Regulatory Stringency, Green Production Offsets, and Organizations' Financial Performance

• Published date: 01 May 2009
• Date: 01 May 2009
• DOI: http://doi.org/10.1111/j.1540-6210.2009.01989.x
• Author: Nicole Darnall

Nicole Darnall

George Mason University

Regulatory Stringency, Green Production Of‌f sets, and

Organizations’ Financial Performance

Fostering Fiscal

Responsibility:

International,

Federal, and Local

Government

Perspectives

Nicole Darnall is an assistant

professor of environmental science and

policy and a ssistant professor of public

and international affairs at George Mason

University. Her research contributes to our

understanding of management strategy

and the policy s ciences by advancing a

nuanced conception of f‌i rms responses to

regulatory and social setting. She specializes

in corporate sustainability, environmental

policy innovation, and the role of external

stakeholders in the environmental govern-

ance of corporations and government.

E-mail: ndarnall@gmu.edu

Some scholars have argued that environmental regulatory

pressures constrain organizations’ f‌i nancial opportunities,

while others maintain that environmental regulations

can spur product and technology innovations and

encourage greater operational ef‌f‌i ciencies. Advocates on

both sides have evidence in support of their positions.

However, considering both perspectives in tandem and

recognizing that other factors may be associated with

improved f‌i nancial performance, we may f‌i nd that

neither position is valid, or that both are. Relying on data

for manufacturing facilities in seven countries, this study

shows that more stringent environmental policy regimes

are related to diminished f‌i rm prof‌i ts. Yet organizations

that are motivated by a green production focus—def‌i ned

as enhancing internal ef‌f‌i ciencies and new product and

technology development—are more likely to improve

their environmental performance.  ey also demonstrate

a greater probability of benef‌i ting f‌i nancially, thereby

of‌f setting the cost of regulation or accruing a net gain.

Organizations spend millions of dollars

annually complying with environmental

regulations (Portney

and Stavins 2000). For this

reason, some scholars argue

that regulations are detrimental

to an organization’s economic

performance insofar as they

constrain f‌i nancial opportuni-

ties (Christiansen and Haveman

1981; Conrad and Morrison

1989; Lave 1973). In spite of

these documented positions,

other researchers suggest that

regulations can spur organiza-

tions to develop innovative

practices that reduce their envi-

ronmental impacts and enhance

operational ef‌f‌i ciencies (Porter

and Van der Linde 1995).

Companies that improve their

environmental performance

also may expand their market

prospects, thereby creating opportunities for competi-

tive advantage (Hart and Ahuja 1996; Khanna and

Damon 1999; Rivera 2002; Russo and Fouts 1997).

Since the mid-1990s, signif‌i cant evidence has accrued

in support of the idea that “green” production can

benef‌i t corporate prof‌i tability (e.g., Hart and Ahuja

1996; Russo and Fouts 1997; Stanwick and Stanwick

2000). However, there are three limitations to these

studies. First, estimating the benef‌i ts of environmen-

tal improvements, in the absence of controlling for

the potential cost of regulation, does not give a full

accounting of whether an organization’s environmen-

tal and f‌i nancial performance are related. Second, we

know little about whether companies that improve

their environmental performance do so because they

utilize dif‌f erent management practices overall. As

such, superior f‌i nancial outcomes may be mistakenly

attributed to improved environmental performance

when in fact they are associated more with a com-

pany’s general management approach and culture.

 ird, prior research has not considered whether

the environmental–f‌i nancial

performance link exists across

multiple countries.  is issue is

particularly important because

many more companies now

operate globally and in multiple

regulatory settings. When all

of these factors are considered

together, we may discover that

environmental performance has

little relationship to a company’s

bottom line.

Understanding the potential

link between regulatory strin-

gency, green production of‌f sets,

and organizations’ f‌i nancial

performance is important to

public policy.  e primary rea-

son the United States and many

other countries do not have

Organizations spend millions of

dollars annually complying with

environmental regulations‥‥

For this reason, some scholars

argue that regulations are

detrimental to an organization’s

economic performance

insofar as they constrain

f‌i nancial opportunities‥‥

Other researchers suggest

that regulations can spur

organizations to develop

innovative practices that reduce

their environmental impacts

and enhance operational

ef‌f‌i ciencies.

418 Public Administration Review • May | June 2009

Regulatory Stringency, Green Productions Offsets, and Organizations’ Financial Performance 419

national climate change policies and do not advance

more robust environmental legislation is the costs

imposed on f‌i rms. As such, realizing that these costs

can be of‌f set—or eliminated entirely—for companies

that undertake proactive environmental practices

would provide policy makers with critical informa-

tion to advance more ambitious environmental goals.

