Texas is emerging as an unlikely powerhouse in the United States in renewable energy. After Texas, which generates one-third of its electricity from renewables, other states leading the charge include Iowa, Oklahoma, and Kansas. Solar panel manufacturers announced plans recently to build four new US plants, with two set to go into production in Texas and one each in Ohio and Indiana.

What’s behind this boom in green technologies? One important factor is companies’ cost of capital. That’s the calculation made by corporate managers everywhere to determine whether a project is worth an investment of funds. Green projects went up because the cost of capital for such projects fell. Years of low interest rates and a sustainable investment boom made it relatively cheap to build factories that can produce solar panels or wind turbines.

And yet, the worldwide drop in interest rates should have ignited an across-the-board investment boom. A company that was perhaps weighing whether or not to build a new factory should have seen near-zero rates and let that tip the scales toward building. But in most cases, that’s not what happened. Companies failed to build as many factories, fund as much research and development, or open as many retail outlets as conventional cost-of-capital models had predicted. Instead, overall business dynamics were sluggish, and the economy was left with an enormous amount of “missing” investment, report Chicago Booth’s Niels Gormsen and Kilian Huber.

When the researchers went looking for that missing investment, they made a discovery: corporate executives were often ignoring conventional cost-of-capital models. “Managers don’t seem to use the stylized models that they’re taught,” says Huber. Even companies with executives who were well aware that capital costs had declined substantially still underinvested in new projects, with green projects being a notable exception.

Gormsen and Huber’s research may explain why. Their findings suggest that managers are allocating resources according to what they think their cost of capital is, which in many cases differs from what conventional models tell them it is. As a result, companies have invested too little overall—except in green projects, which they apparently hold to a less rigorous standard. The findings have implications for both the green boom and general investment dynamics in the US, and may help to explain what kinds of ventures will get funding in the future. The overarching point, says Gormsen, is that “it really matters how companies set their cost of capital.”

The ‘missing’ corporate investment

A foundational notion of traditional financial theory is that capital costs determine investment levels: there’s a simple one-to-one relationship between the cost to corporations of raising capital and the minimum returns that managers expect to earn before they’ll green-light new investments. If, for example, the cost of capital declines by a certain amount, theory predicts that managers will cut their required returns—a measure known as a discount rate—by an equal measure.

When falling interest rates dramatically cut the cost of capital, companies should have reduced their discount rates just as fast. But they didn’t, and according to Gormsen and Huber’s research, discount rates seem to have a life of their own.

This ‘wedge’ may explain sluggish investment

Companies’ discount rates (their required rate of return on an investment) and perceived cost of capital should rise and fall in tandem. But the difference between them has grown substantially, according to an analysis of US companies’ conference calls.

The researchers used standard models to calculate the cost of capital at roughly 2,500 companies in 20 countries between 2002 and 2021. They then sifted through transcripts of those companies’ quarterly conference calls to find out what executives said about discount rates. With industry analysts following each word, and the threat of lawsuits hanging over any misstatements, corporate managers were under pressure to be truthful. (Indeed, by using data on investment levels, returns to investment, and financial prices, the researchers confirmed the accuracy of the discount-rate statements and cost-of-capital calculations.)

Companies don’t report their discount rates on financial statements, but managers sometimes discuss internal calculations on calls, and the researchers identified 110,000 relevant paragraphs in the transcripts. To identify discount rates, Gormsen and Huber relied on managers’ explicit statements about the minimum internal rate of return required to green-light a new investment project, and then they traced how those rates varied from one year to the next.

In the real world, they find, corporate discount rates were more loosely tied to the cost of capital than indicated by traditional models. Even at companies where managers clearly knew that their capital costs had dropped a lot, discount rates barely fell. Instead, the gap between the two widened over time.

“About 40 percent of companies in our sample have the same discount rate in the first year we observed them, and again 10 years later,” Huber says.

