Biography Dinah began her environmental management career in Budapest, Hungary in 1992 when she launched the first office paper recycling system in Budapest office buildings. Working with the Ministry for Environment, Budapest City Government, business and multiple environmental NGO’s, she promoted interest and activity in environmental protection during the early years of Hungary’s transition to a market economy. From 1993 to 1995 she worked as Environmental Manager for Tetra Pak in Hungary. In 1995 she returned to the US to do her masters in law and diplomacy at the Fletcher School, Tufts University, focusing on issues of trade and environment and corporate environmental management. Since then she has been exploring the financial impacts of corporate environmental policy, and helped develop environment, health and safety accounting systems at Baxter International. She is working on her doctorate at Harvard School of Public Health, where she is developing a method for analyzing human toxicity associated with industrial emissions to aid financial analysts and social fund managers in determining the social impacts of investment opportunities.

Submission for “Sustainability Performance and Business

Competitiveness”

Capital Markets and Corporate Environmental Performance - Research in the United States Dinah A. Koehler Harvard School of Public Health Department of Environmental Health Landmark Center 401 Park Drive P.O. Box 15677 Boston, MA 02215 Telephone: 617 384-8827 Fax: 617 384-8859 Email: dkoehler@hsph.harvard.edu

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Abstract

A series of empirical analyses in the United States from 1993-2001 reviewed here provide

insight into whether there is a systematic relationship between environmental and financial

performance and whether it is strong enough to inform both regulatory and firm environmental

strategy. The findings seem to imply that capital markets react long-term to environmental

performance. However, a closer look at the research indicates that U.S. capital markets pay

attention to environmental news, but that it is a short-term reaction and will not necessarily affect

long-term returns. Econometric concerns and model misspecification consistently undermine the

quality of findings.

Keywords: corporate environmental performance, financial performance, capital markets

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Section 1. Introduction

I begin my review of research in the United States on the relationship between capital markets

and corporate environmental performance with the following question: Say a statistically

significant contemporaneous correlation between measures of environmental performance and

financial performance from time t to t+n is found, how are we to interpret this ? The answer will

depend on whether we believe and can demonstrate that environmental expenditures improve

firm profitability in a structural way, thus environmental performance (A) leads to changes in

financial performance (B). Alternatively, it may be a matter of reverse causality, where profitable

firms can afford to invest in environmental performance, B to A. Finally, there may be another

factor C that is affecting both A and B, and this omitted variables bias may be responsible for the

statistical relationship. In this paper I seek to provide insight into which of these different

interpretations is most likely based on empirical work from 1993-2001 and begin by introducing

the foundations of the debate. My reflections are guided by multiple discussions with finance

professors, management scholars and after presentations at numerous forums where this topic

continues to be the substance of a lively debate.

The debate on the relationship between environmental performance of firms and their

financial performance took a new turn when management guru Michael Porter of Harvard

Business School posited that environmental regulation could under certain circumstances offer

firms innovation opportunities, which in turn would outweigh any costs of compliance (Porter

1991). Thus regulatory constraints do not only impose costs on firms, rather, in a dynamic view

of the world, they offer possibilities for innovation offsets (i.e. net financial gain). The challenge

according to Porter and Claas van der Linde is to design innovation friendly regulations (Porter

and Linde 1995). In other words economists adopting a static view of the world have overstated

the perceived trade-off between minimizing private costs and maximizing public gain that

underlies most environmental regulation. While Porter and van der Linde focused on regulation

as the main driver of firm competitiveness (Porter and Linde 1995) and not whether capital

markets might step in where regulation fails, others have argued that the increase in voluntary

environmental initiatives bespeaks a basic business objective (HBR 1994). If it “pays to be

green” then a firm’s engagement in voluntary measures beyond compliance ought to be guided

by consumer and investor preferences (Reinhardt 1999a; Reinhardt 1999b) that are not

necessarily captured in regulation.

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In response to the Porter hypothesis, Palmer et al (Palmer, Oates et al. 1995) argue that

compliance with environmental regulations will always be costly forcing firms to face a trade-off

between social benefits and private costs. In other words, environmental investments will tend to

be a negative net present value (NPV) investment. The trade-off may in fact be overstated, not

because firms benefit from innovation offsets, but because empirical evidence indicates that

regulations do not have an adverse effect on competitiveness partially due to the low costs of

compliance (Jaffe, Peterson et al. 1995). Thus, the financial impact of compliance may be

relatively low, leading to low negative coefficients for environmental performance variables, and

the financial gains from beyond compliance management may be even harder to prove.

According to Palmer and his colleagues, the case studies cited by Porter and van der Linde

provide insufficient evidence of whether or not it pays for a firm to be green.

