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Why firms comply with environmental regulations is an important topic of inquiry for both government policy analysts and corporate officials interested in good internal management practices. Obviously, the government cares about compliance because it wants firms to reduce pollution. But the question about whether or not firms comply with environmental regulations is important to government policymakers for an even more subtle reason. For example, if the government imposes new, stricter environmental regulations on firms, emissions could actually get worse, not better, if the new regulations are not complied with. That is, when projecting the impact of a newly proposed regulation on the environment, policymakers must take into account both the “full compliance” scenario as well as the expected compliance rate. Similarly, from a company’s perspective, even if corporate policy is to strictly comply with all government regulations, some facility managers might ignore that directive as they try to reduce costs or maximize profits. Thus, company officials need to fully understand all of the incentives within their organization if they want to achieve a certain level of compliance within their firm. In addition, some violations of environmental regulations are unavoidable and/or unintentional. Thus, even if a company “intends” to comply, violations might occur and the company might be at risk for government-imposed penalties and bad publicity.
While the evidence is actually rather spotty—and there are some who dispute the figures—the U.S. Environmental Protection Agency (EPA) has estimated compliance rates in the United States to be as high as 80%-90% of all firms. Yet, scholars who have studied firm compliance with environmental regulations have noted that the penalty for noncompliance is oftentimes very small—only a few thousand dollars on average. When the penalty for noncompliance is only a fraction of the cost of compliance itself, one wonders why firms would comply at all! Why don’t firms simply disobey the law and save millions of dollars in compliance costs and instead pay a few thousand dollars in penalties? This research-paper examines both the theory and evidence of why firms comply with environmental regulations, with the goal of gaining a deeper understanding of both government policy as well as the managerial implications for ensuring that firms are acting in both their own—and society’s—best interest.
What Does “Compliance” With Environmental Regulations Mean?
Environmental regulations are complex and multidimensional. They may cover media such as air, water, waste, noise, as well as toxic substances that enter into supply channels. Environmental rules literally take up thousands of pages of government documents. The scope of regulation is all-encompassing. For a manufacturing facility, compliance might include building certain pollution-control equipment, adhering to limits on pollution discharges, limiting recordkeeping and technical storage, training and staffing requirements, and auditing procedures. A complex facility might have hundreds of regulated pollution sources and permits that consume hundreds of pages. In addition, it is not always clear up front whether certain actions are required. Resolving these differences is often something that courts ultimately get involved with. Thus, in some cases, whether a firm is in compliance might ultimately be decided by a court as a judge interprets congressional mandates.
Adding to the complexity of the myriad of rules and technical engineering standards, firms must deal with multiple enforcement authorities. In the United States, much enforcement is delegated to state and local authorities. However, the EPA retains discretion to enforce when it is not satisfied with the effort of state or local officials. While this threat has only rarely been used, the fact that it is available to EPA presumably ensures that state and local authorities do not entirely shirk their enforcement duties. In the United States, private parties can also enforce many of the environmental laws through various legal mechanisms where they can not only compel firms to comply, but they can also be reimbursed for the cost of litigation. These private lawsuits are often initiated by public-interest law firms that are organized to enforce environmental regulations or other public interests. There are several reasons why governments might adopt this dual-enforcement approach. Private citizens who are directly affected by pollution might be better situated to detect environmental violations in their neighborhoods and can be good judges of whether or not they are concerned enough about this pollution to take some action. It is also possible that private enforcement is less costly as private enforcers are not subject to the inefficiencies of government bureaucracies. Finally, the government enforcement agency might simply lack the funds to adequately enforce, and instead would have to rely upon private enforcement agents to fill in the gaps. Despite these apparent benefits, private enforcement might also serve the less noble goal of enhancing private interests at the expense of public interests. Thus, private enforcers might simply be viewed as “bounty hunters” and could even force compliance beyond a level that is socially efficient.
