Risk, Return, and the Cost of Capital

Sandra Dow () and Yuwei Shi ()
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Sandra Dow: Middlebury Institute of International Studies at Monterey
Yuwei Shi: University of California at Santa Cruz

Chapter Chapter 8 in Corporate Finance Under Climate Crisis, 2025, pp 187-221 from Springer

Abstract: Abstract The cost of capital is a cornerstone of corporate finance, shaping investment decisions, valuation, and resource allocation. In the context of the climate crisis, understanding how climate change reshapes this core concept is essential. This chapter examines how climate risks affect the cost of equity, cost of debt, and weighted average cost of capital (WACC). Using the CAPM framework, we analyze how climate change drives shifts in systematic risk (beta) and equity risk premiums, with carbon-intensive sectors facing rising equity costs and green sectors perhaps benefiting from favorable financing conditions. The chapter also investigates the influence of climate risks on sovereign and corporate borrowing costs indicating that countries vulnerable to physical climate risk, especially the Global South will see heightened borrowing costs. At the firm level, climate risk can increase default risk premiums. Scenario analysis and case studies, including insights from the airline and energy sectors, illustrate the consequences for the cost of capital along different climate pathways.

Keywords: Cost of Capital and Climate Risk; Climate Change and Equity Risk Premium; Weighted Average Cost of Capital (WACC); Climate Crisis and Systematic Risk; Sovereign Debt and Climate Risk; Climate Risk Premium in Corporate Finance; CAPM and Climate Risk Integration; Transition Risks and Cost of Debt; Beta Adjustments for Climate Risks; Green Financing and Capital Costs (search for similar items in EconPapers)
Date: 2025
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Persistent link: https://EconPapers.repec.org/RePEc:spr:sprchp:978-3-031-83487-5_8

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DOI: 10.1007/978-3-031-83487-5_8

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