Why Should Corporations Care About Complying with Environmental Regulations in 2023?

For over half a century, the U.S. government has mandated environmental regulations, ranging from emission limits to energy efficiency standards to carbon trading schemes and internalizing environmental costs, designed to limit firms' impact on climate change. Companies have had to make crucial decisions regarding these policies, which may have desired and undesired impacts on the productivity or profitability of the firm. Recent legislation is also a significant determining factor. Just last year, the Inflation Reduction Act of 2022, a climate bill allocating $369 billion toward climate change prevention measures, was passed. Additionally, with an impending Securities and Exchange Committee (SEC) requirement to be enforced this year demanding that firms report the cost of their oil and gas production, company managers will have to make difficult decisions. Now more than ever, with growing support for environmental action, decision-makers’ choices have the capability to influence the firms’ financial and social standing. Corporations should care about complying with environmental regulations because it will benefit their overall financial well-being, especially as climate change becomes an increasingly crucial issue. Let’s take a closer look at some of the possible responses firms may have to environmental regulation and what the consequences might be.

Some firms tend to have more positive responses to environmental regulation than other firms, such that complying with policies is beneficial to their well-being in the ways that matter most to each individual company. A basic positive response firms could have would be to simply comply with these regulations in order to avoid violation costs and legal penalties. Nathaniel O. Keohane et al. investigate what might drive firms’ decision-makers to comply with regulations in their paper “Averting Regulatory Enforcement: Evidence from New Source Review,” using data from a study focusing on the electricity sector. They found that firms more likely to be sued for environmental destruction showed greater emission reductions, with data revealing that power plants named in lawsuits reduced their emissions by, on average, 30%; also, an increase of one standard deviation in the probability of a lawsuit results in a 10% reduction in emissions (Keohane et al. 2009). The authors assert that increased regulatory threat motivates firms to reduce their emissions, and factors like heightened compliance costs, pressure from the public, and liability threats encourage more comprehensive environmental management systems and more frequent inspections by corporations, leading to overall lower toxic emissions (Keohane et al. 2009). Furthermore, while enforcement action is greater at power plants with larger emissions increases, it should be noted that these firms are more likely to be targeted by regulating agencies (Keohane et al. 2009). When considering the potential liability threats to financial well-being, it is clear why many managers change their firms’ behavior to avert the scrutiny of regulators.

Managers may also decide to positively respond to environmental regulation because it will help them to align with investor preferences and attract stockholders. In Alex Edmans and Marcin Kacperczyk’s 2022 article “Sustainable Finance,” the benefits to companies of practicing sustainable finance are examined, and firm owners are advised to define themselves as socially and environmentally responsible market participants. The authors assert that companies with a positive social impact may be more likely to attract investors and customers, as well as be best positioned to avoid the costs associated with violations (and thus are more likely to have higher net income). They argue that a business’s sustainability practices or lack thereof crucially affects its reputation with society, demonstrating that a corporation’s sustainability has a significant impact on portfolio decisions: According to their analysis, investors prefer to hold “green” stocks (stocks from firms who maintain environmentally sustainable practices) over “brown” stocks (stocks from firms who do not maintain environmentally sustainable practices) since divesting from a “brown” stock increases its cost of capital and limits its potential growth (Edmans and Kacperczyk 2022). In an effort to appeal to firm owners with purely profit-aligned goals rather than environmental sustainability goals, the authors note that sustainable business practices are not only important for reasons pertaining to a firm’s social responsibility, but are now also an important attribute at the CEO level. This is all-around advantageous because firms with a positive social impact attract customers, stay relevant with climate change trends, and are most likely to avoid regulatory fines (Edmans and Kacperczyk 2022). Additionally, these companies generate higher risk-adjusted returns, making them preferable even to investors with solely financial motives. Pension fund investors will also be happier, as they care not only about retirement income but what the state of the planet will be when they receive those benefits; thus, they will be satisfied supporting an environmentally conscious company even if profits are somewhat sacrificed. The increasing demand from eco-conscious investors for adequate environmental performance by corporations thus becomes an incentive, as CEO wealth is tied to stock price, and ‘people’s capitalism’ will be a major determinant influencing firms’ choices. It becomes clear, then, that simple ‘greenwashing’ campaigns, in which companies put out a false eco-friendly image without taking any actual steps to comply with regulations, are not truly sufficient and will end up hurting firms more than helping them.

