Does the Market Value Environmental Performance?  

Shameek Konar

Department of Economics

Vanderbilt University

Nashville, TN 37203

(615) 421-8335

konars@ctrvax.vanderbilt.edu

and

Mark A. Cohen

Owen Graduate School of Management

Vanderbilt University

Nashville, TN 37203

(615) 322-6814

cohen@vanderbilt.edu

June 1997

 * This paper is based partly on Chapter 4 of Shameek Konar's dissertation. The authors gratefully acknowledge the W. Alton Jones Foundation for their financial support on this project. All views expressed are those of the authors and not necessar ily those of W. Alton Jones Foundation or members of its staff. Mark Cohen also acknowledges the assistance of the Dean’s Fund for Summer Research, Owen Graduate School of Management, Vanderbilt University.

Previous studies that attempt to relate environmental to financial performance have often led to conflicting results due to small samples and subjective environmental performance criteria. We report on a study that relates the market value of firms in the S&P 500 to objective measures of their environmental performance. After controlling for variables traditionally thought to explain firm level financial performance, we find that bad environmental performance has a significant negative effect on th e intangible asset value of firms. The average "intangible liability" for firms in our sample is 360 million dollars - approximately 8.4% of the replacement value of tangible assets. We conclude that legally emitted toxic chemicals have a significant effe ct on the intangible asset value of publicly traded companies. A 10% reduction in emissions of toxic chemicals results in a $31 million increase in market value. The magnitude of these effects varies across industries, with larger losses accruing to the t raditionally polluting industries.

U.S. firms spent over $85 billion in 1990 to comply with environmental laws, in addition to several billion more on research and development (Rutledge and Leonard, 1992), an amount that represents between 1.5% and 2% of gross domestic product (GDP) . The true cost of environmental protection may be higher, however, as expenditures on environmental protection crowd out other more productive investments (Palmer, Oates and Portney, 1996), and even direct hidden costs are often underestimated. For examp le, a recent study by the World Resources Institute (Ditz et al., 1995) found that the hidden costs associated with 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.

At the same time that these dollars are spent to comply with regulations, some firms are voluntarily reducing pollution beyond legal limits. For example, over 1,200 firms participated in EPA's 33/50 program, agreeing to voluntarily reduce certain c hemical emissions by 33% by 1988 and 50% by 1995 (see Arora and Cason, 1995 for details). Various reasons have been cited for this trend, including: reduced cost from material input usage, reduced cost due to less waste disposal, reduced regulatory scruti ny less public and community, and increased product value and firm competitiveness due to consumer demand for ‘green products.’ 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 bette r environmental reputation.

This paper examines the extent to which a firm’s environmental reputation is valued in the marketplace. Previous literature on firm valuation has focused on both the components of firm value (e.g., tangible versus intangible assets) and the factors that affect these components (e.g., patents, R&D expenditures, market share, 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 pe rformance" from the intangible assets of the firm. Our key finding is that environmental performance has a significant effect on the intangible asset value for 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 firm financial performance. On average, firms in our sample have a 360 million dollar reduction in market value that can be attributable to environmental concerns . This constitutes approximately 8.4% 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, while our empirical results are contained in Section V.

 II. Relationship between Environmental and Financial Performance

Previous literature on the relationship between a firm’s environmental and financial performance has generally fallen into two distinct categories: (1) comparing financial to environmental performance over time, or (2) event studies examini ng the effect of new information about environmental performance on the value of a publicly traded firm.

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 Prior ities (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 correlation between CEP's measures of firm environm ental 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 25 years old. More recently, Cohen et al. (1997) estimated the rela tionship 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. Although Cohen et al. (1997) find there is no penalty for investin g in environmental leaders, they did not attempt to desegregate firm-specific effects. Barth and McNichols (1994) have demonstrated that the market value of publicly traded firms includes an assessment of future Superfund liability. However, Superfund lia bility is based on past performance, not current environmental policies.