Environmental compliance is never a “black or white” issue. For example, water pollution regulations in the United States generally require firms to obtain state-enforced permits that specify the maximum amount of pollutants allowed to be discharged on a daily basis (or some other time-variant measure). Other laws or regulations might require the installation of “best available technology” which would be open to varying interpretations depending upon the size or age of the facility. Other laws might require advance disclosure and testing of “new chemicals,” where there is some ambiguity of what a “new chemical” means. To see how difficult it might be to determine which firms are in or out of compliance, consider the typical water pollution permit. While the exact details vary by state and by industry, suppose a permit requires daily water samples and a facility is determined to be out of compliance if the average daily reading exceeds a certain figure over the entire month. In other words, it would be allowable to be over the limit on some days, but over the entire month the average must be below the permitted level. Under a system like this, it is possible that two identical facilities with identical pollution-control programs could have different average readings if they happen to measure at different times of the day, during different production schedules, or so on. Thus, it is entirely possible that one of the two firms would be considered out of compliance even though both firms on average have identical pollution levels. Similarly, if one of these two facilities has an accidental discharge—perhaps by an employee who makes a mistake and fails to hit the correct switch—that facility might be out of compliance despite good intentions by both facility managers.
It should now be evident that firms might be out of compliance for several different reasons. First, a firm might intentionally violate the law and fail to install or to properly maintain pollution-control equipment. Second, a firm might be out of compliance through negligent behavior—either by not maintaining a piece of equipment properly or by failing to adhere to proper pollution-control procedures. Finally, a firm might be out of compliance with environmental regulations because of events entirely out of its control. For example, an oil tanker might spill oil following an accident with another ship or due to damage it incurs as a result of extremely bad weather. While I have characterized this latter form of noncompliance “accidental,” in truth, all accidents involve some degree of culpability on the part of the party that has the accident. Whether the oil tanker has been equipped with a double-hull, has adequate navigation equipment or lighting to warn approaching ships, has a properly trained crew which is not overworked beyond capacity, and has readily available equipment on board to contain a spill if an accident does happen—will all affect the likelihood that a spill will occur as well as the severity of any spill that does occur. This is also true for a stationary facility that is trying to avoid an accidental discharge due to bad weather, faulty electricity, or even a terrorist attack that is designed to force a discharge of hazardous chemicals. Thus, it is often difficult and/or costly for a government agency to determine the “cause” of polluting activity. This issue will be discussed later, when the notion of “strict liability” versus “negligence” standards is dealt with in the context of monitoring employee behavior.
Economic Theories Of Firm Compliance And Penalties
Economists have studied firm compliance behavior in a similar manner to that of criminal behavior. The Nobel Prize winning economist, Gary Becker (1968), first formalized the “optimal penalty” theory to analyze criminal behavior. The basic insight of that seminal article is that potential criminals respond to both the probability of detection and the severity of punishment if detected and convicted. Thus, deterring criminal activity may be achieved either by increasing the severity of the penalty, by increasing the likelihood that the offender will be caught, or by changing legal rules to increase the likelihood of conviction. The “optimal penalty” for Becker is equal to the harm divided by the probability of detection. This penalty will deter potential criminals optimally because it ensures that they weigh the expected benefit from engaging in criminal activity against the expected cost—which is now set to the “expected social harm” from their illegal activity. In other words, the Becker optimal penalty turns the individual utility maximization problem into one of social welfare maximization.
One of the key insights of this model is that the government can trade off these various policies. Thus, for example, if government resources for police are reduced, the same level of crime control might be achieved by increasing the severity of punishment if caught. Similarly, if a government enforcement agency’s budget is cut, it is theoretically possible to achieve the same level of compliance using increased penalties for noncompliance. In fact, the Becker model actually prescribes setting the probability of detection small (to save on policing resources) and instead setting the penalty as high as possible. However, there may be limits on how high a penalty is feasible—for political reasons, wealth constraints, or limited life expectancy of criminals, or for purposes of preserving marginal deterrence.
While Becker’s model was designed to analyze criminal activity such as burglaries, robberies, or violent crimes, it has since been applied to firm compliance of environmental regulations (see, in particular, Cohen, 1987, 1992; Magat & Viscusi, 1990). The Becker model assumes that the firm is rational and maximizes its expected profits by weighing the cost of compliance against the expected savings from noncompliance. In this case, the expected savings from noncompliance are equal to the direct cost savings from noncompliance minus any penalty that the firm might receive from being detected by enforcement authorities. The higher the probability of being detected and the higher the penalty if detected, the lower the expected cost savings from noncompliance.