Finally, corporations are often driven to respond positively to regulations by their need to be in good standing with banks in order to support their debt. In the 2023 article “Climate Stress Testing” by Viral V. Acharya et al., the authors investigate banks’ responses to climate change by surveying a collection of journal articles exploring institutional reactions, serving as helpful insight for understanding the effect of environmental regulation on the economy as a whole, given that corporations play such an influential role. According to Acharya et al.’s research, banks tend to charge higher interest rates on loans to companies with poor environmental performance and avoid ones with environmental concerns. They note that banks routinely aim to reduce their risk exposure by shortening loan maturities and decreasing access to permanent avenues of bank financing for high-emission firms, which could encourage firm managers to reduce their emissions in compliance with regulations if these loans are an integral aspect of their financial ability to operate. The authors include a study by Delis et al. (2019) that suggests banks charge higher loan rates to fossil fuel firms, leading to increases in loan maturity. They also highlight a study by Kacperczyk and Peydro (2022) demonstrating how firms with higher carbon footprints that have previously borrowed from banks subsequently receive less bank credit. What does all of this mean for firms who are reliant on debt financing? First and foremost, it means that the managers of those firms must ensure that they have a low carbon footprint and should consider switching to more efficient technologies or renewable sources of energy. Even with a larger down payment for these efficient technologies and installations associated with clean energy sources (solar panels, windmills, etc.), this will save them money in the long-run as it will be cheaper to generate power. If firms can save money in this respect, one could assume they are less risky in that they will more easily be able to pay back loans. Particularly, if these companies are competing against greener firms that have taken the initiative in reducing emissions, it would be wise for managers to choose strategies that make them competitive in a market in which their reputation and financing depends on it. Banks’ pricing of climate risks in corporate bond markets are also considered: Bond credit ratings for firms with worse environmental performance are more greatly affected by changes in transition risk, such as commitments to parts of the Paris agreement , and bonds with more negative exposure to climate change risk earn higher returns (Acharya et al. 2023). Accordingly, investors who are concerned about climate risk are willing to pay higher prices for bonds issued by firms with better environmental performance. Evidently, firms for whom credit ratings are crucial will likely respond in compliance with regulations.

Clearly, it is in the best interest of companies to take the necessary actions to comply with environmental regulations rather than employing greenwashing campaigns that present a false image of environmental awareness to the public. If they fail to comply, their financial well-being is at greater risk because they are more likely to be fined or penalized, less likely to gain the interest of investors and consumers, and less likely to get necessary loans from banks. Particularly in 2023 and in subsequent years, this will become even more significant as global events alter interest rates and supply chains, new legislation is passed, and the state of the environment changes. Perhaps managers will shift their business practices to maintain profitability while also appeasing banks, consumers, and investors.

References

Acharya, Viral V., et al. “Climate Stress Testing.” NBER, National Bureau of Economic Research, 10 Apr. 2023 https://www.nber.org/system/files/working_papers/w31097/w31097.pdf .

Edmans, Alex, and Marcin Kacperczyk. Sustainable Finance . Review of Finance, Nov. 2022, https://academic.oup.com/rof/issue/26/6.

Keohane, Nathaniel O, et al. Averting Regulatory Enforcement: Evidence from ... - Wiley Online Library. Journal of Economics and Management Strategy, 16 Feb. 2009, https://onlinelibrary.wiley.com/doi/10.1111/j.1530-9134.2009.00208.x.

Safdie, Stephanie. “Our 2023 Guide to Environmental Regulations in the US.” Greenly, 27 Mar. 2023, greenly.earth/en-us/blog/company-guide/our-2023-guide-to-environmental-regulations-in-the-us.