Environmental and Social Risk, Adaptation, and Equity Value

Abstract

This study investigates the impact of environmental and social (E&S) risks on firm value. Firm value is expected to be a function of current earnings to the extent current earnings reflect cash flows that are expected to recur in future periods (“recursion value”). However, to the extent a firm may be forced to modify its future operating processes, its current earnings are less likely to reflect future cash flows. Instead, firm value is expected to be a function of the net assets in place that can be used to generate an alternative stream of cash flows (“adaptation value”). I find that when E&S risks are present, there is a partial shift from recursion value to adaptation value (i.e., the association between firm value and current earnings is lower, while the association between firm value and book value is higher). These results are consistent with institutional theory, which suggests that firms with poor E&S performance face pressure from stakeholders and society at large to adapt or terminate their current operations. Further, I find that the partial shift to adaptation value in the presence of E&S risk is stronger for firms with high asset tangibility, consistent with tangible assets being more adaptable than intangible assets. By demonstrating the link between E&S risk and adaptation value, this study supports the recent practitioner focus on corporate social responsibility failures as a risk to business continuity.