The effect of climate risk on firm cash holdings: evidence from the euro area

Using a large panel of mainly unlisted firms from 12 euro area countries, we investigate the impact of climate change exposure on firms’ cash holdings. We construct a comprehensive measure of climate risk in the form of drought risk and show that it significantly affects the decisions of firms to hold more cash as a buffer against adverse climate conditions. Our paper provides novel evidence which reveals that drought risk exerts a greater impact on the cash holdings of unlisted firms compared to their listed counterparts. We further introduce different levels of drought severity and demonstrate that unlisted firms hold higher levels of cash reserves as we move towards a scenario of rising climate risk. Our inferences remain unaffected when we employ a battery of tests that address endogeneity concerns. Moreover, our results hold when we consider alternative measures of climate risk and cash as well as different model specifications. Overall, we provide fresh empirical findings which support the precautionary motive hypothesis and have important implications for market participants and policy makers. Our study is also of relevance to the current strategy of the European Union which aims to prevent and mitigate conditions of water shortage under various drought scenarios.