A series of empirical analyses in the United States from 1993-2001 reviewed here

provide insight into whether there is a systematic relationship between environmental and

financial performance and whether it is strong enough to inform both regulatory and firm

environmental strategy. In line with the above points of view, researchers have suggested two

rationales to explain a correlation between environmental performance and financial value. First,

that capital markets care and therefore firms should pay attention to environment, expecting to

benefit from a win-win situation. Secondly, that the environment is costly, and capital markets

should pay attention. Both hinge on finding a change in stock price. I do not summarize all

research in detail here, but focus on several key papers that are exemplary of the research paths

taken to date. The remainder of this paper is organized as follows: Section 2 introduces the

mechanism underlying changes in stock prices and how these can affect corporate behavior. In

Section 3 I introduce the research followed by a discussion and ideas for future research. Finally,

I conclude that regulation will play a critical role in strengthening the impact of capital markets

on corporate environmental behavior.

Section 2. How Capital Markets Affect Corporate Behavior

We can explain the potential reaction of capital markets to new information on firm pollution

with two basic scenarios. In the first scenario shown in Figure 1, information on expected

environmental liabilities or clean-up costs hits the market at time t causing stock price to drop,

because investors expect decreased earnings and dividend payments. A change in stock price

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corresponding to a negative or positive firm-specific event equals the change in the firm’s

present value - to the extent that the marginal financial benefit of acting on the information does

not exceed the marginal cost for market participants (Jensen 1978). The return (i.e. the market’s

discount rate) is unchanged, if the fundamentals of the firm do not change. This is the cash flow

news effect.

_______________

INSERT FIGURE 1 ABOUT HERE

_______________

If the drop is on the day of news release than we can say with a high degree of confidence that

the environmental news caused the drop in stock price for that firm. If the price drop is gradual

over several days (t+n), then we can no longer be as certain, because other news may have

interfered. This scenario is best tested using the event study methodology, described in the next

Section.

A short-term negative price movement does not, however, provide a compelling reason to

argue that there is a long-term business case for sustainable investments. Short-term price

movements do not provide enough substance to formulate buy/sell strategies, unless we believe

sustainability to be a matter for day traders arbitraging on momentum. This brings me to the

second basic scenario, the green investor effect, also shown in Figure 1. Imagine that “green”

investors worried about sustainability hear some pollution news and decide to sell dirty stocks,

which reduces their price. Based on the finance research of Debondt and Thaler (DeBondt and

Thaler 1985), Chopra et al (Chopra, Lakonishok et al. 1992)and La Porta (Porta 1996) we can

expect neutral investors who do not care about environmental performance to buy cheaper dirty

stocks anticipating a higher return. This is the expected returns news scenario, and it is important

to note that here returns are no longer constant. The effect on price can be a temporary panic, and

share price bounces back quickly. Alternatively, when investor’s green preferences are more

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long-lived the price effect is more long term. Whether the green investor effect is short-lived or

long-lived, the dividend is not necessarily affected. In this scenario then, green investor

preferences consistently drive stock price changes for dirty firms, whether or not such a firm

faces an immediate environmental expenditure. If an environmental effect is found, it should be

greater for small firms than for large firms, which exhibit greater risk due to the cash flow effects

of investment projects and thus have a higher correlation between returns and cash flow news

(Vuolteenaho 2000).

Finally, to explain how changes in stock price can affect corporate behavior, consider that

as the stock price of dirty firms falls, investors require to be compensated with a higher return.

Therefore the cost of capital of dirty firms will increase. If the difference in price between dirty

and clean stocks increases and begins to exceed the investment necessary to augment a dirty

technology, then dirty firms will invest expecting an increase in stock price. As a result clean

firms may eventually achieve a lower expected return, and hence a lower cost of capital

(Heinkel, Kraus et al. 2001).

Section 3. Evidence and Evolution of literature

A cursory glance over the literature shows a great variety of methodological approaches. The

vast majority of empirical analyses use a firm’s market value as the measure of financial

performance, which places this research more under the rubric of finance economics. Other

academic disciplines are organizational behavior and accounting. Given the preponderance of

research into whether capital markets value firm environmental performance, the following

Section is organized to provide insight into whether the response of capital markets to

environmental news is temporary or permanent. In modeling work on short and long-term effects

of environmental performance on financial performance a central assumption has been constant

returns, which follows from the random walk theory of stock prices. In other words, in efficient

markets returns are not predictable, and every day, “the stock market return is like the result of

flipping the same coin, over and over again” (Cochrane 1999). Under the assumption of constant

returns, i.e. a constant market discount rate, researchers model the relationship between

environmental and financial performance without accounting for risk. I return to this important

issue in Section 4.

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3.1 Short-Term Event Studies

The classic framework for understanding the financial value of environmental information is the

market efficiency hypothesis. Here the assumption is that all known determinants of stock returns

are incorporated into stock prices, and prices are continuously updated to reflect new

information. If prices do not move when new information is revealed, then the market is already

efficient with respect to that information. Campbell (Campbell 1991) points out that because

stock returns are unpredictable under the strict random walk theory unexpected movements in

stock prices are due only to news about future dividends (i.e. cash flow news). Since the first

study of this phenomenon by Fama et al (Fama, Fisher et al. 1969), event studies have been

widely used to test market efficiency with respect to new information.