One key assumption in the Becker “optimal penalty” model is that the decision maker who must decide whether to comply with a regulation has reasonably good information about the risk of punishment. Not only must the decision maker have good information about the probability of punishment and the size of punishment if caught, but she must also know about the law itself—that is, what compliance is actually required. In some cases, this is itself an impediment to compliance (although certainly not an excuse in the eyes of the law). For example, owners of a small business might not be well versed in the law and might not have access to trade associations or other mechanisms to learn about environmental requirements. In that case, one possible government response is to provide information about environmental regulations, compliance assistance, and other positive forms of reinforcement to ensure compliance—instead of simply relying upon the threat of punishment.
Of course, even if the decision maker at the polluting facility miscalculates the probability of detection or the size of the penalty, the optimal penalty model might work—as long as the government enforcement agency sets the penalty based on the decision maker’s expectations. Thus, for example, some observers have noted that small polluters have much higher compliance rates than one would estimate if simply looking at the objective probabilities and expected penalties. One reason for this high compliance rate might be that small polluters overestimate the likelihood that they will be caught and the size of the penalty—hence they are deterred and comply even though objectively it does not appear to be in their best interest. There is some limited survey evidence that this is the case in the United States.
Note that in the context of environmental compliance, there are various stages at which the government might intervene. Thus, for example, the government might wait until it has discovered an illegal discharge of pollution to determine that there has been noncompliance, and then impose a penalty once noncompliance has been discovered. Alternatively, the government might proactively inspect facilities to ensure compliance with all regulations and impose penalties for failure to install or maintain equipment—even if there has not been any illegal discharge. These alternative approaches are not necessarily equivalent. Not only will they require different levels of government resources to enforce, but also their effectiveness might vary considerably depending upon the circumstances. For example, ex ante monitoring might be more effective when it is difficult to determine the source of pollution ex post. An example of this might be the difficulty of determining the source of a contaminated water supply in an industrial area with many different factories. In that case, inspecting each facility to ensure they have adequate control equipment might be a more feasible and reliable method of determining noncompliance than trying to identify the source of pollution after it has already occurred.
Another example in which ex post sanctions might not be effective is if a firm is nearly insolvent and cannot afford a large penalty; hence, there is little incentive for them to comply. In that case, preemptive inspections might be far more effective. Forcing the firm to comply—or to shut down its operations—will prevent pollution from occurring, while no ex post penalty will deter this illegal behavior. Alternatively, ex post nonmonetary sanctions (e.g., incarceration) might be used against individuals within the firm or the firm owners as a way to increase the severity of sanctions without increasing the monetary penalty. Note that incarceration is not the only form of nonmonetary sanction. Individuals convicted of a crime may be placed on probation, forbidden from engaging in certain lines of business or professions, or may have certain restrictions placed on their rights. Similarly, organizations might be placed on “probation” whereby the court or regulatory agency monitors their future compliance or remediation activity. They might also lose certain rights such as the right to sell goods or services to the government or even the right to engage in an activity such as hazardous waste disposal.
In addition to the threat of sanctions, governments often engage in many positive programs designed to encourage and assist companies in achieving compliance. Especially in the case of small firms which might not have the capacity to pay for full-time environmental staff or to hire consultants, the government might provide technical assistance. In some cases, government tax incentives and/or low-interest loans might also be used to lower the cost of compliance.
Nongovernmental “Sanctions” And Firm Compliance
As noted previously, one reason firms might comply with environmental regulations is the threat of government-imposed penalties if they do not comply. However, as also noted earlier, researchers long ago observed that the risk of being caught and the expected penalty from noncompliance is extremely low—and that if most firms were to do this simple cost-benefit calculation, they would find it is not in their best interest to comply! Thus, there must be other reasons for compliance in addition to the immediate threat of government sanctions.
One reason firms might comply with environmental regulations is the threat of sanctions outside the normal government enforcement mechanisms. For example, a facility that is continuously found to violate pollution control laws might have a difficult time convincing a local zoning authority to grant a license to expand its facility. To the extent bad publicity follows a government enforcement action, investors might shun the stock of that company either for reasons of social conscience or simply because they fear there are other hidden problems with the company. In other words, investors might use the environmental compliance record of a company as an indicator of the quality of management. Presumably, if a manager is good at navigating the complex world of environmental regulations, he is also good at navigating the equally complex world of manufacturing and sales. Finally, certain consumers might be less likely to purchase products from companies with poor environmental records. Firms with consumer brand-name products and reputations are likely to be more sensitive to consumer demand and thus are more likely to be subject to this type of pressure. There is growing evidence that a small but significant percentage of consumers care enough about environmental performance of firms to make it one criterion in their purchase decision—at least at the margin when price and quality are otherwise equal. In fact, a significant percentage (10%-15%) of new product introductions involves some form of “green marketing.” Thus, the marketplace might reward firms that comply with environmental regulations.
