The exclusionary effect on the cost of equity : an empirical study of the direct exclusion effect on tobacco companies’ and fossil fuel companies’ cost of equity

2019

The purpose of this paper is to examine the exclusion effect on excluded stocks’ cost of equity

capital. We study the effect by examining European and US tobacco stocks before and after

2010, relative to chosen comparable companies. Our findings suggest that exclusions of

tobacco companies can have a significant direct effect on the cost of equity. The direct effect

can be explained by Merton’s market segmentation model, and a premium for “boycotted”

stocks. Exclusionary investing creates a segmented market, which reduces the demand for the

excluded stocks, causing limited risk-sharing and restricted diversification opportunities for

investors. Thus, investors will require a risk premium for holding excluded stocks, implying a

higher cost of equity for excluded stocks.

Additionally, we study coal companies to examine the effects and implications of excluding

fossil fuel companies. Our results indicate that the exclusions of coal companies have no

significant direct effect on the cost of equity. These findings could imply that there is not a

sufficient number of investors who have excluded coal stocks. The coal industry has been the

primary focus for exclusions within the fossil fuel industry. Hence, the direct exclusion effect

of oil and gas companies on their cost of equity will likely be limited.