It would be surprising if these sophisticated managers misunderstood the assignment, says Gormsen, describing the relationship between capital costs and discount rates as “one of the core things we’ve been teaching MBAs” over the years. But business schools mostly focus on teaching managers what they ought to do, he says, and less exactly how they ought to do it. MBAs learn to estimate how much it would cost for them to get funding and then use that figure to determine the return a project would need to generate to be profitable. While they are armed with tools such as the capital asset pricing model (which is used both to price financial securities and to calculate expected returns for assets), managers are largely left to figure out the details on their own. In most cases, their solutions to the problem appear to look a lot different than those their teachers in academia would have arrived at.

The differences in discount rates could shift investment from brown to green corporations enough to reduce company-level emissions by 20 percent in the long run, the researchers calculate.

Why the high discount rates? Beliefs about value and risk aversion

Looking for clues, Gormsen and Huber hypothesize that many managers may believe that keeping discount rates high shows that they’re exercising financial discipline and feeling confident of future profitability. The primary reason executives gave during conference calls for keeping discount rates stable as capital costs fell was that doing so increased their companies’ value. Managers at 59 percent of the companies studied said they pursued such a practice either because it prevented the return on a given project from falling below their cost of capital or because it guaranteed higher returns to investors, the researchers find.

The second-most-cited reason managers gave for adding to the wedge between a company’s cost of capital and discount rate was risk that’s specific to a given enterprise. A corporation’s cost of capital captures the returns that investors demand in exchange for assuming a given risk, but each investment project poses its own unique perils.

It turns out that companies engaging in riskier investments built in larger wedges, the research finds. One-third of managers who spoke during conference calls argued that prudence was needed to account for risk. The CFO of Halyard Health (now part of healthcare services and logistics giant Owens & Minor) explained that in coming up with its overall discount rate, he ratcheted up the figure a bit “to reflect the risk in the portfolio and execution.”

When managers did drop discount rates, they were responding to competitive pressures, the study finds. At companies in fragmented industries, discount rates decreased almost one to one with declines in their cost of capital, in line with economic models. In contrast, companies in industries where market power is concentrated held discount rates relatively high, even when the cost of capital was low or falling. This is what dampened investment volume, the researchers conclude.

In total, the wedge between the average cost of capital and the average discount rate widened by a sizable 2.5 percentage points during the two decades studied, they calculate. The results indicate that it is this change in corporate investment return requirements that explains much of what’s happened to the missing investment.

Knowing this could help illuminate corporate investment decisions—and improve policy makers’ understanding of what sorts of economic interventions are most likely to spur investment, overcome weak productivity gains, and improve pay, the researchers assert.

“Corporate investment directly contributes to economic growth,” Huber says. “When firms invest more, they come up with new ideas and technologies, which eventually lead the economy to grow faster. And everyone benefits, as wages will be higher.”

Boardroom versus classroom

There may be another reason, beyond financial discipline and risk aversion, that corporate managers haven’t followed the rules in setting discount rates. Financial literature often assumes that corporate managers have perfect information about how much capital costs them; but in reality, the figure can be fiendishly difficult to calculate, even when armed with the prescribed models. For any given company, the cost depends on an unobservable input—namely, the amount investors expect to earn from holding a combination of a company’s outstanding stocks and bonds. But there is no way for anyone, even the most informed managers, to know exactly what investors are forecasting.

The result is that the amount managers think capital is costing them is likely to diverge considerably from what models tell them. Is that the case? Considering the sizable potential effects of capital cost on corporate and economic performance, it’s worth knowing.

There’s been no easily accessible record of how much corporate managers think they’re paying—corporations do not typically report this, much less archive it. To overcome this, the researchers turned again to their database of investor conference calls, collecting references to company-level “cost of capital,” the “weighted cost of capital,” and the abbreviation “WACC” (for weighted average cost of capital) between January 2002 and September 2021 for all companies available in the Refinitiv database, a frequently used repository of corporate information. The researchers then compared these results with company-level data on cost of capital and discount rates for almost 1,800 of the same companies.