Another reason firms might comply is due to social norms and the fact that individuals generally want to abide by laws they understand. Thus, assuming managers know about the environmental standards they are supposed to adhere to, compliance might be simply the result of a moral obligation. Compliance might also be higher to the extent that individuals and firms believe the rules are legitimate and fairly applied. To the extent social norms and legitimacy explain compliance, we would expect that the role of the government is largely to inform regulated firms of the requirements, and perhaps provide them with assistance in the form of technical know-how and encouragement to comply. It would also be important for the government to fairly enforce regulations, as people are more likely to adhere to laws that they believe are fairly and uniformly enforced.
Compliance Within The Firm: Monitoring Employee Behavior
Thus far, we have largely assumed that decisions made at the corporate level will be implemented in the field. Thus, if the owner or top manager of the company wants its facilities to comply, we assume they will do so. Put differently, if the “optimal penalty” is imposed on the owners of the firm, it is assumed that they will have the appropriate incentive to ensure that their firm is in compliance. Thus, the government enforcement agency can simply impose an optimal penalty on the company that is generating the emissions and not worry about the individuals involved. In reality, however, corporate owners and managers have their own enforcement problem when trying to convince employees to act on the company’s behalf. This is no different from any other organizational design problem for a firm manager—how to motivate employees to work in the best interest of the firm. This is a classic “principal-agency” problem, whereby the principal (firm) must design an appropriate incentive contract to motivate the agent (employee). In a principal-agency problem, the principal has a difficult time motivating her agent’s behavior only if the “effort” by the agent is unobservable. In other words, if the principal can perfectly (and costlessly) observe the action of the agent, it would be easy to design an incentive contract—the agent would only be paid if she acted in the principal’s best interest. In reality, of course, it is almost never possible to fully observe the agent’s actions.
Any student of organizational design or organizational economics will realize how difficult it is to evaluate and compensate employees to work optimally on the firm’s behalf. Few employees have only one task that can be monitored, and no employee’s actions can be monitored perfectly without cost. Thus, for example, suppose a facility manager’s compensation is based on his unit’s profitability. To reduce costs, he might decide to postpone required maintenance of pollution control equipment. Suppose further that a hurricane floods his plant, resulting in the bursting of an overflow tank that should have kept hazardous wastes from flowing into a local water supply. Was the resulting pollution caused by an act of nature or by the negligence of the manager who could have prevented the tank from bursting if it had been properly maintained? As discussed above, the government might decide to either use a “negligence” standard in deciding about the appropriate punishment—that is, impose severe punishment only in the case that it is determined the pollution control equipment was not properly maintained, and impose no (or less) punishment if the “accident” occurred despite the best efforts of the facility. Alternatively, the government might impose a “strict liability” standard on such discharges, in which case it does not care if the pollution is “caused” by a natural disaster or intentionally. In the United States, some environmental regulations are enforced based on negligence standards, while others are based on strict liability.
It is clear that imposing a “strict liability” standard is less costly to the enforcement agency than a negligence standard, since in the former case there is no need to investigate the cause of the pollution—if it happens, the firm suffers the consequences. This is also true in the case of the employer-employee relationship. It will be less costly for the employer to use a strict liability standard than to have to investigate the cause of any polluting event. Thus, at first blush it might seem that a “strict liability” standard should be imposed by the owners of the firm on its facility manager. However, that shifts the risk of natural disasters onto individuals who are less able to bear that risk than firm owners who are likely to be wealthier and more diversified. Shifting the risk to the facility manager could have several effects. First, to attract people into that profession—where they risk being fined or laid off in the event of an act of nature beyond their control—would require paying a “risk premium.” Second, individuals faced with that situation are likely to “overcomply” to avoid the negative consequences of a violation. Thus, for example, the facility manager might purchase costly backup equipment that the firm does not otherwise want—solely to avoid the personal liability associated with a polluting event. While we cannot cover all of the nuances of this situation, it is clear that designing an optimal incentive contract is not a trivial exercise.