Event studies offer the strongest econometric results when they are limited to one or at

most five trading days after the event to ensure that confounding news does not obscure the

effect of interest.1 Thus for example, in the five trading days following the 1986 explosion at

Union Carbide’s Bhopal, India plant, leaving approximately 4000 people dead and another

200,000 injured, the market value of Union Carbide’s common stock price fell approximately $1

billion or 27.9% (from $3,443 million to $2,483 million) (Blacconiere and Patten 1994).2

Furthermore, the stock price of Union Carbide suffered a sustained drop in returns for over 1

month and pulled down the stocks of 47 chemical firms for at least 10 days after the accident.

Similarly, the stock of Exxon suffered a sustained drop over six months (Jones, Jones et al.

1994), with a value loss ranging from $4.7 billion to $11.3 billion depending on the length of the

event window.3 Hamilton (Hamilton 1995) found that when the toxic release inventory (TRI)

data were first released to the public in 1989 the stock value of TRI-reporting firms dropped by

an average of $4.1 million. Similarly, Konar and Cohen (Konar and Cohen 1997a) found that for

40 out of 130 firms that suffered the greatest drop in stock price after the 1989 TRI release, 32

significantly reduced their reported TRI releases per dollar of revenue by 1992. Khanna et al

(Khanna, Quimio et al. 1998) evaluated investor reactions to repeat annual release of TRI data in

1989-1994 for 91 chemical firms and find significant negative abnormal returns on the day

following the release of TRI data in four out of their six sample years (1991-1994). These

researchers conclude that capital markets reward and punish different levels of environmental

performance, measured in changes in TRI emissions. Most environmental event studies to date

find a significant negative impact of pollution news on stock prices.4

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It should be no surprise that capital markets react negatively to major events such as the

Bhopal incident or Exxon Valdez oil spill. It is more surprising that capital markets react

negatively to routine events such as annual TRI releases, which are not illegally emitted, and

thus TRI event studies merit a closer look. Re-analyzing Hamilton’s (Hamilton 1995) results for

the 1989 TRI release, Cram and Koehler5 utilize Zellner’s (Zellner 1962) seemingly unrelated

regressions (SUR) and find that prior researchers overestimated the significance of the TRI

effect, because they failed to account for contemporaneous correlation across firms.

Contemporaneous correlation arises when all sample firms experience the same event (e.g. TRI

release to the public) on the same day, “clustering.” When event clustering is not adjusted for

researchers will more likely reject the null hypothesis of no significant change in returns. In

contrast to Hamilton, Cram and Koehler find that with SUR the aggregate average TRI impact

on stock prices is no longer significant. They do find, however, a statistically significant stock

market reaction to the news for each individual firm on the event day and that approximately half

of the total 368 firms had an abnormal drop in stock price on the event date. This ambiguous

result could equally be assigned to chance, and puts into question the finding of a TRI effect

isolated in event studies.

According to these event studies most environmental events are cash flow news, as

evidenced by a short-lived negative market reaction. In fact we should not expect the market

response to be sustained, unless markets are slow to incorporate environmental cash flow news

into stock price, as has been documented in the post earnings drift literature. However, U.S.

capital market players react to news about a significant accident or fine, regardless of whether it

involves damage to the environment and public health or not. This does not prove irrevocably

that sustainability will eventually result in an increase in stock price. It simply means that capital

markets are efficient with respect to information related to future environmental expenditures,

and that this news leads to a short-term decrease in stock price. The drop in stock price does not

necessarily tell us whether capital markets have incorporated the indirect social costs of

pollution. In fact in their event study Karpoff et al (Karpoff, Lott et al. 1998) find that the drop in

stock price is comparable in dollar value to the fines and penalties issued by the government. A

drop in stock price more likely indicates what capital markets believe to be the direct expected

expenditures in cleaner technology or cleaning-up – in other words the costs of being eco-

efficient.

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Several concerns complicate the analysis of Scenario 1. In the United States is that the

average costs of compliance are low or not reported and thus will have a limited negative impact

on share prices. The other main problem is that some types of environmental information, such

as minor accidents, spills or mandated release of TRI emissions are not indicative of a cash flow

impact. Generally, environmental events are a difficult area to study with this methodology,

since they are difficult to define clearly and tend to be regulation driven and hence more readily

anticipated. The market will tend to price in their effect gradually, which may not at any point in

time lead to a statistically significant signal or a specific “event” date (Schipper and Thompson

1983; Campbell, Lo et al. 1997). Most importantly, findings of short-term price changes do not

offer compelling proof of a systematic or sustained effect of environmental performance on firm

financial performance.

