Does flood risk affect the implied cost of equity capital?

Abstract

Utilizing monthly city level precipitation data across China from 2006 to 2019, this paper constructs an objective flood risk index and investigates the impact of flood risk on the implied cost of equity capital for A-share listed companies. First, our study finds a positive correlation between the flood risk and the implied cost of equity capital and this result holds when we use instrumental variables for flood risk. Second, empirical results reveal that flood risk influences the implied cost of equity capital through two channels: physical risk premium and investor sentiment. Third, we discover that companies with higher ESG (Environmental, Social, and Governance) ratings, higher information disclosure quality and better city infrastructure, are capable of mitigating the adverse impact of flood risk on their implied cost of equity capital. These findings have important implications for investors, policymakers, and corporate stakeholders in understanding and mitigating the financial risks associated with climate change in a rapidly developing economy.