Empirical Evidence On Firm Compliance
The empirical evidence on firm compliance largely focuses on understanding whether or not government enforcement and monitoring activities increase compliance—and hence deter illegal behavior. Due to data availability, much of this literature has focused on three industries—(a) oil spills from tankers and transfer operations, (b) water pollution from pulp and paper mills, and (c) steel industry emissions. Cohen (2000) contains a review of the empirical evidence on the effectiveness of government enforcement activities in reducing pollution. In the case of oil spills, most of the violations are either “accidental” discharges (which as discussed earlier might oftentimes be characterized as being partly “caused” by negligence) or intentional violations such as cleaning out a tanker and disposing wastes directly into a waterway. In contrast, the pulp and paper and steel industries involve ongoing pollution that is controlled through continuous processes. Pollution is allowed, but only at a level specified in the government-granted permit.
In general, these studies show that both increased government monitoring and increased enforcement activities result in reduced pollution and/or increased compliance. Studies at the plant level (e.g., pulp and paper or steel mills) have documented a specific deterrent effect. “Specific deterrence” refers to the effect that an inspection or enforcement activity targeting a particular firm has on that firm’s subsequent environmental performance. While there might be many reasons why firms tend to improve their environmental performance following a government inspection, one reason appears to be the threat of more punitive sanctions if a violation is found on a repeat inspection. There is evidence that the EPA, for example, imposes a higher penalty on “repeat violators” than on those who are found to be in violation of environmental regulations the first time. Thus, we would expect (and find) that firms are more careful after their first violation.
Other studies have measured monitoring and enforcement at an aggregate level (e.g., state, region, or port). In many cases, the demonstrated effect could be labeled “general deterrence.” General deterrence refers to the effect of an enforcement activity on the behavior of a large number of persons or firms who might not have been targeted by the initial enforcement effort. A series of empirical studies beginning in the mid-1980s have documented a general deterrent effect on both the frequency and volume of oil spills from increased Coast Guard monitoring activities. For example, random port patrols—where the Coast Guard simply looks for evidence of oil sheens—has been found to deter spills. However, the magnitude of any deterrent effect differs by monitoring activity, and there is some evidence that “targeted” monitoring—where “high risk” vessels are targeted for increased inspections—enhances the deterrent effect of Coast Guard activities. There is only limited evidence that higher government-imposed penalties have any deterrent effect on oil spills. This might be due to the relatively small fines that have been traditionally levied on spills (oftentimes only a few hundred or thousand dollars)—hence, it is not known if significantly higher penalties would have a larger deterrent effect.
As discussed earlier, community pressure outside of government enforcement agencies might also deter firms from violating environmental regulations. There is some evidence that simply publicizing those firms that are out of compliance may bring about sufficient shame and/or community pressure to convince managers to clean up their acts. Several experiments in information disclosure programs in emerging economies such as Indonesia and China have been promoted and reported on by the World Bank (see http://www.worldbank.org/nipr). Although some of these experiments are designed to fill a void where no regulations are in place, others have explicitly used the power of information disclosure as a method of pressuring firms to comply with government regulations. This is particularly useful in countries where government enforcement resources are limited. It has also been noted that information programs like this are likely to be more successful to the extent that the local community is educated and politically active.
Thus far, we have largely ignored any differences among firms and instead simply said that some comply and others do not. The “optimal penalty” model would predict that differences in compliance rates would be due to either perceived (or actual) differences in the detection rate or differences in the cost of compliance. Thus, if it costs some firms more than others to comply, for example, we would expect compliance rates to differ. In addition, we already discussed the possibility that organizational design and incentives within the firm might cause some firms to comply less than others. Government enforcement agencies are particularly interested in understanding which firms are more likely to be out of compliance so that they can target their enforcement activities. Unfortunately, the evidence to date is rather weak and somewhat mixed.
One of the factors thought to be important in understanding compliance is firm size; however, it is not clear whether larger or smaller firms are more likely to comply. First, we need to be careful in specifying what we mean by size. There might be a huge difference between “facility” size and “company” size, for example. A multibillion-dollar business might own hundreds of very small facilities scattered across the world. Another company of the same size might have one enormous plant that is centrally located. These are very different companies and are likely to have different approaches to environmental compliance.