3.2 Long-Term Market Value Studies

Long-term models evaluating the relationship between firm performance and stock performance

draw from various schools of thought, such as accounting, asset pricing and organizational

behavior, yet most suffer from model misspecification. Thus for example, Holthausen

(Holthausen 1994) reanalyzes the balance sheet model used by Barth and McNichols (Barth and

McNichols 1994) to evaluate the effect of estimated Superfund liability on market value of

equity (MVE). Rather than assume, as did Barth and McNichols, that capital markets can

rationally estimate environmental liabilities from sources other than a company’s financial

statements, Holthausen assumes that the market’s assessment of environmental liability was

exactly equal to what firms accrue in their financial statements. Despite assuming the market is

fully informed of Superfund liabilities, his simulations show that changes in firms’ market value

are still greater than expected. As an explanation Holthausen points out that Barth and

McNichols assumed that measurement errors associated with assets, liabilities and their proxy

for environmental liabilities are uncorrelated with each other and with the net asset value of all

omitted variables. This is likely to be false, since book values of assets and liabilities are

predominantly historical cost measures likely to induce correlation in the measurement errors of

both variables. In conclusion it is not clear whether there is a Superfund effect from Barth and

McNichols’ work, even though they find that the market recognizes Superfund liability in excess

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of amounts (on average to 28.6% of MVE) accrued by 477 firms named Principal Responsible

Party (PRP) between 1982-91.6

King and Lenox (King and Lenox 2001) use Tobin’s q to isolate the incremental effect of

TRI emissions on firm market value and re-visit Hart and Ahuja’s (Hart and Ahuja 1996)

analysis. After controlling for several determinants of firm value (e.g. firm size & capital

intensity) used in organizational behavior literature, they find a negative association between

TRI emissions and Tobin’s q for 652 firms between 1987-1996, but cannot offer any insight into

the mechanism underlying the association. Using the same model Dowell et al (Dowell, Hart et

al. 2000) find that the adoption of international environmental standards can improve a firm’s

financial value compared to firms adopting a U.S. standard abroad for 89 manufacturing and

mining firms between 1994 and 1997.7 However, a more likely explanation is that a third factor

affects both Tobin’s q and the measure of environmental performance. To test this concern King

and Lenox control for firm fixed effects in their model and find that the TRI effect remains

significant, though they point out that this model can also obscure evidence of other potentially

significant firm specific attributes of importance to TRI emissions levels. These may or may not

be directly related to a firm’s environmental strategy. Other researchers have started to address

this concern, noting that gains in firm financial performance associated with environmental

performance may be coincidental (interact) with the adoption of the latest technology (Dowell,

Hart et al. 2000), R&D expenditures (McWilliams and Siegel 2000), or variables that could

increase firm productivity or firm growth (measured in % annual change in sales) (Russo and

Fouts 1997). This endogeneity concern can undermine these approaches.

Garber and Hammitt (Garber and Hammitt 1998) use the capital asset pricing model

(CAPM) (Markowitz 1952; Sharpe 1964; Lintner 1965) to analyze the effect of Superfund

liability on the cost of equity capital of 73 chemical firms from 1976-1992. Theorizing that

Superfund liability should depress current stock price in a “wealth effect” (i.e. cash flow effect)

and increase firm risk (the CAPM beta), Garber and Hammitt augment the model with a measure

of Superfund liability (e.g. number of Superfund sites). They do not find a significant cash flow

affect of Superfund liability. Furthermore, they find no significant incremental effect of

Superfund liability on beta for the full sample after controlling for industry-wide effects. Yet

after dividing the sample into large and small firms, 23 large firms with market capitalization

above $1 billion experience an increase in beta, which is not extended to 54 small sample firms

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with market capitalization under $500 million. They postulate that investors have more

information on Superfund liability for large chemical firms leading to a higher discount rate

relative to small firms.8

Here too omitted variables bias will cause an overstatement of the Superfund liability

effect. According to finance economists the CAPM beta does not predict returns and should not

be used for cost of capital estimation. CAPM has been under revision since 1981 when Banz

(Banz 1981) found that between 1926 and 1975 the shares of firms with large market values had

smaller risk adjusted returns on average than similar small firms. The “size effect” continued to

puzzle researchers until Fama and French (Fama and French 1992) presented evidence that when

stocks were sorted by size (market capitalization) and beta, high-beta stocks have no higher

returns than low-beta stocks of the same size. Furthermore, small stocks have a low market value

relative to book value. To account for these anomalies Fama-French (Fama and French 1993)

combined all three (beta, size and book equity to market equity) in a 3-factor model.9 In addition

to the “size effect”, others argue that ratios of market value to accounting measures, return on

human capital, GDP forecasts and the momentum effect undermine CAPM. The debate rages on,

with some finance economists asserting that findings of CAPM anomalies are entirely spurious

or that CAPM is actually untestable (Roll 1977).10

Cost of equity capital estimation using the traditional CAPM beta is thus hopelessly

imprecise. Fama-French (FF) (Fama and French 1997) note a difference of 2% per year in cost of

capital estimation between the CAPM and 3-factor model. This can be a significant error relative

to the finding of increases in a CAPM beta-based cost of capital estimate between .006 and

