This research exploits Australia's ratification of the Kyoto Protocol, which mandates the country to reduce carbon emissions, thereby exposing Australian firms to increased carbon risk, as a quasi-natural experiment to examine the causal effect of carbon risk on firm capital structure. We find that the Kyoto Protocol ratification leads to a decrease in financial leverage of heavy carbon emitting firms and such a decrease is more pronounced for financially constrained firms. Further analysis indicates that increased carbon risk leads to higher financial distress risk, which motivates firms to decrease financial leverage.

We find that U.S. corporations increase their cash holdings in response to higher economic policy uncertainty. The increase in cash holdings is not attributed to a reduction in firm investments. This increase is more pronounced for financially constrained firms or those with larger exposure to policy uncertainty. Holding more cash in the presence of policy uncertainty alleviates the negative impact of policy uncertainty on capital investment and firm innovation outputs. Our findings demonstrate that cash holdings represent an important channel in mitigating the negative effect of policy uncertainty on firm real economic activities.