On the one hand, larger firms might have a lower cost of compliance to the extent there are economies of scale in compliance. At the facility level, there might be economies of scale due to construction costs and scaling of pollution control equipment. For example, doubling the capacity of a facility might require running the plant an extra shift— which might require more electricity and maintenance of pollution control equipment. However, doubling the capacity at a facility like this would not necessarily require duplicating the expensive pollution control equipment that is already in place. In contrast, doubling the capacity of a company by building an identical facility at a different location might indeed cost the company twice the amount to comply with environmental regulations. In some cases, there might also be economies of scale at the corporate level. For example, a large firm with many facilities might be able to afford a full-time compliance staff that can maintain continual vigilance over state-of-the-art compliance techniques as compared to a small firm that might not keep up with innovations or have to hire an expensive consultant to assist with its compliance program. In other words, a large corporation that owns many small facilities can spread the cost of acquiring knowledge across many of its facilities, whereas the owner of a single facility does not have that opportunity. In addition to economies of scale, it is also possible that larger firms are more visible in their communities—and hence more subject to community pressure to comply with environmental regulations.
On the other hand, larger firms might have more difficulty motivating employees to comply with environmental regulations. That is, to the extent there are more problems associated with the principal-agency relationship in larger firms, we might expect less compliance. For example, a firm that has many facilities spread out worldwide will find it costlier to monitor employee behavior than a firm with a single facility. Similarly, a facility manager with 3,000 employees will find it more difficult to monitor employee behavior than a facility with only 10 employees. Some sociologists have also argued that larger firms might have more political power and thus are more likely to be able to “get away with” noncompliance.
While the evidence on size is somewhat mixed, most of the studies to date have found that larger firms are actually less likely to be in compliance. This is particularly true if the facility is part of a multifacility company. However, these studies are generally looking at firm size within an industry. They do not, for example, compare very small machine-shop operators with large integrated steel manufacturers.
Another possible reason for differences in compliance rates is that firms have different ownership structures. For example, suppose that it is in the firm’s best interest to comply with environmental laws—that is, the owners of the company want to comply. If the owner of the company is also the person who makes the decision on what pollution control equipment to install, when to hire someone to maintain the equipment, and so on, we can be assured that the firm will most likely be in compliance. However, if the company is a publicly traded firm whose owners are thousands of shareholders, the owners of the company will not be making those day-to-day decisions. Further, it will be very costly for those owners to monitor the behavior of the manager who is hired to maintain the pollution control equipment. Once again, this is an example of a principal-agency problem, where shareholders (principals) hire managers (agents) to act in their best interest. Yet, we know that due to the high cost of monitoring, we can expect some degree of shirking on the part of managers. While the evidence in the environmental area is not strong, there is more general evidence that corporate crimes (including environmental crimes) are less likely to be committed by companies whose managers own a significant share of the company’s stock than in companies where managers have little stock in the company (see Alexander & Cohen, 1999). This fact also suggests that many of the environmental violations that occur in large, publicly traded firms are likely to be caused by negligence or employee shirking—not by deliberate company policy. That is because if it was in the company’s best interest to violate the law, we would expect managers who have a larger stake in their companies to be more likely (not less likely) to commit the violation.
Another important factor thought to affect compliance is the financial ability of the firm. Firms that are in financial distress are thought to be less likely to comply as they focus their attention (and scarce resources) on trying to meet payroll and stay in business. There is some evidence of this effect (see Alexander & Cohen, 1996) where it has been found that firms violating environmental criminal laws are more likely to be in financial distress than average. Another factor thought to affect compliance is the country in which the facility’s corporate headquarters are located. For example, the managers of a facility located in the United States, but whose parent company is headquartered in Italy, might not be as familiar with U.S. environmental laws and thus might not be in compliance.
Finally, there is some evidence that the extent to which cooperative approaches and compliance assistance—as opposed to coercive threats of punishment—are effective in inducing firm compliance. Most of those studies have been conducted outside the United States, for example in Canada and Denmark, where the environmental enforcement agencies’ roles have oftentimes been viewed as being more cooperative than in the United States. While it has generally been found that firms do respond to increased inspections and the threat of punishment, there is also evidence that, beyond some point, the threat of punishment becomes counterproductive, while cooperation and other forms of positive assistance might be effective (see, e.g., May & Winter, 1999).