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Corporate managers’ perceived cost of capital did indeed deviate significantly from what standard models predicted, the researchers observe, and these differences are big enough to imply that traditional models of how the cost of capital affects investments might actually be of little predictive value. This calls the models’ relevance into question. The idea behind the investment-based capital asset pricing model, for example, is that companies have perfect information about their cost of equity, or expected stock returns, and base their investment decisions on that figure. But if companies don’t really have perfect information, and their managers aren’t using these models to guide their decisions, what are the models good for?

Another concern is that mistakes in managers’ perceived cost of capital can lead them to make bad investment decisions. Companies that use an incorrect cost of capital are likely to also use an incorrect discount rate, and this may lead them to take on the wrong investments. Such behavior can harm the economy. In one estimation, Gormsen and Huber find that these mistakes can reduce GDP by more than 5 percent.

These results again point to a need for a better understanding of the links between financial markets, the perceived cost of capital, and corporate investment, the researchers note.

The path to going green

As managers have gone their own way in setting discount rates, and have invested relatively less than economists would have expected, many have nonetheless embraced green projects. To a large extent, Gormsen, Huber, and Booth PhD student Sangmin Oh write, the level of green investment is determined by companies’ own perceptions of their cost of capital, and managers think that the cost of capital, potentially driven down by the rise in green investing, is lower for green projects.

Green investing is, of course, a cause célèbre for many investors, while others consider it a politically misguided crusade. But as the controversy has raged, its advocates have seemingly made significant progress in lowering companies’ perceived cost of capital for green investments.

The growing popularity of ESG investing impelled this progress. Until 2016, Gormsen, Huber, and Oh’s research indicates, the perceived difference in the green-versus-brown cost of capital was next to zero. But between then and 2021, the gap expanded to the point where the cost of capital for the greenest companies was almost 1.5 percentage points lower than for the brownest. Paralleling that change, discount rates for the greenest bunch were about 3 percentage points lower than for the brownest companies.

Green investing makes a real impact

Investor funds flowing into green companies have lowered these companies’ perceived cost of capital over time, research finds. 

These gaps may be large enough to have real-world implications, the researchers write. Specifically, the differences in discount rates could shift investment from brown to green corporations enough to reduce company-level emissions by 20 percent in the long run, Gormsen, Huber, and Oh calculate. This finding, they assert, indicates that climate capitalists—people who invest in green companies in order to encourage more green investments—could play an important role in stimulating environmentally friendly production.

As it happens, late 2023 saw a sell-off in green stocks, with wind and solar shares hammered. Two-thirds of the 620 people who responded to a Bloomberg Markets Live Pulse survey indicated wariness toward electric-vehicle stocks. The iShares Global Clean Energy ETF lost 20 percent of its value in 2023, after having risen 140 percent in 2020. After disappointing returns, investors were fleeing sustainable funds, reported the Wall Street Journal in November, under the headline “Wall Street’s ESG Craze Is Fading.”

That could be bad news for the fight against climate change. Money pouring into or out of companies with green credentials could tip the scales for executives weighing whether or not to build wind farms, solar panels, or electric vehicles, which may help to explain the complicated politics in the US around ESG investing. Some Republicans have alleged that such investments prioritize political goals over investor returns, and a group of 26 Republican-led states, with Texas and Utah at the helm, has in court challenged a federal rule from the Biden administration that allows retirement plans to consider ESG issues in investment decisions. After a judge tossed out the suit this past September, the group announced plans to file an appeal. This followed a failed attempt by Congress to repeal the same rule.

But those large clean energy projects rising out of Texas, Iowa, Oklahoma, and other red states are evidence that company executives are betting they’ll make money. This past November, despite the ESG backlash and investors fleeing green stocks, Longroad Energy, a Massachusetts company with projects under construction in Arizona, among other places, secured $600 million in debt financing to expand its renewables portfolio.

Such investments figure into cost calculations and may produce decisions that an array of politicians may not like. But if a corporation’s path to financial returns happens to lower emissions, muscle out dirtier alternatives, and even turn fanciful notions of hydrogen power and carbon capture into commercial reality, the company’s managers are unlikely to quibble. When they think going green will be profitable, that’s the direction they will be going.

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