Environmental regulation and firm capital structure dynamics

Focusing on the toughest-ever environmental policy in China, this paper investigates the causal evidence of how environmental regulations influence listed firms’ capital structure dynamics. The difference-in-difference estimation findings showed that the speed of leverage adjustment of highly polluting firms significantly declined after the implementation of tightened environmental regulations, compared with that of low-polluting firms. The dynamics of this impact turned out to be significant instantly after the policy shock and persisted for at least two years. Furthermore, the negative impact of environmental regulations on the speed of leverage adjustment by highly polluting firms was much weaker for firms with better corporate governance capacity and stronger for firms with higher information asymmetry. This study also identified that the possible channel of these main findings is that the cost of the debt and equity of highly polluting firms significantly increased after the implementation of the environmental regulations. Additional findings suggested that the tightened environmental regulations mitigated the speed of leverage adjustment of highly polluting firms because they increased these firms’ adjustment costs. All main empirical findings passed a variety of endogeneity tests, including propensity score matching difference-in-difference and the inclusion of province fixed effects. These findings were also consistent across a battery of robustness tests, such as an alternative indicator of highly polluting industries, an alternative estimator of the speed of leverage adjustment, the extension of the sample period, and placebo tests with falsified event dates.