One of the least-studied issues of firm environmental compliance is the individual motivation of employees and managers. While there are many theories about why individuals might comply (e.g., the threat of punishment, according to the economic model; or social norms of behavior, according to sociological theories), there is little empirical evidence of individual behavior. The evidence discussed previously is largely at the firm—not individual—level. The few surveys of environmental managers give conflicting results, partly due to the fact that these studies have asked hypothetical questions. It would be difficult to ask an environmental manager a question like “Why don’t you comply with the law?” Because of the sensitive nature of these questions, it has also been difficult for researchers to gain the cooperation of companies in conducting such studies. Nevertheless, a very fruitful area of future research would be to survey managers and employees to understand their motivations.
Why Do Firms Go “Beyond Compliance”?
To those who wonder why firms comply with environmental regulations, an even more intriguing question now appears to be of importance: why firms might reduce pollution even in the absence of (or beyond existing) regulatory standards. There is a growing trend in both the United States and abroad for firms to reduce emission levels beyond the legally required mandate. For example, over 1,200 firms participated in EPA’s 33/50 program, agreeing to voluntarily reduce certain chemical emissions by 33% by 1988 and 50% by 1995 (U.S. Environmental Protection Agency, 1999). More recently, EPA has promoted the “Performance Track” program, which
recognizes and drives environmental excellence by encouraging facilities with strong environmental records to go above and beyond their legal requirements. Members set typically four public, measurable goals to improve the quality of our nation’s air, water, and land. Members include major corporations, small businesses, and public facilities that are steering a course toward environmental excellence. Currently, the program has about 50 members and welcomes all qualifying facilities. (U.S. Environmental Protection Agency, 2007a)
Outside the governmental arena, there is a growing movement to construct “green buildings” that use less water and electricity and otherwise provide environmental benefits (see, e.g., U.S. Green Building Council, 2007). Many companies have adopted “voluntary” codes of conduct sponsored by their trade associations that mandate various environmental activities not otherwise required by law (see, e.g., www.responsiblecare.org, which is the chemical industry’s initiative).
Theoretically, there are many potential reasons why firms would voluntarily go beyond compliance. All of these reasons are ultimately in the firm’s best interest—that is, they are likely to be consistent with the firm’s profit motive. One very important reason why firms might go beyond compliance is because it reduces their costs. Companies often find that their waste streams are inefficient as they are essentially throwing out very expensive chemicals that could otherwise be used in their production processes. Not only do they save on disposal and pollution control costs, but they also save through reduced input costs. For example, 3M saved hundreds of millions of dollars through their Pollution Prevention Pays program. Similar programs are found throughout the manufacturing sector, and many companies find that these programs can provide them with a competitive advantage (e.g., Shrivastava, 1995; Reinhardt, 1999).
Aside from production-cost efficiencies, however, there are many other reasons why firms might find it in their self-interest to reduce pollution beyond the required level. For example, consumers might demand products that are less environmentally damaging or whose manufacturers are less polluting. To the extent consumers are willing to pay more for such products, or simply to choose environmentally responsible products when price and quality are equal, firms will enter that segment of the market. Com-munity groups might pressure firms to reduce pollution by threatening implicit or explicit boycotts, zoning restrictions, and less favorable treatment elsewhere in community activities. Concerns over workplace safety and employee morale might make some form of pollution reduction in the firm’s best interest. Companies that go beyond compliance might also be treated more leniently in the event that an accident occurs or the firm is otherwise found to be out of compliance in a technical area. Indeed, EPA has indicated that Performance Track members will be given some reductions in regulatory reporting requirements (which lowers the cost to the firm) under the theory that these firms are less likely to be out of compliance. Other benefits to firms are detailed at U.S. Environmental Protection Agency’s Performance Track Benefits Web site (U.S. Environmental Protection Agency, 2006). All of these reasons are similar to the reasons why firms might comply with environmental regulations (other than the threat of direct government enforcement and penalties).
While this is still an emerging topic of inquiry, there is growing evidence that many of these factors have contributed to voluntary reductions in emissions. The most widely studied form of “beyond compliance” behavior is the Toxic Release Inventory (TRI). In 1986, Congress passed the Emergency Planning and Community Right-to-Know Act, requiring manufacturing establishments to publicly disclose the quantity and type of toxic chemicals released into the environment. The first reports were due to EPA no later than July 1, 1988 for toxic emissions in the calendar year 1987. The first public disclosure of TRI data occurred on June 19, 1989. Almost immediately, there were local and national newspaper headlines identifying the “worst polluters.” One environmental group took out full-page advertisements in the New York Times identifying the nation’s largest emitters of toxic chemicals.
