SHORT-RUN AND LONG-RUN IMPLICATIONS OF ENVIRONMENTAL REGULATION ON FINANCIAL PERFORMANCE

Abstract

I. INTRODUCTION The Porter hypothesis asserts that properly designed environmental regulation motivates firms to innovate, which ultimately improves financial performance (Porter 1990, 1991; Porter and van der Linde 1995; van der Linde 1993). Many economists criticize this claim, arguing that firms voluntarily seek opportunities to improve financial performance regardless of regulation (Palmer, Oates, and Portney 1995). In particular, critics argue that environmental regulation undermines firms' abilities to pursue opportunities to improve financial performance. Although these arguments generally focus on the effect of regulation on long-run financial performance, they also apply to the effect of regulation on short-run financial performance. (1) Porter and van der Linde (1995) introduce their argument by indirectly attributing competitiveness to financial performance in the context of lower costs and higher revenues: Competitiveness at the industry level arises from superior productivity, either in terms of lower costs than rivals or the ability to offer products with superior value that justify a premium price, (pp. 97-98) Jaffe and Palmer (1997) describe this focus on financial performance as the strong version of the Porter hypothesis: The shock of a new regulation may therefore induce them [firms] to broaden their thinking and to find new products or processes that both comply with the regulation and increase profits, (p. 610) Our analysis tests the strong version of the Porter hypothesis: tighter regulation improves the financial performance of individual firms. By-testing this hypothesis, we contribute to the economic literature that assesses the effects of environmental regulation on various aspects including firms' competitiveness, innovation activities, employment, productivity, investment, location decisions, and financial performance. Previous empirical studies that examine consequences of environmental regulation generally do not examine both short-run and long-run consequences. In contrast, our study empirically examines both the short-run and long-run effects of environmental regulation on financial performance. In particular, we test the Porter hypothesis in terms of both short-run and long-run effects of Clean Water Act regulation (hereafter water regulation) on the financial performance of publicly owned firms in the chemical manufacturing industries. To measure financial performance, we use return on sales (i.e., profits divided by sales), which captures profitability. As our measure of clean water regulation, we use permitted wastewater discharge limits, which are imposed on individual facilities. To strengthen our analysis, our study draws upon a panel data set. Thus, we are able to control more completely for heterogeneity across firms and exploit both interfirm and intrafirm variation. Our results indicate that tighter clean water regulation (i.e., lower permitted discharge limits) improves financial performance in both the short run and long run with a stronger effect in the long run. In particular, return on sales increases by 1.5% in the short run and 4.5% in the long run. II. RELATIONSHIP BETWEEN ENVIRONMENTAL REGULATION AND FINANCIAL PERFORMANCE A. Theoretical Literature To guide our empirical analysis, we first assess two conflicting theoretical arguments exploring the effect of environmental regulation on financial performance. Porter and van der Linde (1995) argue that properly designed and implemented environmental regulation removes organizational inertia and ultimately improves financial performance. Innovation and improved resource productivity are the mechanisms through which this relationship unfolds. As long as firms perceive their production processes and products as elements in a dynamic setting rather than a static setting, firms seize regulation as an opportunity to invest in technologies that not only minimize strains on the environment but also maximize the efficiency of production processes and/or improve the quality of products. …