The Reputational Penalties for Environmental Violations - Empirical Evidence

8/19/2019 The Reputational Penalties for Environmental Violations - Empirical Evidence

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The Booth School of Business University of Chicago

The Reputational Penalties for Environmental Violations: Empirical Evidence

Authors(s): Jonathan M. Karpoff, John R. Lott, Jr. and Eric W. Wehrly

Source: The Journal of Law & Economics, Vol. 48, No. 2 (October 2005), pp. 653-675

Published by: The University of Chicago Press for The Booth School of Business,University of Chicago and The University of Chicago Law School

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653

[ Journal of Law and Economics, vol. XLVIII (October 2005)] 2005 by The University of Chicago. All rights reser ved. 0022-2186/2005/4802-0024$01.50

THE REPUTATIONAL PENALTIES FOR

ENVIRONMENTAL VIOLATIONS:

EMPIRICAL EVIDENCE*

JONATHAN M. KARPOFF,

University of Washington

JOHN R. LOTT, JR.,

American Enterprise Institute

and

ERIC W. WEHRLY

University of Washington

Abstract

This paper examines the sizes of the fines, damage awards, remediation costs, andmarket value losses imposed on companies that violate environmental regulations.Firms that violate environmental laws suffer statistically significant losses in themarket value of firm equity. The losses, however, are of similar magnitudes to thelegal penalties imposed, and in the cross section, the market value loss is related tothe size of the legal penalty. Thus, environmental violations are disciplined largelythrough legal and regulatory penalties, not through reputational penalties.

I. Introduction

Do firms that pollute the environment hurt their reputations? Many re-searchers believe they do. Michael Porter and Claas van der Linde claim thatenvironmental insensitivity lowers a firm’s sales and increases its costs.1

Similarly, Sheoli Pargal and David Wheeler, Seema Arora and Timothy Ca-

son, and Shameek Konar and Mark Cohen claim that community pressure

* Jonathan M. Karpoff is the Norman J. Metcalfe Professor of Finance and Eric W. Wehrlyis a Ph.D. candidate at the University of Washington Business School; John R. Lott, Jr., is aresident scholar at the American Enterprise Institute. We thank an anonymous referee, SamPeltzman (the editor), Mike Barnett, and seminar participants at the University of Washingtonand the 2002 Environmental Protection Agency conference Economics and the Environment

for helpful suggestions, Graeme Rankine for collaboration in an earlier version of this paper,and Elvis Ziu for research assistance. Karpoff received support from the Dean’s DiscretionaryFund at the University of Washington’s School of Business.

1 Michael E. Porter & Claas van der Linde, Toward a New Conception of the Environment-Competitiveness Relationship, J. Econ. Persp., Fall 1995, at 97.



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654 the journal of law and economics

and informal sanctions can penalize environmental violations.2 As an ex-ample, the Exxon Valdez oil spill so angered many consumers that it triggeredboycotts of Exxon’s retail outlets.3 Konar and Cohen argue that environ-mentally conscious investors can penalize polluting firms by increasing theircosts of capital and decreasing their market values, a notion that is modeledby Robert Heinkel, Alan Kraus, and Josef Zechner.4

In this paper, we measure the extent to which market-imposed sanctions—what we label “reputational penalties”—impose significant costs on firmsthat violate environmental regulations. Along the way, we provide the firstlarge-sample estimates of the share valuation impact on firms that violateenvironmental regulations. We also examine the sizes of the legal penaltiesimposed on violating firms.

The existence and size of any reputational penalty is important for publicpolicy. Optimal penalty theory, as discussed by Gary Becker, requires thatthe expected total penalty for an illegal activity equals the activity’s totalsocial cost.5 The total penalty consists of explicit legal sanctions imposedthrough regulatory, civil, and criminal proceedings, plus reputational pen-alties. If reputational penalties are large, then legal penalties optimally shouldbe small. Conversely, small reputational penalties imply a more importantrole for legal penalties in an optimal framework.

Using data from 478 environmental violations by publicly traded com-panies for 1980–2000, we find that allegations or charges that a firm violatedenvironmental regulations correspond to economically meaningful and sta-tistically significant losses in the firm’s share values. Initial press announce-ments containing allegations of a violation are associated with an average

abnormal stock return of

1.69 percent. When the initial announcementindicates that the firm formally has been charged with a violation, the averageabnormal stock return is 1.58 percent.

