We investigate how a firm’s environmental management efficiency affects spare debt capacity. We compute the firm-specific expected and unexpected carbon emissions, and two measures of debt capacity for 1,307 European firms in 20 countries during the 2002-2022 period. We define spare debt capacity as firm-specific debt flexibility and analyze it through three transition-risk mechanisms: information asymmetry reduction derived from the mandatory carbon disclosures; information asymmetry reduction derived from information stability; and bankruptcy risk increase derived from unexpected carbon emissions. With respect to the first mechanism, we find no direct link between total emissions and spare debt capacity, highlighting the need to decompose emissions. For the second mechanism, expected emissions show a positive and significant association with spare debt capacity, suggesting that stable and predictable environmental information helps reduce information asymmetry. For the third mechanism, unexpected emissions are negatively related to spare debt capacity, consistent with their role as signals of higher environmental and compliance risk, increasing perceived bankruptcy risk. Further analysis shows that the results hold in the presence of liquidity reduction, additional capital investment, and assurance practices, as well as for firms operating under different environmental uncertainty scenarios (firm-level, industry-level, and macroeconomic), and those facing business uncertainty. Our study introduces a novel method for separating emissions into expected and unexpected components, enabling tests of pecking-order and trade-off theories mechanisms related to debt capacity. These insights can help lenders integrate environmental factors into credit assessments and support firms’ managers in designing financing strategies for the transition to cleaner production. • Firms with environmental efficiency show better debt flexibility • Expected emissions are strongly related to spare debt capacity • Unexpected emissions proxy for future environmental risk and cut debt capacity • Strong link confirmed across varied uncertainty environments
Castro et al. (Tue,) studied this question.