.034% per month due to Superfund liability (Garber and Hammitt 1998). Furthermore, FF find

that the market premium (Rm-Rf) varies through time, and has a standard error of 3.01% per year,

which will significantly affect the precision of cost of capital estimates using CAPM. Garber and

Hammitt’s results would thus merit re-analysis with a stronger baseline model.11

More recently, Stone et al (Stone, Guerard et al. 2001) compare the returns of several

KLD social screens with the S&P500 index from 1984-2001. Using the FF results, they carefully

control for size (market capitalization), growth, dividend yield and beta by matching 20 fractile

portfolios on these variables. They find no significant cost or benefit of social screening on

portfolio returns. In fact, they suggest that in a market adverse to risk bearing, growth, size

and/or high price-earning’s ratios, socially responsible portfolios could do worse because of their

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factor exposures. While portfolio comparisons may have some weaknesses relative to regression

analysis,12 Stone et al use an empirically convincing equilibrium model of asset returns as the

starting point of analysis.

Section 4. Discussion

This brief overview of the research in the US shows that econometric concerns tend to

consistently undermine the quality of findings. We can trace an evolution from simple analysis

of the relationship between firm performance and stock price changes using few control

variables, matching on one variable, few data years, and industry specific runs to more complex

models more closely aligned with finance economics research. Researchers have yet to

demonstrate that environmental expenditures improve firm profitability in a structural way, and

that it is not a matter of reverse causality, where profitable firms can afford to invest in

environmental performance. A more likely explanation of the research to date is that various

omitted variables affecting both environmental and financial performance are responsible for the

apparent statistical relationship. As researchers attempt to refine their models with additional

variables to reflect the financial impact of firm specific characteristics, organizational behavior

and strategy and eliminate the concern of omitted variables bias, this will erode statistical power.

Parsimony is key in model development. Recent developments in accounting and finance

research help understand the challenge of adopting an analytical model.

Market returns are driven primarily by revisions in capital market expectations of the

profitability of future transactions. This makes it more difficult to justify using contemporaneous

accounting values and organizational characteristics to evaluate market returns, when it is

changes in firm fundamental information that drive the market’s valuation of a firm’s future

earnings. Finance economist John Campbell notes that the type of cross-Sectional models

employed in this research (even an improved CAPM), which regress stock returns on

contemporaneous innovations to variables of plausible significance make it hard to distinguish

between cash flow (Scenario 1) and expected return news (Scenario 2) (Campbell 1991). Finding

a correlation between environmental and financial performance at any time between the release

of pollution news to the markets at t to t+n does not tell us why or how capital markets

interpreted the news. In other words we do not know which of the two scenarios outlined in

Section 2 dominate. Without knowing whether cash flow changes underlie changes in emission

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levels and/or whether capital markets consider this important cash flow news it is hard to

conclude that capital markets encourage firms to spend money for environmental quality

improvements. Campbell and Shiller (Campbell and Shiller 1988) posit that accounting studies

assessing whether securities respond to earnings announcement or other news do not necessarily

ask whether the response is “consistent with a particular fundamental valuation model for the

security price” that correctly predicts stock price behavior (Fama 1976).

Lee (Lee 1999) points out that accounting research in the second half of the 1990s is

marked by a gradual shift away from studies that focus exclusively on the contemporaneous

association between accounting information and returns (i.e. stock prices), toward a research

objective focused on using accounting information in a predictive role. He notes that the residual

income model, which expresses firm value as the sum of its invested capital and the discounted

present value of the residual income from future activities, is a promising baseline model,

variations of which have been used to evaluate the value-relevance of environmental

information.13 By emphasizing the need to improve the forecasting of key valuation parameters,

recent accounting research is converging with the search for a fundamental valuation model by

finance economists. This same shift needs to be made by researchers of environmental and

financial performance.

The risk-return framework has guided finance economics research toward an equilibrium

model of market returns, but has not fully been incorporated in the literature reviewed here.

Garber and Hammitt (Garber and Hammitt 1998) are the exception, yet they do not update their

model to reflect new finance research conducted since the late 1980s, which undermines their

findings. According to Eugene Fama professor of finance, anomalies can only be studied relative

to an equilibrium model representative of economic theory of factors affecting stock valuation

(Fama 1998). Equilibrium models proposed by finance economists include state variables, such

as interest rates, investor psychology and business cycles (Hirschleifer 1970). These will affect

the market’s discount factor (i.e. market risk as a function of investor preferences), which

behaves stochastically (Cochrane 2001). Shiller (Shiller 1981) and LeRoy and Porter (LeRoy and