In addition to studies of firm performance over time, several recent studies have examined the contemporaneous effect of negative environmental "events" on stock prices for publicly traded firms. Klassen and McLaughlin (1996) found significant nega tive abnormal returns when firms had bad environmental news such as oil spills, and positive returns when firms received environmental awards. Hamilton (1995) found significant negative abnormal returns (averaging $4.1 million) on the day that the toxic r elease inventory (TRI) were first announced in 1989 in a sample of 436 publicly traded firms that had TRI emissions. Konar and Cohen (1997a) expand on this result by showing that these abnormal returns were important enough to affect future firm environme ntal performance. In particular, firms that had the largest stock price reaction to 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. This study combine s 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 or not firms that perform well on environmental criteria also perform well financially. Unlike previous research, our analysis is based on a relatively comprehensive list of companies - the Standard and Poor's 500. In addition, the environmental performance measures are based on actual government records or government-manda ted securities filing disclosures. Unlike previous studies, we do not rely on subjective or anecdotal analysis to characterize environmental performance.

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 firms value can be disaggregated into its tangible and intangible assets. Tangible assets consist of the replacement value of property, plant and equipment, cash, inventory, etc. Intangible assets are factors of production or specialized resources tha t allow the firm to earn profits over and above the return on its tangible assets. Common examples of intangible assets that augment the earning power of firms are patents, trademarks, proprietary raw material sources, brand names and firm goodwill. Howev er, intangible assets may also be liabilities detracting from the earning power of the physical assets of a firm. Examples of intangible liabilities might include consumer mistrust following fraudulent activities or future environmental risks.

Our approach to decomposing the market value of firms follows the work of many other authors interested in different aspects of firm valuation, such as monopoly power (Lindenberg and Ross, 1981), research and development investment (Jaffe, 1986), a dvertising (Megna and Mueller, 1991), and brand equity (Simon and Sullivan, 1993). We join this literature by investigating the role of environmental reputation on market value. Following Lindenberg and Ross (1981), the market value of the firm can be exp ressed as:

MV = V_T + V_I (1)

where MV is the market value of the firm, and V_T and V_I are the portions of firm value attributable to the tangible and the intangible assets of the firm, respectively. While the market value of the firm is observable, subcomponen ts V_T and V_I are not. However, accounting values and replacement costs may be used to value the tangible assets of the firm with a certain degree of error. If we divide equation (1) by the tangible asset value V_T we get:

(MV/V_T) = 1 + (V_I/V_T) (2)

The tangible asset value of the firm V_T may also be measured by the replacement cost (RC) of the tangible assets of the firm. The value for RC may be estimated using accounting based values for the assets of the firm. The left hand side of e quation (2) may then be written as (MV/RC) which is by definition Tobin’s q. For purposes of this paper, we calculate Tobin’s q as:

(3)

Thus for a firm with no intangible asset value Tobin’s q should equal 1. As the value of the firms intangible assets increases the value of Tobin’s q will increase.

Theory does not dictate a specific functional form for an equation to estimate q. Although authors have used a number of different specifications, most studies use the additive form derived from the specification in equation (1). The market value of the firm is thus the sum of the values accruing to the tangible and the intangible assets of the firm, i.e. M = V_T + V_I. Dividing both sides by the tangible asset value of the firm gives us:

q = M/V_T = 1 + V_I/V_T (4)

In order to estimate the impact of various factors on the intangible asset value of the firm, the following regression equation is estimated:

(q -1) = V_I/V_T = a + S b X + e (5)

where X is a matrix containing the explanatory and control variables thought to affect intangible asset values. This specification is not unique to this paper, and is essentially the model estimated by Hirsch and Seaks (1993) and others. Instead , our main contribution is to include environmental performance as explanatory variables in estimating the intangible assets. An alternative semi-log specification may also be used, where the right hand side variable is the natural log of q:

ln(q) = a + S b X + e (6)

In this paper, we estimate both functional forms.