Knowledge of this relationship may also be used to

encourage additional companies to voluntarily reduce

their environmental impacts beyond what is required

by law, which can improve societal welfare with fewer

government resources. Moreover, to the extent that

more companies begin to reduce their pollution

beyond the requirement of the law, regulators can

allocate their scarce resources to monitoring compa-

nies that pose the greatest potential environmental

harms.  is issue is particularly important in the

U nited States, as Congress has continually under-

funded regulatory inspections and audits, with the

result that the environmental inspection rate is less

than 2 percent annually (Davies and Mazurek 1998).

Finally, understanding the relationship between

regulatory stringency, green production of‌f sets,

and organizations’ f‌i nancial performance can create

more support for private sector partnerships with

government managers. For instance, environmental

ministries worldwide have been promoting company

participation in voluntary environmental programs

(VEPs). Within the United States alone, more than

13,000 companies are participating in government-

sponsored VEPs (Mazurek 2002). VEPs provide par-

ticipating organizations with incentives to improve

their environmental performance beyond regulatory

requirements (Darnall and Carmin 2005). However,

concerns recently have been introduced about the ef-

f‌i cacy of these programs (Koehler 2007; EPA, Of‌f‌i ce

of Inspector General 2007). At issue is the fact that

that many VEPs suf‌f er from weak monitoring and

sanctioning mechanisms that mitigate free-riding

behavior. In the presence of free-riding, participants

receive program benef‌i ts (including public recogni-

tion, access to regulators, information sharing, and,

in some instances, consolidated and expedited per-

mitting) while failing to improve the environment

in a meaningful way. Weak VEP design structures

have been attributed to policy makers’ desire to bal-

ance the development of programs having rigorous

mechanisms for monitoring and sanctions with the

goal of creating a f‌l exible means for a larger number

of participants to move beyond the parameters estab-

lished by the traditional regulatory system (Darnall

and Sides 2008). However, by providing a stronger

business justif‌i cation that encourages f‌i rms to par-

ticipate in these programs, regulators may be able

to enhance VEP rigor, encourage more widespread

participation, and improve the natural environment

to a greater degree.

 is study addresses these issues by evaluating the

benef‌i ts associated with proactive environmental strat-

egies and assessing the costs associated with the strin-

gency of the traditional regulatory system. It accounts

for the potentially endogenous relationship between

environmental and f‌i nancial performance using data

for organizations operating in seven countries. By tak-

ing this approach, the research of‌f ers a more complete

view of whether the regulatory system constrains com-

panies’ f‌i nancial opportunities and whether environ-

mental improvements benef‌i t companies f‌i nancially.

Relationship between Environmental

and Financial Performance

Neoclassical economic theory suggests that organiza-

tions operate with ef‌f‌i ciency-driven goals. Possessing

perfect information, managers allocate their resources

internally so that ef‌f‌i ciency in the production process

is maximized.  is position suggests that compli-

ance with environmental regulations imposes costs

on organizations and that these costs reduce f‌i rms’

overall competitiveness (Christiansen and Haveman

1981; Conrad and Morrison 1989; Lave 1973). If

we believe this traditional view, then there is little

incentive for f‌i rms to adopt proactive environmental

strategies. However, corporate innovation has changed

signif‌i cantly in recent years, and its pace is increasing.

Innovation spans virtually all organizational bounda-

ries, it is increasingly global, and it involves stake-

holders rarely considered in the past.  ese changes

create signif‌i cant opportunities for companies that

improve their environmental performance beyond

that required by law. Firms that innovate by reevalu-

ating their internal processes (which otherwise are

overlooked) and by increasing ef‌f‌i ciencies (by reducing

unnecessary materials purchases, increasing productiv-

ity, and reducing waste in the production cycle) stand

to benef‌i t signif‌i cantly from lower production costs

(Porter and Van der Linde 1995). Additionally, corpo-

rate innovation can lead to new product and technol-

ogy development opportunities. Each of these factors

can enhance an organization’s social legitimacy, which

facilitates their long-term survival and competitiveness

(Hof‌f man 1997).

Scholars advancing this “revisionist view” suggest

that f‌i rms do not always pursue prof‌i t-maximizing

opportunities because of information asymmetries in

the marketplace, which af‌f ect managers’ abilities to

make optimal production decisions (Scott 2001).

Related to the natural environment, organizations do

not consistently maximize their prof‌i ts because of at

least three factors: a poor understanding of the organi-

zation’s environmental costs (Ashford 1993), weak inter-

nal coordination to remedy existing inef‌f‌i ciencies, and

signif‌i cant inertia that prevents organizational action

that would allow for the exploration of innovative ideas

to traditional problems (Cordano and Frieze 2000).