ANALYSIS
Can capital markets create incentives for pollution control?

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Abstract

It has been observed that upon trading-off the costs and benefits of pollution control, profit-maximizing firms may choose not to invest their resources in pollution abatement since the expected penalty imposed by regulators falls considerably short of the investment cost. Regulators have recently embarked on a deliberate strategy to release information to markets (investors and consumers) regarding firms' environmental performance in order to enhance incentives for pollution control. In this paper, we analyze the role that capital markets may play to create such incentives. Evidence drawn from American and Canadian studies indicates that capital markets react to the release of information, and that large polluters are affected more significantly by such release than smaller polluters. This result appears to be a function of the regulator's willingness to undertake strong enforcement actions as well as the possibility for capital markets to rank and compare firms with respect to their environmental performance.

Introduction

A large number of authors have pointed out the lack of appropriate monitoring activities and weak enforcement pertaining to the implementation of environmental regulations. Resources devoted to monitoring activities allow regulators to perform only a limited number of those activities. Moreover, when compliance with the standards is found to be lacking, it is generally acknowledged that fines or penalties (as imposed by regulators and courts) are too low (compared to pollution abatement costs) to act as effective deterrents. For example, Russell (1990) writes: `Efforts to monitor regulated behaviour appear to have been inadequate to the task—a very difficult task in many instances—and typical enforcement practices appear to have been insufficiently rigorous'. The General Accounting Office of the United States has repeatedly reported deficiencies in the monitoring and enforcement activities of the United States Environmental Protection Agency (see GAO, 1987, GAO, 1991, GAO, 1993, GAO, 1994).

If indeed the expected penalty for non-compliance, as imposed by environmental regulators and courts were so low, one would have difficulty in explaining the generally high level of compliance with regulation in developed countries, and the very large variance in the environmental performance of plants in developing countries. Hence there must be other incentives than those provided by regulators and courts that could explain a polluter's environmental performance. As such, the potential role and impact of local communities and markets (including consumers and investors) are the object of increasing scrutiny. Afsah et al. (1996) have recently developed a new paradigm for controlling industrial pollution in developing countries which explicitly includes, as sources of incentives, local communities and markets. Once the role and potential impact of these agents are properly acknowledged, once the conditions under which the action of these agents may be effective are identified, fines and penalties imposed by regulators and courts may not appear to be in many circumstances the most appropriate or effective incentives for pollution control. In fact, the USEPA has recently pointed out that `EPA's job should grow from primarily the `enforcer' to include greater emphasis on helping citizens make informed choices in their daily lives' (EPA, 1991).

Hence, while there is a growing concern that fines and penalties imposed on agents out of compliance are not severe enough to have a deterrence effect, some authors have challenged the conclusion that polluters therefore have no incentives to comply with environmental standards. In particular, in view of the increasing facility of access and exchange of information, markets (both consumers and investors) bear an increasing amount of attention as to their capacity to generate incentives for pollution control. A significant amount of research and experiments remains to be performed in order to identify the circumstances under which the activities of these agents may be effective, the conditions under which the incentives they generate may substitute for or complement `typical enforcement practices', and the proper role of the regulator to empower these agents. In this paper, our purpose is to discuss and examine how investors have reacted to the release of public information regarding the environmental performance of specific plants, as observed and measured by fluctuations on the stock market. [A related but different question of interest is whether or not firms with good environmental performance have a higher market valuation than firms with bad environmental performance, other things being equal. On analysis of this nature, see Cormier et al. (1993) and the references therein.] While some of this information is revealed through regular coverage by newspapers, it also includes a deliberate use and release of information by regulators regarding the environmental performance of individual plants.

In the next section, we discuss the nature of the role of capital markets with respect to providing incentives for pollution control. In Section 3, we briefly describe the methodology typically used to measure the reaction of investors to the release of environmental information. In Section 4, we review the results of the studies that have examined the reaction of investors to the announcement of environmental incidents (such as lawsuits, fines, accidents, etc.), or list of polluters (e.g. Toxics Release Inventory). We also present the results of a new study that examines the reaction of investors to the publication of lists of firms in British Columbia that either fail to comply with environmental regulations or that are of concern to the Ministry of the Environment of British Columbia. We conclude in Section 5.

Section snippets

The role of capital markets

Unanticipated events, or new information may lead capital markets to revise their expectations regarding the profitability of an enterprise. Changes in market values thus provide estimates of changes in the net present value of expected profits as a result of the event, or new information, relative to the situation where the event would not have occurred or the information would not have been available.

It has been argued earlier that penalties imposed by regulators and courts are generally set

Event-study methodology

The methodology used in this field of research is akin to event-study analyses which is based on the assumption that the capital market is sufficiently efficient to evaluate the impact of new information (events) on expected future profits of the firms. The methodology was originally developed by Fama et al. (1969) and Fama (1976). It has been used to analyze the reaction of investors to numerous events of a different nature: product liability suits (Viscusi and Hersh, 1990), airline crashes (

Empirical analyses

Following these lines of argument, a number of papers have investigated, using the event-study methodology, how capital markets can provide incentives for pollution control. Muoghalu et al. (1990) examine the impact of environmental enforcement measures related to the American RCRA (Resource Conservation and Recovery Act) and the Superfund Acts on firms' financial value. Their sample consists of 128 initial lawsuits against firms and 74 case settlements (involving a fine) announced in the print

Concluding remarks

It has been observed that upon trading-off the costs and benefits of pollution control, profit-maximizing firms may choose not to invest their resources in pollution abatement since the expected penalty imposed by regulators falls considerably short of the investment cost. This however ignores that markets and communities can also create incentives for pollution control to the extent that they possess information regarding a polluter's environmental performance. Regulators have recently

Acknowledgements

We are grateful to Jean-Francois L'Her, Jean-Marc Suret and David Wheeler, and anonymous referees for their comments. Financial assistance was provided by the Fonds FCAR. Usual disclaimers apply.

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