IV. Environmental and Firm Performance Data

This section describes the data collected for both environmental variables and financial variables. Our approach in data collection and empirical analysis has been to replicate existing studies of market valuation in order to isolate any ad ded value contributed by environmental reputation.

The most significant constraint on sample size is the availability of environmental performance data. This restricted our analysis to an industry-balanced sample of the largest publicly traded firms in the U.S., the Standard and Poor’s 500. Aft er eliminating non-polluting industries (primarily banking and insurance), we were left with 321 firms, most of which belong to the manufacturing sector, SIC 20-39. Throughout the study, the number of observations varies depending on the specification and which variables have missing data points.

The primary year of the study is 1989, but lagged values for certain variables have been used. Since the sampling is non-random the data are not perfectly representative of the US manufacturing universe, but the sample consists of a variety of larg e firms from very diverse lines of business. Table 1 contains a complete list of variable definitions, sources, and descriptive statistics. Table 2 reports the correlation between these variables.

Our measure of firm performance and valuation is based on Tobin’s q, defined above as equation (3). Data for the S&P 500 in 1989 are taken from Compustat. The value of the common stock is calculated using the year-end common stock ma rket price multiplied by the number of shares outstanding (MVE). The market value of the preferred shares is proxied by the liquidation value of these shares (LPS) as reported in the company balance sheets. Long term (LTDEBT) and short term debt (STDEBT) values for the firm are taken from the company balance sheet. The replacement value of the firms assets is the sum of the property plant and equipment (net) of the firm (PPEN), cash and short term investments (CASH), receivables (REC) and inventories (INV ).

Since market valuation is based on expected future profitability, there is a strong linkage between studies that estimate market values and those that examine firm profitability. Schmalensee (1989) thoroughly reviews the empirical literature on fir m performance and provides a basis for specifying an empirical model predictive of firm profitability. These variables include the market share of the firm, industry concentration ratios, sales growth, advertising intensity, research and development inten sity, firm size, risk levels, and the import intensity in the markets for the firms products. Each is discussed briefly below:

Market share of firm. Cross sectional differences in the intangible market value of firms and their q values can be partly explained by the extent of monopoly power of the firm. Firms with a higher market share or industries with high er concentration have been found to have q values (Commanor and Wilson, 1967). We proxy market power by the market share of the firm within its primary four digit SIC code (MSH89) and the four firm concentration ratios at the four digit SIC code le vel (CON89).

Sales Growth. Recent growth in firm-level sales is found to be positively correlated with profitability (Schmalensee, 1989; Hirsch, 1991). We measure sales growth as the increase in sales between 1987 and 1989 (GR8789).

Risk. Firms that have above average market risk will have lower market value per dollar of tangible assets, i.e., a lower q (Hall and Weiss, 1967; Bothwell, Cooley and Hall, 1984). One measure of risk is the leverage ratio, LEV89 (deb t divided by market value). Highly leveraged firms present a higher risk to equity holders of the firm, since shareholders have little protection in the case of firm bankruptcy.

Import-Consumption Ratios. Previous studies have documented that higher levels of foreign competition are likely to be correlated with reduced domestic profitability (Schmalensee, 1989). Thus, we measure the ratio of imports to total dom estic consumption (IMPIO) as a measure of import penetration.

Research & Development Expenditures. R&D intensity has been found to be positively correlated with firm profits (Hirschey and Weygandt, 1985; Cockburn and Griliches, 1988; Megna and Mueller, 1991). R&D may be measured directly th rough expenditures or indirectly through patents. We use expenditures (RD89), although we also used the number of patents as an alternative specification.

Advertising Expenditures. Advertising expenditures can lead to product differentiation and consumer loyalty, resulting in brand equity. Commanor and Wilson (1967), Hirschey and Weygandt (1985) and Simon and Sullivan (1993) all find significa nt positive relationships between firm level advertising expenditures and profitability. Advertising expenditures (ADVAL89) were taken from data published by the Arbitron Company, which compiles firm-specific advertising expenditures for firms that spend more than three thousand dollars annually on advertising in any of 9 major media outlets, including, TV, major newspapers, radio, magazines etc.

