Corporate environmental management and environmental & financial performance

Published: April 8, 2008, 9:18 pm

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Recent research in developing countries has shown that many manufacturing firms comply with environmental regulations, even when monitoring and enforcement are weak or non-existent. Although this result seems counterintuitive at the first instance, the behavior of the firms may have been influenced by pressure, which could have emerged from the on going economic liberalization program. It can be articulated that the observed abatement incentives that are provided by the factors other than the conventional enforcement and firms that are adopting environment-friendly practices such as total quality management (TQM) is witnessing improved efficiency and performance across the firms. While various reasons could be cited for such a trend, which includes cost reduction through improvement in material input usage, and lower waste disposal, increased public and community activism, increased product value and firm competitiveness due to consumer demand for 'green products', a problem often noticed is the persistence of differential compliance of environmental regulation across the firms. The underlying factors of such a phenomenon is yet to be investigated.

Measurement of Environmental Performance

In the existing literature, environmental performance is measured either by the amount of pollution produced by the production plants per unit of dollar or by the total toxic releases by the firms. All these studies are in the context of developed countries and the studies conducted on developing countries are based on self-reported environmental compliance of the firms. These studies ignore the underlying production process, which converts the inputs into outputs and pollutants. There are relatively few studies that have tried to measure the environmental performance of the firms after taking into consideration the production process of the firms. These studies measure the environmental performance by adopting a linear programming approach using either the firm level data for the developed countries or macro. There is no study that uses firm level data to measure environmental performance in developing countries.

Data Envelopment Analysis (DEA) assesses the environmental performance of a set of producers by grading their ability to produce the largest equi-proportional increase in the desirable output in the presence of environmental costs as an endogenous variable. A non-parametric approach can be utilized to obtain the piecewise linear production frontier defined by the best practice firms from observed data on inputs, outputs and pollution, against which we would compare each firm’s performance. From the frontier, hyperbolic efficiency measures are defined whereby desirable outputs are expanded and undesirable outputs are contracted while simultaneously contracting inputs. Desirable outputs are assumed to be strongly disposable implying that the disposal of any output can be achieved without incurring any cost in terms of reduced production of other outputs. Undesirable outputs may, however, be only weakly disposable; that is, the plant may have to expend resources (or reduce the good output) to reduce them. Environmental efficiency (performance) would be measured by comparing the maximum simultaneous equi-proportionate expansion of desirable outputs and contraction of inputs and undesirable outputs when pollution disposal is costless to that possible when the latter is costly. It represents the extent to which a firm would be constrained in increasing its desirable output and reducing pollution simultaneously when pollution reduction is costly. Firms that are less constrained have a lower opportunity cost of pollution reduction and are considered to be more environmentally efficient, i.e., they choose a better mix of desirable output, undesirable output and inputs. Research on the analysis of environmental performance variation is almost non-existent (except Khanna et al. 2002) for both developed and developing countries. Khanna and Anton have studied why firms are adopting the environmental self-regulation or what is driving corporate environmentalism, but they do not measure the environmental performance, which recognizes their production process or its various determinants.

Environmental and Financial Performance

Literature on the relationship between a firm's environmental and financial performance can be clubbed into two categories, viz., comparative studies on financial to environmental performance over time, and analyze the effect of environmental performance on the capital market value of a publicly traded firm, generally through an event study. Such studies exist both for the developed and developing countries. These studies have shown that poor environmental performance lowers the market valuation of firms and thus reduces banks' willingness to extend credit to such firms. Some of these studies have also used multivariate regression methods to examine the effect of pollution-output ratio, the extent of pollution reduction and adoption of voluntary environmentally friendly initiatives on the firm's profitability.

In order to assess the relationship between environmental performance and financial performance, Tobin’s q can be used as the market-based measure of financial performance. As Tobin’s q is defined as the ratio of the market value (Value theory) to the replacement cost of assets of the firm, it will measure market value by the sum of the value of common stock, the market value of preferred stock and total liabilities (short-term debt and long-term debt). The replacement value of assets is the sum of the property, plant and equipment of the firm, cash and short-term investments, receivables and inventories. Konar and Cohen show that for a firm with no intangible asset value, its market value would equal the replacement value of its tangible assets and Tobin’s q should equal 1. As the value of the firm’s intangible assets increases, the value of Tobin’s q will increase. While the primary focus of this kind ofstudy should be to examine the impact of the environmental efficiency and the ESR on the firm's financial performance, itshould also consider other explanatory variables that have been utilized in the extant literature.

Public Policy Implications

Suchkind of analysis is expected to provide four broad types of information. First, to decipher within industry and between industries evidence on the existence of environmental inefficiency. This enables performance assessment to determine whether a change is needed, what that change should be so as to emulate with the industry best performing firm and introduce appropriate improvements. Second would be the evidence on the direction and magnitude of the impact of the explanatory variables on estimated environmental efficiency. The third aspect relates to the firm specific evidence on their ability to keep up with the best practice environmental efficiency standards, conditional on their circumstances as characterized by the explanatory variables. Finally, the responses of the capital market towards the environmental performance of a firm. All such information generated throughsuch kind ofstudy would be useful for policy purposes. It identifies factors exerting significant impact on the environmental efficiency and how this environmental efficiency is valued in the capital market. To the extent that these factors are subject to government influence, they can be manipulated to improve overall environmental performance of manufacturing firms.This kind of study helps inidentify factors that can be used in the design of incentive-based regulation, as ithelps indecipher environmentally (in)efficient firms whose performance has been achieved despite (because of) these factors.

Corporate environmental management and environmental & financial performance

Contents

Measurement of Environmental Performance

Environmental and Financial Performance

Public Policy Implications

Further Reading

Citation

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