This article examines the effects of environmental performance on the default probability and the cost of capital of Italian small and medium-sized enterprises (SMEs). The empirical analysis is based on a data set of 16,567 Italian SMEs over the period 2013-2022. Both the cost of debt and the cost of capital are measured using a specific model tailored to Italian SME sectors. In our analysis, we also utilize a random effect model, focusing on multiple measures of a firm's probability of default (PD). To cope with potential endogeneity issues, we have applied the instrumental variables (IV) two-stage least squares (2SLS). Our study contributes to SME financial management and environmental performance literature by demonstrating the significant role of environmental factors in reducing default risk and financing costs. We find that environmental improvements notably benefit the cost of capital more than the cost of debt, particularly aiding equity holders. Differently from previous works, this article focuses on the effect of environmental variables on default risk, cost of debt and cost of capital in two ways: (a) it is based on a large sample of unlisted Italian SMEs; (b) it uses an estimate of the default probabilities and the cost of capital suitable for private capital companies.