We also control for the size of firm and industry effects. The natural log of the replacement value of firm assets (LNRV89) is used to control for effects related to the differences in the size of the firm. Industry-wide effects on the intangible a sset value of the firm are controlled for by including industry dummies at the two digit SIC code for the firms. We also attempt to control for the ‘dying firm effect’ by looking at the capital expenditure-depreciation differential (INV89). Lindenberg and Ross (1981) find that with declining capital stock tend to have lower intangible asset values. Finally, the age of a firms assets may be playing an important role in determining the intangible asset value for the firm. Firms with older technologies and e quipment may be less efficient and hence may not be as profitable as firms with new technology.

We examine two widely available environmental performance measures: (1) TRI88, the aggregate pounds of toxic chemicals emitted per dollar revenue of the firm, and (2) LAW89, the number of environmental lawsuits pending against the firm. These d ata were provided by the Investor Responsibility Research Center (1993) and are now readily available to the investing public. Reporting of toxic emissions (TRI) data is required under the Community Right to Know Law (1986), which mandates that firms emit ting any one of a list of 320 toxic chemicals and employing more than 10 people report their emissions to EPA. These plant-by-plant data are subsequently compiled into firm-level data and reported in the media. Previous studies by Hamilton (1995) and Kona r and Cohen (1997a) have shown that the disclosure of TRI data has had a significant effect on firm stock prices and subsequent firm behavior. These data were first released to the public in 1989. We use the 1988 emission levels to reflect environmental p erformance, since there is a lag between the actual emissions and the date the data are released. The litigation data for 1989 is taken from 10K disclosure forms required by the SEC.

Table 3 lists the results from the estimation of equations (5) and (6). The dependent variable in this regression is Tobin’s q for the year 1989. Most of the independent control variables conform in sign and significance to our expec tations based on the prior literature. Tobin’s q (and hence financial performance) is positively related to R&D expenditures, market share, industry concentration, firm growth rates and advertising expenditures (although the latter is not stati stically significant). It is negatively related to the leverage ratio and tangible assets. Age of assets, risk, and import concentration were not statistically significant.

After controlling for the traditional explanatory factors of Tobin’s q, we turn our attention to the effect of firm specific environmental performance on intangible asset value. Both the variables used to measure environmental performance ha ve a negative impact on Tobin’s q, and are statistically significant (p < 0.01). This confirms the hypothesis that poor environmental performers are expected to have future costs and lower future profitability than their peers. The effect is muc h more pronounced for toxic chemical (TRI) disclosures than for lawsuits.

Table 3 reports several different specifications of the model. The second specification uses the market share of the firm (MSH89) to proxy for monopoly rents instead of the industry-level four firm concentration ratio (CON89). They may not both be used simultaneously because they are highly correlated (r = 0.651). Since it results in a better fit, the remaining specifications use market share. The third specification is the complete model which includes the ‘dying firm’ variable, INV89 and the age of the firms assets AGE89. Both these variables are not statistically significant but have the hypothesized signs. The final specification in Table 3 estimates a semi-log specification as suggested by Hirsch and Seaks (1993). The estimation of the semi-lo g specification does not change any of the result with the exception that the sign on the AGE89 variable changes, but is still not statistically significant.

Having established that environmental performance affects firm market valuation, the next issue to be addressed is the economic significance of these results. Instead of Tobin’s q, we specify the dependent variable to be V_I, the i ntangible asset value of the firm. Table 4 reports on two specifications, corresponding to columns (2) and (3) in Table 3. The results are qualitatively similar to those reported in Table 3, and the environmental variables still remain negative and statis tically significant. The only exceptions are that the constant term and the log of the replacement value (LNRV89) switch signs and are statistically significant, and the risk variable (LEV89) is no longer significant. In the second specification, the AGE8 9 variable is significant (p < 0.10) and positive, indicating that firms with newer plant and equipment have higher intangible asset values.

