Climate Policy Risk and Corporate Financial Decisions: Evidence from the NOx Budget Trading Program

We find that manufacturing firms adopt more conservative capital structures in response to the Nitrogen Oxides (NO x ) Budget Trading Program (NBP) of 2004, a regional cap-and-trade program aimed at mitigating the NO x emissions of power plants in 11 midwestern and southeastern states in the United States. Our further analysis demonstrates that, because the NBP induces an electricity price shock, it affects manufacturers’ financial decisions by raising their operating leverage and distress risk. We also find that firms respond to the NBP’s adoption heterogeneously: they adjust their financial leverage more dramatically when facing greater electricity intensity, financial distress threats, or competitive pressure. In addition, firms adapt not only capital structure, but also other financial policies in response to the regulation. Overall, our study shows that climate policy risk constitutes an essential consideration in firm financial decisions. It also highlights potential unintended consequences of policy responses to climate change for the corporate sector. This paper was accepted by George Serafeim, Special Section of Management Science on Business and Climate Change. Funding: The authors gratefully acknowledge generous financial support from the Alliance Manchester Business School Strategic Research Investment Fund. Supplemental Material: The data files and online appendix and data are available at https://doi.org/10.1287/mnsc.2022.4617 .