Porter 1981) demonstrate that simplified asset-pricing models of constant returns and changing

expectations of dividend cash flows do not fully describe the volatility of post WWII stock

prices. In a variance decomposition of stock returns, Campbell (Campbell 1991) determined that

variance about news of future cash flows accounts for 1/3 to 1/2 of the variance in unexpected

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stock returns (defined as the excess of dividend growth over the commercial paper rate). The

remainder is due to news about future expected returns. In 1980s researchers also noted that this

excess volatility is closely related to the predictability of multiperiod returns, which increases

over intervals of several years (DeBondt and Thaler 1985; Fama and French 1988; Campbell and

Viceira 1999). In fact as the number of years used to compute returns increases (1, 3, 10 years),

the constant-expected return model is rejected even more strongly.14 Two common risk

adjustment approaches are to use risk-adjusted returns and a multi-factor model that accounts for

various sources of market risk. When researchers do not apply basic finance economics

approaches to regressions on market value of equity, the results are less likely to be robust. Ball

(Ball 1978) warns, “Some anomalies that have been attributed to a lack of market efficiency

might well be the result of a misspecification of the pricing model.”

An equilibrium model of market returns in fact yields very different results. In a

compellingly simple manner Heinkel et al (Heinkel, Kraus et al. 2001) demonstrate that the

number of green investors is key to affecting stock prices as in the second Scenario outlined in

Section 2 of this paper. They design an equilibrium model of capital markets assumed to be

efficient with two types of risk averse investors: neutral investors, who are insensitive to

environmental concerns, and green investors who have preferences on firm environmental

performance. Theses investors are faced with opportunities to invest in three types of firms:

acceptable firms with clean technology, reformed firms who invest to make their technologies

acceptable and unacceptable firms who do not invest in cleaner technology. After conducting

sensitivity analysis on various parameters, they note that a key determinant of whether a

polluting firm will reform is the fraction of funds controlled by green investors. They conclude

that at least 25% green investors are necessary to change corporate environmental investment

strategy. By a generous estimate, in 2001 11.75% of all U.S. investing managed by professionals

involved a social screen.15 Green investors are not likely to affect stock prices. In fact, when

Heinkel et al calibrate their model at 10% green investors no polluting firm would invest to

become acceptable to green investors, unless the expenditures are 1% of expected cash flow. In

this latter case approximately 10% of polluting firms would opt to invest in cleaner technology.

When green investors are still price takers, as is the case in U.S. capital markets, we

cannot expect a green investor effect as described in Scenario 2 (refer to Figure 1). This should

raise our skepticism of long-term effects on stock returns in this research. A more conservative

14

view of the research to date indicates that the response of U.S. capital markets to environmental

performance can best be described by Scenario 1: information on expected environmental

liabilities or clean-up costs hits the market at time t causing stock price to drop without

necessarily affecting returns. Environmental news is more likely to be cash flow news. This

implies that capital markets do not care long-term about environmental performance and cannot

prompt firms to pay attention to environment, because a win-win situation is unlikely. Secondly,

it implies that environmental compliance is costly, and that capital markets do in fact pay

attention to news of environmental expenditures, promptly incorporating these costs.

Section 5. Future Research

Future research paths should focus on probing the mechanism of Scenario 1. A central challenge

of explaining a cash flow news effect is how to estimate firm level environmental expenditures

and whether they are properly reported to the investing public. Furthermore, if expenditures are

involved, are they an immediate cost or a future cost? Do they reflect the social costs of

pollution?

Researchers struggle to estimate environmental expenditures mostly because data on

environmental expenditures are hard to find and underreporting continues to be a widespread

problem. Around 1990 rising concern about corporate underreporting of Superfund liability

forced the SEC to refocus on environment,16 and the SEC and EPA drafted a Memorandum of

Understanding for information provision. From 1990 to 1995 the EPA Office of Enforcement

and Compliance Assurance (OECA) provided quarterly data to the SEC Division of Corporate

Finance.17 The information highway was interrupted due to OECA reorganization and has not

been taken up again by the SEC. A 1998 OECA study on the disclosure of environmental legal

proceedings in registrants' 10-K statements in 1996 and 1997 found a 74 percent non-reporting

rate.18 The growing corporate environmental reporting movement may become a credible plug

for this gap.19 However, availability of financial data related to environmental management is

limited by the capability of firm managers to collect and voluntarily disseminate such

information, which is scattered throughout the firm, and facility in particular, and often of

minimal financial import (Ditz, Ranganathan et al. 1995; Koehler 2001). Researchers therefore

must undertake their own cost estimates or very rarely use the Census Bureau’s Pollution

Abatement Cost and Expenditure survey (PACE).20

15

Various methods to evaluate the financial implications of environmental expenditures on

the firm level are explored. Most firms claim that costs of Superfund clean-up are hard to

estimate and thus do not recognize the liability in their financial statements early in the long

(sometimes up to 30 year) clean-up. Therefore Barth and McNichols (Barth, McNichols et al.