It turns out, however, that these losses are similar in size to these firms’legal penalties. In a subsample of 148 firms on which we have informationon the legal penalties, the mean fine or damage award (in constant year 2000dollars) is $13.2 million, and the mean forced compliance or remediationcost is $93.6 million. The combined legal penalty equals 2.26 percent of

2 See Sheoli Pargal & David Wheeler, Informal Regulation in Developing Countries: Evi-dence from Indonesia, 104 J. Pol. Econ. 1314 (1996); Seema Arora & Timothy Cason, WhyDo Firms Volunteer to Exceed Environmental Regulations? Understanding Participation inEPA’s 33/50 Program, 72 Land Econ. 413 (1996); and Shameek Konar & Mark A. Cohen,Why Do Firms Pollute (and Reduce) Toxic Emission? (Working paper, Vanderbilt Univ., Owen

Grad. Sch. Mgmt. 1998).3 Philip Shabecoff, Six Groups Urge Boycott of Exxon, N.Y. Times, May 3, 1989, at A17.4 Shameek Konar & Mark A. Cohen, Does the Market Value Environmental Performance?

83 Rev. Econ. & Stat. 281 (2001); and Robert Heinkel, Alan Kraus, & Josef Zechner, TheEffect of Green Investment on Corporate Behavior, 36 J. Fin. & Quant. Analysis 431 (2001).

5 Gary S. Becker, Crime and Punishment: An Economic Approach, 76 J. Pol. Econ. 169(1968).



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reputational penalties 655

these firms’ share values, on average. Thus, while environmental violators

lose market value, the losses reflect these firms’ legal penalties. Market-

induced reputational penalties, on average, are negligible. We therefore con-clude that legal penalties, and not reputational penalties, are the primary

deterrents to environmental violations.

This paper is organized as follows. Section II describes the controversy

about the existence and size of a reputational penalty for environmentalviolations. Section III describes the data, and Section IV reports on the share

value effects for firms investigated for or charged with environmental vio-

lations. Section V reports on the sizes of the legal penalties for violations,

and Section VI investigates the importance of reputational penalties. In Sec-tion VII, we investigate the determinants of cross-sectional differences in the

market value losses. Section VIII concludes the paper.

II. The Reputational Cost Controversy

A. Details of the Controversy

As Benjamin Klein and Keith Leffler argue, reputation disciplines certaintypes of wrongdoing because market transactions internalize their costs.6

Companies that defraud customers, for example, lose sales. Those that cheat

employees or other suppliers face higher input costs or lost trade credit. The

cost of the illegal activity is internalized because the cheating firm loses atleast some of the gains that accrue from repeat business with consumers,

employees, or suppliers. Consistent with such arguments, previous researchindicates that reputational costs are large for false advertising,7 product re-

calls,8 lack of safety,9 deceptive bidding practices,10 punitive damages law-suits,11 defense procurement fraud,12 and financial misrepresentation.13 Jon-

athan Karpoff and John Lott find that over 90 percent of the penalties imposed

6 Benjamin Klein & Keith B. Leffler, The Role of Market Forces in Assuring ContractualPerformance, 89 J. Pol. Econ. 615 (1981).

7 Sam Peltzman, The Effects of FTC Advertising Regulation, 24 J. Law & Econ. 403 (1981).8 Gregg Jarrell & Sam Peltzman, The Impact of Product Recalls on the Wealth of Sellers,

93 J. Pol. Econ. 512 (1985).9 Mark L. Mitchell & Michael T. Maloney, The Role of Market Forces in Promoting Air

Travel Safety, 32 J. Law & Econ. 329 (1989).10 Clifford Smith, Jr., Economics and Ethics: The Case of Salomon Brothers, 5 J. Applied

Corp. Fin. 23 (1992).11 Jonathan M. Karpoff & John R. Lott, Jr., On the Determinants and Importance of Punitive

Damages Awards, 42 J. Law & Econ. 527 (1999).12 Jonathan M. Karpoff, D. Scott Lee, & Valaria Vendrzyk, Defense Procurement Fraud,

Penalties, and Contractor Influence, 107 J. Pol. Econ. 809 (1999).13 Jonathan M. Karpoff, D. Scott Lee, & Gerald S. Martin, The Cost of Cooking the Books

(Working paper, Texas A&M Univ. & Univ. Washington 2004).



