Climate change exposure, environmental performance, and the cost of capital in the energy sector: Fossil fuel versus renewable energy firms

Abstract As the largest emitter of greenhouse gases, the energy sector is expected to make significant investments in green transformation to help combat climate change. However, the effect of climate risk on sector firms' cost of capital has been neglected in the literature. This study fills this gap by investigating the impact of climate change and environmental performance on the cost of capital in the energy sector using a large sample of energy firms from 34 countries. Specifically, we comparatively examine the impact of climate risk on weighted average cost of capital, cost of debt, and cost of equity for fossil fuel and renewable energy firms. Moreover, we examine the moderating role of corporate environmental performance on the relationship between climate risk and the cost of capital. Our results suggest that energy firms domiciled in countries with higher exposure to climate change have a significantly higher weighted average cost of capital, cost of equity, and cost of debt than the firms domiciled in countries with lower exposure to climate change. However, this effect is significantly stronger for fossil fuel firms than for renewable energy firms. Importantly, energy firms, both fossil fuel and renewable energy, can mitigate the adverse effect of climate change on their cost of capital by engaging in pro‐environmental policies. These findings suggest that climate risk exposure and the environmental performance of energy firms are important factors to consider when designing policies to accelerate the green transformation of the energy sector.