1997) need to use EPA’s Record of Decision cost estimates and EPA Haz-site reports instead of

firm reported information to estimate liability. They note that it is very difficult to estimate site

remediation costs using publicly available data.21 Unfortunately, they find that the numbers of

Superfund sites per firm not their cost estimate is the strongest predictor effect of Superfund

liability on MVE.22 Similarly unable to find a significant cash flow affect of Superfund liability

on stock prices, Garber and Hammitt (Garber and Hammitt 1998) assume average costs of $41.1

million in addition to 20% transactions costs discounted at 5% based upon prior research. Other

methods include scenario analysis of the impact of new regulations on different industries

(Repetto and Austin 2000; Austin and Sauer 2002), and real options to evaluate off-balance sheet

items (Cortazar, Schwartz et al. 1998). Real options may be particularly well suited to modeling

the uncertainties surrounding renewable resource harvesting and management. Business scholars

and economists still struggle with how to translate environmental risk into financial risk,

particularly when regulation does not provide adequate guidance. Thus for example, levels of

TRI emissions, which have no legal liability, are not indicative of future expenditures and do not

obviously pose a financial risk.

Recently at the 3rd EPA workshop on capital markets and corporate environmental

performance in October 2002 researchers noted the need to evaluate the social impacts of

pollution and how to compare public and private cost/benefit of “internalizing” externalities. The

methods of cost benefit analysis employed by the EPA when new regulations are under

consideration would be helpful in determining the social impacts and costs associated with

pollution. Researchers discussed various questions such as, whether shareholder dialogue or SRI

screens can affect corporate behavior and/or stock price changes. What are the conflicting

interests preventing more investment in pollution reduction? Is there a difference between how

small and large firms allocate resources to environmental compliance? Do earnings shocks affect

pollution levels? What are the externalities associated with pollution and do firms internalize

these? Are markets informed of these and what is role of regulation in promoting transparency?

Under what circumstances can capital markets supplement, complement, or substitute for

16

regulation? If not, why not? Finally, it bears mentioning that this analysis has focused

exclusively on environmental damage from production technologies, which in fact misses the

main environmental/sustainable sources of environmental damage, product use. From the

perspective of sustainability corporate environmental performance measures should cover

production processes and product use as done in life cycle assessment (LCA).

Section 6. Conclusions

This debate has been sparked in part by the perception that the expected future constraints

imposed by sustainability need to be addressed, either by regulation or markets. Where

government action is often slow in coming and potentially unfair, scholars and commentators put

unrealistic faith in the potential of markets to incorporate environmental externalities first. In fact

the fervent desire to demonstrate that corporations can be rewarded by capital markets for their

environmental expenditures has often colored the research and how it is interpreted. Capital

markets are consumers of information, and when the information on the cost of pollution is not

obviously in the public domain, we should not naively expect an impact on share prices.

Researchers should focus on defining and estimating the social costs that are to be recouped via

markets or regulation. To date most cost estimates cover private sector expenditures in clean

technology, but do not incorporate social cost estimates. Finally and most importantly, the

minority in most capital markets, “green” investors are still price takers, implying that

shareholder pressures will not change corporate behavior on average unless there is more

systematic change in the form of regulation. That regulation can have a supply side slant, where

firms are forced to internalize social costs in their pricing structure, or a demand side focus,

where capital market players a required to account for the social impacts of their investments.

The UK government has taken the latter route, followed by France, Germany and others. Only

with additional regulation forcing internalization of environmental externalities will capital

markets systematically become more responsive to information on social impacts of pollution.