In order to estimate the economic significance of the environmental performance of firms on their intangible asset value, the following equation is used to estimate ENV, the impact of a firm’s environmental performance on its intangible asset value :

ENV = -89.236 TRI88 - 0.16118 LAW89

The value of the environmental performance of companies is then reported both in dollar terms (per firm), and as a percentage of the tangible asset value of the firm in Table 5. The results are reported by industry for those industries in the sample wh ich had at least seven companies. Firms in industries with fewer than seven companies are classified under the ‘other’ category. The results in Table 5 are indicative of general industry trends in terms of pollution. The average loss for all 231 firms in the sample is 362 million dollars which is 8.4% of the replacement value of assets of the firms studied.

The second column in Table 5 reports the loss in intangible asset value as a percentage of the replacement value of the firms assets. The loss value is the largest for the chemical (28.2%), miscellaneous manufacturing (27.8%), primary metals (24.9% ) and paper (19%) industries. Smaller losses are reported in the Transportation equipment (0.9%), petroleum and coal (1.2%), food products (1.3%), electric machinery (2.7%) and non-electric machinery (3.8%). The petroleum industry might appear to be an an omaly, since it is a both a heavy polluting industry and has come under increasing scrutiny in recent years. However, it should be noted that the petroleum industry is very capital intensive, and their replacement value is approximately five times the ave rage replacement value for all the firms in the sample.

The loss in the intangible asset value is derived from two sources, the loss due to toxic releases and the losses due to environmental litigation. The component of the total loss resulting from environmental litigation is very small for most of the industries studied. For all industries except chemicals and miscellaneous manufacturing the loss amounts to less than a million dollars. Thus, primary component of loss in value for these industries is the level of toxic emissions. The main exception is for the miscellaneous manufacturing industry, where about 1.0 billion dollars is due to litigation, which constitutes 67% of the total value loss in the industry group. This result is driven to a certain extent by the outliers in the environmental litigat ion data since the two firms with a large number of lawsuits lie within this industry group.

In addition to attributing a small but significant portion of intangible asset value to environmental performance, we can examine the effect of changes in the environmental performance on the market value of firms in our sample. For example, for th e average firm in our sample, a 10% reduction in TRI emissions (from 3.44 to 3.09 tons per thousand dollar revenue) results in a $30 million increase in intangible asset value (89.236 * 10% of 3.44 = $30.7), which constitutes about 7/10 of 1% of the repla cement value of assets for the average firm. If we had data on the cost of reducing TRI emissions by 10%, we could directly compare the costs and benefits of further reductions in TRI from the firm’s perspective. In contrast, a reduction in one environmen tal lawsuit increases average firm value by only $160,000. Given the high cost of litigation, it does not appear that being sued has a significant effect on firm valuation.

This paper compares the environmental and financial performance of manufacturing firms in the S&P 500. The primary objective of the study is to explore the effect of firm level environmental performance on financial performance and inta ngible asset value. In doing so, this paper extends the existing literature in two fields of research. It is one of the first attempts to incorporate firm level environmental performance into cross-sectional studies of firm profitability using Tobin’s q and intangible asset values. At the same time, it contributes to the literature in environmental economics by evaluating the importance of environmental performance on market valuation.

After controlling for the effect of a number of variables on firm level financial performance, we find that bad environmental performance has a significant negative effect on the intangible asset value for publicly traded firms that belong to the S &P 500. This effect is both statistically and economically significant. Firms in our sample lose an average of about $360 million in market value, which constitutes approximately 8.4% of the replacement value of tangible assets. The effect of environm ental litigation on intangible asset value, though statistically significant, tends to be economically insignificant in most industries. On the other hand the effect of toxic emission levels tends to be both statistically and economically significant. We also find that the magnitude of the loss varies across industries with larger losses accruing to the traditionally polluting industries.

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