Database manuscript Environmental Externalities Shaping a Firm’s Zero Leverage Decision: Analyzing Debt Demand and Supply Determinants

Zero-leverage firms remain a puzzle in corporate finance. Traditional views focus on demand factors like financial flexibility or supply factors like credit constraints and often conflating these elements. This research presents a supply-side mechanism linking environmental externalities to access to debt. Based on the 'brown premium' in debt markets, creditors favor firms with high negative externalities because of strong cash flows, whereas they discount sustainable firms with high initial costs. This creates a supply constraint that precludes leverage for environmentally friendly firms. Using a theoretical model, we derive a proposition and test it with a bivariate probit on 1,022 firms across 54 countries from 2011-2022. The results show that environmental impacts significantly reduce debt availability, especially for firms with low externalities, with the effect moderated by a company’s development stage, the environmental sensitivity of the industry sector where the company operates, the institutional characteristics associated with environmental regulation, as well as the environmental score of the company. The study highlights the importance of joint demand-supply estimation to mitigate bias, suggesting that capital markets may penalize green firms through debt rationing.