The market response to environmental incidents in Canada: a theoretical and empirical analysis.

• Author: lapplante, Benoit

1. Introduction

   There is a growing concern that regulations that promote safety (e.g., automobile safety and product safety) may have little impact on the level of risk associated with the utilization of such products |21; 29~. A similar concern has been recently raised with respect to regulations that promote safety in the workplace |12~. A reason often advocated to explain this phenomenon is the lack of adequate enforcement mechanisms. In particular, it is often argued that fines imposed on agents not complying with these regulations are not severe enough to have a deterrence effect |30~. With respect to the enforcement of the Ontario Environmental Protection Act (R.S.O. 1980, c. 141), Saxe writes that "the majority of fines were too low to act as effective deterrents" |23, 104~. However, some authors have challenged this view in showing that the market provides additional monetary incentives for firms to comply with the regulations by punishing non-complying firms through lower stock market prices. For example, some analyses have shown that public announcements of lawsuits against American firms not complying with workplace safety |8~, product safety |31~ and environmental regulations |19~ have caused significant drops of the equity value of these firms. In this last study, it was found that the announcement of lawsuits against firms violating the American Resource Conservation and Recovery Act (RCRA 1976) had a significant negative impact on their equity value on the day of the announcement, while announcements of suit settlements (e.g., fines) had no effect. In most studies, authors argue that the reductions in stock prices have some deterrence effect on firms.

   Following Muoghalu, Robison and Glascock |19~ (henceforth MRG), this paper examines the impact of the announcement of environmental incidents on the firm's equity value using a sample of 47 events involving Canadian firms between 1982 and 1991. Like its American counterpart, Canadian environmental regulations (both federal and provincial) are of a "command-and-control" nature.(1) However, it is claimed that enforcement of the regulation has been more severe in the United States. In a comparative qualitative analysis of the regulatory approach in Canada and the United States, Marchant notes that "the United States has one of the most adversarial industry-government relationships in the world, and the hardball attitude of some U.S. industry on some issues may have been the cause of stiffer and less compromising enforcement on the part of the U.S. Environmental Protection Agency" |18, 46~.(2) Our analysis extends MRG's study in two different directions. First, unlike previous papers concerned with similar questions, our analysis is based on a theoretical model that describes how shareholders update their beliefs as to the profitability of the firm when certain environmental incidents are announced. Second, in addition to the announcement of lawsuits and suit settlements,(3) we examine shareholders' reaction to two other categories of events: the announcement of environmental incidents likely to lead to a lawsuit (e.g., levels of pollution above provincial/federal limits, spills) and the announcement of investments in emissions control equipment.

   The paper is organized as follows. In section II we present the main features of our theoretical model. In section III our data set is presented and discussed. The event-study methodology is briefly described in section IV and our results presented in section V. We find that the announcement of investments in emissions control equipment are followed by a decrease in the equity value of firms. We also find, contrary to MRG, that Canadian shareholders react negatively to the announcement of suit settlements, not to the announcement of lawsuits. These results yield support to the view that the enforcement of environmental regulations has generally been more severe in the United States than in Canada. Section VI provides concluding remarks.

2. A Theoretical Model of Optimal Timing of Compliance

   How is the regulator to decide whether or not there is violation of the emissions standards in a situation where not only the firm's rate of discharge is stochastic, but where also the regulator obtains an imperfect measure of that rate of discharge? Presented this way, the problem is one of statistical quality control to which a number of authors have provided answers |2; 15; 28~. However, these answers are not entirely satisfactory. In all these models, the optimal sample size is chosen before the monitoring process actually takes place. The firm's optimal strategy (choice of pollution level) is also determined at the beginning of the regulatory process. This lack of dynamics prevents the firm's optimal strategy to evolve from a state of no compliance to a state of compliance: in these circumstances, the firm's optimal solution is always either to comply or not comply. There is no room for the firm to change (update) its compliance strategy as the regulator samples its pollution level. Such models cannot explain why a firm would suddenly announce that it will invest in emissions control equipment. How can it be that it was not optimal for the firm to comply with the environmental regulation yesterday, but that it is today?

   Moreover, the literature has so far ignored an important characteristic of the enforcement of environmental regulations: even if a violation is correctly detected (i.e., the regulator judges there is a violation while indeed there is one), it does not necessarily follow, as implicitly assumed in previous papers, that the regulator will try to obtain compliance through legal prosecution. There is ample evidence that environmental regulators prefer to obtain "voluntary" compliance from polluters |4; 20~. Legal action is a last resort. Hence, we prefer to model the regulator's monitoring and enforcement problem in such a way as to offer dynamics not only to its decision process, but also to the firm's optimal compliance strategy. Not only shall we observe the regulator updating its belief with respect to the firm's compliance with the emissions standard, but we shall also be able to determine the exact moment for which it becomes optimal for the firm to comply with the emissions standard. Immediate compliance is in general not optimal since the probability of enforcement through penalties is too small. While previous authors have argued that the small number of court cases related to the violation of environmental standards is the prima facie evidence of poor monitoring and enforcement, we show that it may simply be the result of good anticipation by the firm as to the probability of being sued in any given period. This framework of analysis also allows us to provide an explanation for a firm's incentive to announce investments in emissions control equipment. We first present a theoretical model of the regulator's behavior. Then, given this behavior, the firm's compliance strategy is derived.

   A Model of Regulator's Behavior

   Our main objective is to describe a process by which the regulator updates its belief as to the state of compliance of the firm with the emissions standard. As one would like to observe, we show that the higher the measured level of pollution the higher the regulator's belief that the firm does not comply with the emissions standard.

   A firm produces a good |x.sub.t~ and emits a pollutant in quantity |P.sub.t~ in period t. This quantity is stochastic and is a function of whether or not the firm complies with the emissions standard. Let

   |P.sub.t~ = |P.sup.c~ + ||Theta~.sub.t~ (1)

   be the level of pollution if the firm complies with the regulation, and

   |P.sub.t~ = |P.sup.nc~ + ||Theta~.sub.t~ (2)

   if it does not comply. ||Theta~.sub.t~ is a pollution shock in period t. We assume that |Mathematical Expression Omitted~. Hence, the firm's mean (expected) level of pollution is |P.sup.c~ if the firm complies with the regulation, and |P.sup.nc~ if it does not comply. If the emissions standard is strictly smaller than the firm's unregulated level of pollution, then |P.sup.c~ |is less than~ |P.sup.nc~.

   In each period, the regulator obtains a measure |Mathematical Expression Omitted~ of the firm's stochastic pollution level. In period t, we thus have

   |Mathematical Expression Omitted~

   where ||Psi~.sub.t~ captures the possibility of a measurement error. We assume that |Mathematical Expression Omitted~. Hence, the measure obtained in period t is unbiased. It follows that |Mathematical Expression Omitted~ if the firm complies with the emissions standard and |Mathematical Expression Omitted~ if it does not comply.

   Before measuring the firm's level of emissions, the regulator cannot observe whether the firm complies with the emissions standard. Nonetheless, it holds a prior belief ||Rho~.sub.0~ that the firm does not comply. The value of this prior belief is determined by a number of factors among which is the presence or absence of an emissions control equipment. Indeed, given that emissions standards are...