less tangible assets protecting the interest of banks, and thus the higher the cost of bank loans (Strahan 1999).
- Current ratios (CR): Current assets to current liabilities. Consistent with Guner (2006), the prediction in this study is the cost of bank loans decrease with current ratios increase.
- Prior charges ratios (PC): It is measured by prior charges to total tangible assets which is an indicator for the amount of secured debt owned by other lenders (Cotter 1998b). This study predicts positive relation between prior charges ratios and the cost of bank loans.
Leverage ratios, interest coverage ratios, current ratios and prior charges ratios are the most widely accepted financial covenants in bank loan contracts to control risks of listed Australian firms (Cotter 1998b). Therefore, this study includes these ratios as variables for borrowing firms' risk.
- Loan maturity (MATURITY): The length of the time before bank loans matures measured in natural log of years. There is no consistent conclusion of the impacts of loan maturity on the cost of bank loans (Goss & Roberts 2008; Schneider 2008).
- Loan purpose (PURPOSE): Dummy variable. Loan purpose affects the cost of bank loans (Goss & Roberts 2008; Shockley & Thakor 1997). Loan purpose in this study includes recapitalization, acquisition, general corporate purpose, and others.
- Loan size (SIZE): It is measured as natural log of the loan size. Firms with lower risk tend to have easier access to large size loans (Strahan 1999). Hence, the prediction is larger size loans tend to have lower cost of bank loans.
- Loan types(TYPE): The cost of bank loans differs from loan types (Preece & Mullineaux 1996). As line of credit and term loans have comparatively common structures, this study includes dummies for line of credit and term loans (Strahan 1999).
- Secured status (SECURE): This study use it as a dummy variable with value 1 for loans secured by assets, otherwise 0. Previous studies indicate that loans secured by assets are tend to have higher cost of bank loans (Goss & Roberts 2008; Strahan 1999). Consistent with them, this study predicts positive relation between secured status and the cost of bank loans.
The source of qualitative data in this study will be obtained through semi-structured interviews with the senior corporate lending managers from the five banks in Australia. Interviews are productive in yielding abundant useful information (Leedy & Ormrod 2005, p.146). Semi-structured interview is the basic form of interviews in qualitative study and it have central open-ended questions which are flexible and adjustable (Sarantakos 1998, p.255). The structured component makes the data comparable while the unstructured component allows new insights emerging and questions adjustment from the interview process (Kumar 2005, p.125). An interview checklist will be developed to be delivered to the subjects of the five banks in Australia in advance of the interviews; adjustments will be made where necessary during the interviews. The using of tape recorder is considered to be the most effective way to record the answers accurately during the interviews while taking notes will be an alternative way (Sarantakos 1998, p.261).
Secondary quantitative data will be used in the quantitative phase of this study to investigate the extent corporate environmental performance impacts on the cost of bank loans. AXS and OSIRIS database can provide the information on the proxies of firms' characteristics and the data to proxy corporate environmental performance will be obtained from NPI.
Qualitative Data Analysis
This study follows the three flows of qualitative data analysis by Miles & Huberman (1994, p.10-11) which are data reduction, data display as well as conclusion drawing and verification. The three flows are simultaneous and cyclical (Miles & Huberman 1994, p.10; Sarantakos 1998, p.315). The recordings or notes from interviews will be summarised under the guidance of the four main questions mentioned above. The information after reduction will be assembled according to specific themes, with text, graphs or charts involved. Following the data display, conclusions related to research question will be drawn. The same processes following will be useful in the validity testament of the current conclusions (Sarantakos 1998, p.315-316).
Quantitative Data Analysis
- Descriptive statistics: Descriptive statistics will provide this study with basic patterns in the data by observation and measures (Creswell 2003, p.172; Neuman 2006, p.347). The observation will tell general information of the data in this study such as firms' characteristics and emissions types, as well as information on selected bankers. Measures of central tendency and dispersion will be used for generating further information on each variable.
- Correlation analysis: Correlation analysis is useful in measuring the existence, direction and strength of the correlation between variables (Sarantakos 1998, p.383). This study will undertake three association tests between the cost of bank loans and 1) independent variables, 2) control variables respectively. Correlation analysis will help test the significance of the correlation between the cost of bank loans and the control variables which will facilitate the subsequent multivariate regression analysis by excluding the control variables with low correlation strength.
- Multivariate regression analysis: It can provide information on the explanation power of an array of variables to dependent variable as well as the effect direction and extent of each variable on dependent variable (Neuman 2006, p.369). This study will firstly develop the multivariate regression model as follows:
Contributions to Literature
There has been little research on the impact of corporate environmental performance on the cost of debt (Schneider 2008). As such this study will add to the literature by investigating the extent to which corporate environmental performance impacts the cost of debt in Australia. Given that this study is specified to the cost of bank loans, it will contribute to bank loan pricing literature by examining the explanation power of corporate environmental performance in the cost of bank loan. Inclusion of corporate environmental performance in cost of bank loans alleviates the problem of correlated omitted variables. This study also involves the research on the environmental covenants in bank loans which will contribute to the literature on loan covenants. Further, this study will be expected to fill the gap of how the banks in Australia assess the environmental risks resulting from borrowing firms' poor environmental performance.
In addition, the definition of corporate environmental performance in this study contributes to the corporate social responsibility literature.
Contributions to Practice
This study will utilise the data in NPI which will empirically justify the validity of NPI and thus will facility the researchers undertaking research on relative areas. A better understanding of the considerations of environmental issues in banks' lending processes will to some degree provide Australian regulators with insight into the effectiveness of the current environmental laws and regulations. Further, the results will be expected to be valuable for firms' managers in terms of providing them with proper environmental management to get easier access to bank loans. Also, the results will be hoped to be valuable for bankers by extending their understanding on banks' environmental risk assessment and management.
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