Underinvestment and optimal capital structure under environmental constraints

We develop a Q-theoretical model for levered firms subject to environmental constraints (regulations). The model highlights the implications of environmental constraints on dynamic investment and optimal capital structure decisions. We find that environmental constraints can lead equityholders to become endogenously risk averse. Moreover, environmental constraints give rise to underinvestment in capital and asset sales, which is attributed to the carbon abatement effect caused by environmental constraints. In addition, firms with environmental constraints use conservative debt for low business risk and choose high leverage for high business risk relative to firms without environmental constraints, which is governed by the trade-off between abatement cost effect and risk-aversion effect caused by environmental constraints. Firms with environmental constraints have high credit spreads. Our theoretical results are consistent with some empirical findings.