AccessMyLibrary provides FREE access to millions of articles from top publications available through your library.
U.S. firms spent more than $120 billion in 1994 to comply with environmental laws, in addition to several billion more on research and development (Vogan, 1996), an amount that represents between 1.5% and 2% of gross domestic product (GDP). However, the true cost of environmental protection may be higher. For example, expenditures on environmental protection may crowd out other more productive investments (Palmer, Oates, & Portney, 1995). Even direct costs are often underestimated. For example, a recent study estimated the hidden costs of environmental protection (such as product design or production changes, waste disposal, depreciation, and overhead) can account for as much as 22% of an oil refinery's operating budget (Ditz, Ranganathan, & Banks, 1995).
At the same time that these dollars are spent to comply with regulations, some firms are voluntarily reducing pollution beyond legal limits. For example, more than 1,200 firms participated in the EPA's 33/50 program, agreeing to voluntarily reduce certain chemical emissions by 33% by 1988 and 50% by 1995 (Arora & Cason, 1995). Various reasons have been cited for this trend, including reduced cost from material input usage, reduced cost due to less waste disposal, reduced regulatory scrutiny, less public and community pressure, and increased product value and firm competitiveness due to consumer demand for "green products."(1) Regardless of the reason or reasons behind this beyond-compliance movement, an important empirical question arises: does the market value firms that have better environmental reputations than those that do not? It is possible that firms that exceed regulatory standards do so at their own financial peril. Alternatively, these firms may expect to reap some benefits from a better environmental reputation.
This paper examines the extent to which a firm's environmental reputation is valued in the marketplace. Previous economics literature on firm valuation has focused on both the components of firm value (such as tangible versus intangible assets) and the factors that affect these components (such as patents, R&D expenditures, market share, and brand names). We extend the standard economic technique of decomposing a firm's market value into its tangible and intangible assets, by separating out environmental performance from the intangible assets of the firm. Our key finding is that there is a significant positive relationship between environmental performance and the intangible asset value of publicly traded firms in the S&P 500. Firms that have worse environmental performance have lower intangible asset values after controlling for other standard variables known to affect the market value of a firm. On average, firms in our sample have a $380 million reduction in market value that can be attributable to environmental concerns. This constitutes approximately 9.0% of the replacement value of tangible assets.
Section II reviews the literature on the effect of environmental performance on firm value. Section III briefly reviews the economics literature on firm valuation and derives the theoretical model for the empirical analysis that follows. Section IV describes the data, and our empirical results are contained in Section V. Section VI contains a few concluding remarks.
II. Relationship between Environmental Performance and Market Value of Firm
Previous literature on the relationship between a firm's environmental and financial performance has generally fallen into two distinct categories: comparing financial to environmental performance over time, or analyzing the effect of environmental performance on the market value of a publicly traded firm, generally through an event study examining the effect of new information (such as an oil spill or EPA penalty).
Previous studies that attempt to relate environmental to financial performance over time have often led to conflicting results. Most of the early work in this area was based on a series of industry studies published by the Council on Economic Priorities (CEP) in the early 1970s that examined the pollution-control records of the petroleum refining, steel, pulp and paper, and electric utility industries. For example, Spicer (1978) found significant positive correlation between CEP's measures of firm environmental performance in the pulp and paper industry and firm financial performance. However, Mahapatra (1984) concluded just the opposite, using a larger sample and time period. Similar findings are reported by Jaggi and Freedman (1992).
These prior studies suffer from several problems, including small samples, lack of objective environmental performance criteria, and the fact that they are based on data now nearly 30 years old. More recently, Cohen, Fenn, and Naimon (1995) estimated the relationship between environmental and financial performance based on several objective measures of environmental performance and a large sample of companies: the S&P 500. They constructed "industry-balanced" portfolios of the environmental laggards and leaders in each industry, and found that stock market performance in the environmental leaders portfolio equaled or exceeded that of the environmental laggards during the period 1987-1990.
In addition to studies of firm performance over time, several recent studies have examined the effect of environmental performance on the market value of publicly traded firms. Most of these studies have examined the contemporaneous effect of negative environmental "events" on stock prices. Klassen and McLaughlin (1996) found significant negative abnormal returns when firms had bad environmental news such as oil spills, and positive returns when firms received environmental awards. Similar results for negative environmental events were reported by Karpoff, Lott, and Rankine (1999) and Jones and Rubin (forthcoming). Hamilton (1995) found significant negative abnormal returns (averaging $4.1 million) on the day that the toxic release inventory (TRI) was first announced in 1989 in a sample of 436 publicly traded firms that had TRI emissions. Konar and Cohen (1997) expand on this result by showing that these abnormal returns were important enough to affect future firm environmental performance. In particular, firms that had the largest stock-price reaction to the announcement of TRI subsequently reduced their TRI emissions more than their industry peers.
Although the event studies have shown that the market reacts to discrete environmental events, they cannot analyze longer-term trends or objective measures of firm environmental performance that are not tied to a particular date. Barth and McNichols (1994) go beyond the event-study methodology and demonstrate that the market value of publicly traded firms includes an assessment of future Superfund liability. However, Superfund liability is based on past performance, not current environmental policies.
This study combines many of the best features of the previous literature by disaggregating the market valuation of objective measures of firm environmental performance. We offer new evidence on whether the market values firms that perform well on environmental criteria. Our analysis is based on a relatively comprehensive list of companies (the S&P 500) and objective measures of environmental performance based on government records and government-mandated SEC disclosures. Unlike many previous studies, we do not rely upon subjective or anecdotal analysis to characterize environmental performance, and do not rely solely on the risk of "bad outcomes" such as Superfund liability, oil spills, or government enforcement actions. Instead, we seek evidence that the market values positive environmental performance.
III. Decomposing Firm Valuation into Tangible and Intangible Assets
A firm's valuation in the financial markets is based on future profitability. Assuming efficient capital markets, security prices provide the best available unbiased estimate of the present value of discounted future cash flows (Fama, 1970). A firm's value can be disaggregated into its tangible and intangible assets. Tangible assets consist of the replacement value of property, plant and equipment, cash, inventory, and so forth. Intangible assets are factors of production or specialized resources that allow the firm to earn profits over and above the return on its tangible assets. Common examples of intangible assets are patents, trademarks, proprietary raw material sources, brand names, and firm goodwill. …