A study by Hamilton (1995) showed that publicly traded firms whose TRI releases were first reported on June 19, 1989, experienced statistically significant negative abnormal stock returns. In other words, stock prices for these companies went down more than would have been expected by any normal market price change on that day. The implication of this drop in stock price is that investors updated their expectation of future pollution-related expenditures or liabilities (e.g., expecting a higher probability of accidents, increased likelihood of exposure under other regulatory programs such as Superfund, or risk of future regulation), which would reduce future firm profitability. In a follow-up study to determine the effect of the stock price reductions on firm behavior, Konar and Cohen (1997) found that firms that received a significant stock price reduction upon disclosing their TRI emissions subsequently reduced their emissions more than their industry peers—even if their industry peers had higher levels of emissions to begin with. Although this implies that investor reaction to TRI may have helped spur on emission reductions, we do not know the exact reason for either this significant investor reaction or subsequent firm behavior. Moreover, stock price reductions cannot fully explain the reductions in TRI emissions since not all firms that reduced emissions were subject to significant stock price reductions on the day TRI emissions were released. Other possible explanations include consumer or local community pressure. Yet another possibility is that, when faced with political pressure for more regulation, firms preempt new laws by voluntarily going beyond compliance (Maxwell, Lyon, & Hackett, 2000).
Public Policy And Managerial Implications
As we have discussed, there are many reasons why firms comply or do not comply with environmental regulations. Since government resources are limited, those who enforce environmental regulations are only likely to inspect a small fraction of polluting facilities in any year. If the goal of government policy is to improve the environment at the least cost to society, then enforcement resources need to be focused on the most “bang for the buck” by identifying polluting sources that are most likely to be out of compliance and/or to cause significant harm to the environment or humans—and those that are most likely to be responsive to enforcement activities as well as compliance assistance. Thus, empirical evidence of who is most likely to be out of compliance can assist government agencies in planning a targeted enforcement strategy. In general, it has been found that targeted enforcement should focus on firms that have previously been found to be out of compliance. However, studies have also been able to identify more general firm characteristics that suggest targeting certain types of companies might be appropriate. In terms of sanctions, the evidence to date suggests little deterrent effect from fines that are in the few-thousand-dollar range. To have any real deterrent effect, giving significantly larger fines and/or targeting individuals instead of firms may be appropriate. Finally, there is evidence that community pressure and social norms can be important factors in both compliance and going beyond compliance. Thus, mandatory information disclosure programs can be an effective—and relatively inexpensive approach—for government agencies to improve compliance.
For corporate managers, there are also several important lessons to be learned. First, ensuring that a firm is complying with environmental regulations reduces the risk of penalties associated with noncompliance. As we have seen, even though the dollar value of fines might not be very high, being labeled an environmental scofflaw can have other negative consequences for a firm. Having a bad environmental reputation can make it difficult to hire employees and to obtain approval for expansion by local authorities, and might also increase the risk of future government enforcement actions. It might also hurt sales from companies or consumers who care about the environmental record of companies they purchase from. Similarly, many firms have come to realize that going beyond compliance and managing their environmental risks can result in an improved competitive stature—either through lowering costs or enhancing their corporate image with regulators, local communities, and consumers. Of course, not all firms will benefit from going “beyond compliance” and even those that do will have a point beyond which further pollution reduction costs more than the benefits the firm receives. How much voluntary overcompliance a firm undertakes is a complicated issue that requires sophisticated management.
In fact, many scholars have argued that when we observe a firm that is going beyond compliance, it is a signal of very good management and the firm is likely to be well run in other dimensions and thus be competitive and profitable.
Ensuring that employees follow corporate policies to comply with environmental laws is no different from enforcing other internal compliance policies. Employees need to understand company policy as well as know that noncompliance will result in consequences for them personally. Companies that do not consistently instill compliance norms as part of the corporate culture should not be surprised when employees cut corners on environmental compliance when confronted with a tight budget or competitive pressures. Thus, leading-edge firms oftentimes include environmental outcomes as part of key employee’s performance evaluations.
While ensuring that compliance is part of the corporate culture and that there are consequences for those who do not follow company policy, there are also opportunities to use the environment as a positive force for employee relations. Employees want to work for companies that they feel good about and that are highly regarded in their communities. Thus, a strong environmental culture can contribute to employee satisfaction and retention—something that ultimately saves the company money and increases productivity.
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