Firm ESG reputation risk and debt choice

• Published date: 01 September 2024
• Author: David P. Newton,Steven Ongena,Ru Xie,Binru Zhao
• Date: 01 September 2024
• DOI: http://doi.org/10.1111/eufm.12468

DOI: 10.1111/eufm.12468

ORIGINAL ARTICLE

Firm ESG reputation risk and debt choice

David P. Newton

1

|Steven Ongena

2

|Ru Xie

1

|Binru Zhao

3

1

School of Management, University of

Bath, Bath, UK

2

Swiss Finance Institute, NTNU Business

School, KU Leuven and CEPR,

University of Zurich, Zürich, Switzerland

3

Bangor Business School, Bangor, UK

Correspondence

Ru Xie, School of Management,

University of Bath, Bath, UK.

Email: r.xie@bath.ac.uk

Abstract

Using a novel sample covering 3783 US public firms

from 2007 to 2020, we examine how negative media

coverage of firm‐level environmental, social, and

governance (ESG) practices affects a firm's debt choice.

We find that firms with higher ESG reputation risk rely

more on public bond than bank loan. The social and

governance components, in particular, matter. More-

over, firms that receive more negative news coverage

display a higher propensity to issue new bonds as

opposed to securing new bank debt. Overall, our study

presents empirical evidence on the relation between

firm ESG reputation risk and debt financing.

KEYWORDS

capital structure, debt choices, debt structure, ESG reputation

risk, information asymmetry

JEL CLASSIFICATION

G20, G21, G30, G32

Eur Financ Manag. 2024;30:2071–2094. wileyonlinelibrary.com/journal/eufm

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This is an open access article under the terms of the Creative Commons Attribution License, which permits use, distribution and

reproduction in any medium, provided the original work is properly cited.

© 2023 The Authors. European Financial Management published by John Wiley & Sons Ltd.

We extend our heartfelt thanks to two anonymous referees for their invaluable feedback and guidance. We thank Moez

Bennouri, Zuzana Fungáčová, Richard Fairchild, Claudia Girardone, Owain ap Gwilym, Winifred Huang, Marcin

Kacperczyk, Tat‐Kei Lai, Xiang Li, Gaizka Ormazabal, Livia Pancotto, Pietro Perotti, Hanwen Sun, Fanis Tsoligkas, and

participants at the Bank of Finland BOFIT seminar, Bath Brownbag seminar, 11th International Conference of the

Financial Engineering and Banking Society, and 2022 European Banking Authority (EBA) Policy Research Workshop

for helpful comments. The paper was previously circulated under the title ‘Banks vs. Market: Are Banks More

Effectively Facilitate Sustainability'.

1|INTRODUCTION

In recent years, the importance of a company's environmental, social, and corporate

governance (ESG) reputation has significantly increased. Previous research has demonstrated

that the adoption of ESG practices can enhance a firm's shareholder value and competitive

advantage (Donaldson & Preston, 1995; Godfrey et al., 2009; Hillman & Keim, 2001; Hoepner

et al., 2016). A strong ESG reputation not only earns the goodwill of stakeholders but also

reduces credit risk by mitigating the impact of stakeholder sanctions (Eisenkopf et al., 2023;

Godfrey, 2005; Godfrey et al., 2009; Koh et al., 2014), legal risk (Hong et al., 2019), and

downside risk (Hoepner et al., 2018). Additionally, it helps corporations in obtaining financing

(Cheng et al., 2014) and lowering the cost of debt (Amiraslani et al., 2022; Chava, 2014; Degryse

et al., 2023; Hauptmann, 2017; Seltzer et al., 2021).

While prior studies have extensively discussed the influence of ESG reputation, the

understanding of how a firm's ESG reputation shapes its choice of debt remains unclear. Given

that ESG practices are primarily internal operations of firms, the task of assessing a firm's ESG

performance or reputation by external entities becomes complex unless the firm voluntarily

discloses pertinent information.The voluntary nature of disclosurescan lead to inconsistencies in

ESG ratings, potentially deepening the information gap between insiders and outsiders. This

disparity is especially pronounced when firms intentionally withhold or manipulate information.

Media, conversely, can serve as a powerful tool to bridge this gap (Deephouse, 2000). They

provide a consolidated view of the company's ESG practices to external stakeholders, effectively

reducing apprehensions and minimizing information asymmetry. Consequently, media coverage

functions as a mechanism to mitigate outsiders' uncertainty about a firm's internal operations,

acting as a reputation signal, as proposed by Weigelt and Camerer (1988) and Fombrun and

Shanley (1990). Building upon this backdrop, we aim to accomplish this by directly gauging the

firm's ESG reputation through its media coverage. This approach allows us to capture a more

realistic and comprehensive view of the firm's ESG reputation risk, ultimately enabling us to

assess how this reputation intertwines with the firm's financing decisions.

Our conceptual framework is built on the theoretical literature, which posits that bank loan

financing offers substantial advantages over public debt in terms of monitoring efficiency,

access to private information, and the ability to establish long‐term lending relationships

(Berlin & Loeys, 1988; Boyd & Prescott, 1986; Diamond,1984; Fama, 1985). Conversely, diffused

public debt ownership and the associated free‐rider problem reduce bondholders' incentives to

engage in costly information production and monitoring. Since banks are able to efficiently

monitor borrowers and detect firms' misbehaviors easily through strict monitoring compared

with public debtholders (Ben‐Nasr, 2019), firms with high ESG risk, have strong incentives to

hide their misbehaviors by avoiding the reliance on bank loans.

Moreover, the level of information asymmetry varies across different ESG components. ‘S’is

considered the most complex ESG factor to analyze. One of the biggest challenges is that it

lacks a reliable, quantitative measurement standard. ‘G’has a similar problem in terms of

information disclosure (Neilan et al., 2020; O'Hare, 2022). Therefore, in comparison with ‘E’,‘S’

and ‘G’practices are less transparent and have a higher degree of information asymmetry for

outsiders. As a result, we can expect a more pronounced reduction in asymmetric information

among ‘S’and ‘G’practises even as negative news coverage increases (remember, ‘any news is

good news’here in terms of reducing information asymmetry). If the information asymmetry

theory holds for our settings, it is plausible to hypothesize that firms are more sensitive to

changes in information opaqueness surrounding ‘S’and ‘G’issues.

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NEWTON ET AL.