With companies and consumers taking increasingly proactive roles to promote sustainability in business, those who don’t keep up are taking a financial risk. Companies that engage in environmentally harmful practices face public scrutiny, increased operating costs, and potential legal issues. One way to measure a business’s tendency to experience these issues is carbon risk—the problems faced directly from high carbon output and overreliance on fossil fuels.
The wide variety of consequences caused by high carbon risk inspired Kogod School of Business professor of accounting Tharindra Ranasinghe to explore it further in his research. As somebody who frequently studies risk management, his interest in carbon risk stemmed from its impact on firms across industries and the scope of its effects on business.
“There are papers that find carbon risk increases a firm’s cost of capital, affects its future profitability, and increases litigation risk,” he explained. “It affects businesses’ reputation, social legitimacy, and financial attributes. Even from a purely financial perspective, managers must actively work to reduce carbon risk.”
Though the issues caused by carbon risk are well-documented, Professor Ranasinghe’s research has uncovered even more. He’s currently working on papers highlighting high carbon risk’s hidden costs, ranging from higher job risk to increased rates of financial misreporting. In one paper, for instance, Ranasinghe discovered that CEOs of firms with high carbon risk face greater job insecurity and therefore seek higher pay to compensate for the possibility of losing their jobs later. In another, he found that these firms are also more inclined to engage in questionable reporting practices.
“During periods of high carbon emissions, firms are more likely to engage in earnings management—that is, creative use of accounting methods to report inflated profits,” Ranasinghe said. “This is presumably to offset investor concerns over these higher emissions by reporting higher profits. My paper suggests that carbon risk exacerbates other risks, such as financial misreporting.”
Professor Ranasinghe’s research challenges the idea that ESG (environmental, social, and governance) issues are purely societal. “When we think of these issues, we tend to think of the firm from a stakeholder perspective—the firm ensuring the welfare of a broader group of constituents and not just the shareholder,” he said. “But even from a pure shareholder perspective, carbon risk entails a broad range of costs and risks.”