The influence of financial status on the effectiveness of environmental enforcement

Abstract

This paper analyzes the influence of financial status on the effectiveness of environmental enforcement. It considers multiple dimensions of both enforcement and financial status. Regarding enforcement, the paper considers both the likelihood of enforcement, as captured by the likelihood of inspections conducted at regulated facilities, and the severity of enforcement, as captured by the size of sanctions imposed on polluting facilities found violating their effluent limits. As indicators of corporate financial status, the paper considers measures of liquidity, solvency, and profitability [a proxy for corporate managerial skill], all of which can influence the likelihood that a firm faces liquidity and/or bankruptcy constraints. The paper first develops a theoretical model of optimal abatement in the presence of liquidity and bankruptcy constraints and uses the model to investigate the impact of financial status on optimal abatement and the effectiveness of enforcement. Then the paper empirically examines the interactions between enforcement and financial status using data on wastewater discharges from US chemical manufacturing facilities for the years 1995 to 2001. Empirical results suggest that the financial status dimensions considered here in general play an important role in determining the incentives created by enforcement. As the most striking result, we show theoretically and empirically that, when financial dimensions are included in the analysis, the conventional wisdom regarding the effect of enforcement likelihood on abatement no longer holds, i.e., increased enforcement can actually lead to worse environmental performance.