17

Figure 1. Capital Market Reaction to Environmental News

18

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Footnotes

1 Dasgupta and Laplante (Dasgupta and Laplante 2001) use an 11 day event window (five days prior to five days post the news release) determined empirically from their data to yield “the best statistically significant results.” They unfortunately do not clarify whether they cleaned the sample of any firms with confounding events during this long event window. 2 The case resulted in a $350 million settlement. 3 Jones et al (Jones, Jones et al. 1994) show that the market responded with the greatest drop in value on July 24th when Exxon announced an $850 million charge to second quarter earnings for out of pocket costs associated with the Valdez spill, which was partly responsible for Exxon’s lowest quarterly earnings in 20 years. See also (White 1996). 4 However, Jones and Rubin (1998) find no overall significant effect on value-weighted returns of 98 negative environmental events between 1970 and 1992 for electric power companies or oil firms. Other environmental event studies include (Klassen and McLaughlin 1996), (Blacconiere and Northcutt 1997), and (Bosch, Eckard et al. 1996). 5 Cram, D.P. and D.A. Koehler, "Pollution As News: Controlling for Contemporaneous Correlation of Returns in Event Studies of Toxic Release Inventory Reporting," MIT Sloan School of Management & Harvard School of Public Health (2000). 6 This critique applies to other papers employing the same balance-sheet valuation model: (Campbell, Sefcik et al. 1996a) and Campbell et al "Disclosure of Private Information and Reduction of Uncertainty: Environmental Liabilities in the Chemical Industry," working paper, Univ. of Washington (1996b). 7 Dowell et al attempt to validate their environmental management quality proxy with firm reported TRI emissions relative to the industry average and find that companies adopting a more stringent internal global environmental standard are relatively less polluting in the US. This is not surprising, since they find for their sample that firms adopting a global environmental standard are larger (in log firm assets) with the highest multinational presence (% domestic/foreign assets) for which a measure of US domestic pollution is less relevant. Multinational firms with a high degree of overseas manufacturing relative to US domestic manufacturing will always appear cleaner, measured in US emissions, relative to firms with a heavy US manufacturing presence, regardless of their environmental management standard. They also note sampling biases. 8 In contrast, Botosan (Botosan 1997) finds that higher disclosure actually reduces costs of capital. 9 This model has an unusually high R2 of 90-95%, but is criticized for being empirically motivated without the backing of a theoretical framework. 10 See (Campbell 2000b) for an excellent summary of this literature. 11 In an Appendix Garber and Hammitt propose a unique multifactor model using the monthly percentage change in industrial production, the excess return of 20-year government bonds over 30-year Treasury bill returns (Rf) and the excess 20-year high-grade corporate bonds returns over the 20-year government bond return. They find an increased risk due to Superfund exposure for the large firm sample, though this model explains even less of the variance in their firm sample returns than the traditional CAPM and is not related to the Fama-French 3-factor model. 12 Fama (Fama 1998) cautions that the 3-factor model is still an incomplete model of average equilibrium returns and can produce different results from an approach matching portfolios on size and BE/ME. 13 The Feltham-Ohlson (F-O) assumes that market value is “equal the net present value of expected future dividends, and is shown, under clean surplus accounting, to also equal book value plus the net present value of expected future abnormal earnings (which equals accounting earnings minus an interest charge on opening book value)” (Feltham and Ohlson 1995). This model helps to valuate firms who do not pay out dividends. Using F-O Johnson et al find that hazardous waste clean-up (which has to be expensed under FASB Issue No. 90-8), penalties for non-compliance and TRI emissions negatively affected market value of equity for 275 S&P500 firms from 1988-90. Whereas capitalization of clean-up and remediation arising from Resource Conservation and Recovery Act (RCRA) sites had a positive effect on market value of equity, which may indicate that the market reacts more negatively to costs which are expensed rather than capitalized, as predicted by F-O. Johnson, M.F., M. Magnan, and C.H. Stinson, "Nonfinancial Measures of Environmental Performance as Proxies for Environmental Risks and Uncertainties," Univ. of Michigan (1998) See also Lancaster, K.A.S., "Valuation Analysis of Environmental Disclosures," Cal. Polytechnic State Univ. (1998); Clarkson, P.M., Y. Li, and G.D. Richardson, "The Market Valuation of Environmental Capital Expenditures by Pulp and Paper Companies," Univ. of Waterloo (1998); Li and McConomy (Li and McConomy 1999) 14 Short-term returns exhibit a serial autocorrelation, the momentum effect documented by Jegadesh and Titman (Jegadeesh and Tietman 1993), whereas in the long-term returns are mean-reverting (Poterba and Summers 1988).

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See (Cochrane 2000), (Campbell 2000b), (Campbell 2000c) and (Campbell, Lo et al. 1997) for excellent summaries of the return predictability literature. 15 2001 Nelson’s Directory of Investment Managers, HostedSurvey.com, an online survey firm, and the Hastings Group, a public relations firm. 16 In 1975 the National Resource Defense Council (NRDC) sued the SEC for failing to comply with the requirement of including environmental impacts in its actions as a federal agency under the National Environmental Policy Act. 17 Items EPA informally transmitted to the SEC: (1) name of Potentially Responsible Parties (PRPs) on the Site Enforcement Tracking System (SETS); (2) RCRA and CERCLA cases on the Consolidated Docket Enforcement System (DOCKET) filed but not concluded; (3) RCRA corrective actions in Corrective Action Reporting System (CARS); (4) all concluded civil judicial cases with an assessed federal penalty of $100,000; (5) criminal cases on the Criminal Docket System (CRIMINAL); and (6) EPA's List of Violating Facilities. 18 http://es.epa.gov/oeca/oppa/secguide.html 19 Launched in March 1999 in London, the Global Reporting Initiative (GRI) guidelines are to aid corporations in preparing voluntary sustainability reports. Emphasizing global applicability, the guidelines aim to encourage harmonization and thereby elevate the quality and internal consistency of reporting. However, without consensus on how to measure the outcomes of pollution, it is still questionable whether the correct variables are being proposed. 20 The concerns with PACE are noted in (Jaffe, Peterson et al. 1995). 21 Barth and McNichols find an average net present value cost per site of $15.12 million in 1991 dollars. 22 They acknowledge that noise in their cost estimates may undermine the significance of the effect of liability proxies on MVE.