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on firms committing private frauds reflects lost reputation.14 Only a smallportion of the financial penalties imposed on such firms is due to criminalor civil penalties and other court-imposed costs.

Many researchers argue that reputational concerns motivate, or shouldmotivate, firms to comply with environmental rules. As an example, Chris-topher Decker finds that firms that comply with environmental rules receivenew construction permits from environmental agencies more quickly thando firms with many instances of noncompliance.15 Cohen argues that evidenceof an environmental violation might adversely affect customers’ perceptionsabout the safety or quality of the firm’s products.16 Paul Downing and JamesKimball suggest that managers comply with environmental regulations be-cause they care about their companies’ images—a notion that is supported

by survey evidence reported by Irene Henriques and Perry Sadorsky and byPiotr Zerbe.17 According to these arguments, the firm’s customers, employees,and suppliers can be motivated by environmental concern to change their

reservation prices in doing business with the firm. Environmentally costlyactivities that attract unfavorable attention could then lower demand for thefirm’s products or increase the firm’s costs. Using similar arguments, ShakebAfsah, Benoit Laplante, and Wheeler, and Laplante, Paul Lanoie, and MaitéRoy suggest that pressure by nonshareholder stakeholders can motivate firmsto control pollution emissions.18

The counterargument holds that reputational penalties are small for en-

vironmental violations. Environmental violations differ from frauds and other

types of wrongdoing in that they impose costs on parties other than those

with whom the polluting firm does business. As an example, downstreamfishermen are damaged if an electroplating company dumps toxic chemicalsinto a municipal storm sewer. But the fishermen do no business with the

14 Jonathan M. Karpoff & John R. Lott, Jr., The Reputational Penalty Firms Bear fromCommitting Criminal Fraud, 36 J. Law & Econ. 757 (1993). Cindy Alexander obtains similarresults using a sample of purely criminal cases. Cindy R. Alexander, On the Nature of theReputational Penalty for Corporate Crime: Evidence, 42 J. Law & Econ. 489 (1999).

15 Christopher S. Decker, Corporate Environmentalism and Environmental Statutory Per-mitting, 46 J. Law & Econ. 103 (2003).

16 Mark A. Cohen, Environmental Crime and Punishment: Legal/Economic Theory and Em-pirical Evidence on Enforcement of Federal Environmental Statutes, 82 J. Crim. Law & Crim-inology 1054 (1992).

17 See Paul B. Downing & James N. Kimball, Enforcing Pollution-Control Laws in theUnited States, 11 Pol’y Stud. J. 55 (1982); Irene Henriques & Perry Sadorsky, The Determinants

of an Environmentally Responsive Firm: An Empirical Approach, 30 J. Envtl. Econ. & Mgmt.386 (1996); and Piotr M. Zerbe, Evaluation of Predominant Environmental Management Prac-tices in the Canadian Pulp and Paper Industry (Working paper, Univ. British Columbia, Dep’tResource Mgmt. & Envtl. Stud. 1997).

18 See Shakeb Afsah, Benoit Laplante, & David Wheeler, Controlling Industrial Pollution:A New Paradigm (Policy Research Working Paper No. 1672, World Bank 1996); and BenoitLaplante, Paul Lanoie, & Maité Roy, Can Capital Markets Create Incentives for PollutionControl? 26 Ecological Econ. 31 (1998).



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firm, and the firm’s customers have no direct incentive to lower their demands

for the firm’s products if the dumping does not affect the quality of those

products. As a result, the polluting electroplating company could experienceno reputational costs.

This counterargument implies that environmental violations are similar to

such regulatory violations as check kiting and failure to report currency

transactions, which Karpoff and Lott and Alexander find to have negligiblereputation costs.19 Consistent with this view, Julie Doonan, Lanoie, and La-

plante report survey evidence that indicates that unfavorable press coverage

and consumer pressure do not affect pollution output by paper pulp mills.20

The debate over the size of any reputational costs has affected the U.S.Sentencing Commission’s deliberations over criminal penalties for environ-

mental violations. The commission issued sentencing guidelines for crimesby organizations in 1991 but specifically excluded environmental violations

from these guidelines. It since has considered several proposals for environ-

mental guidelines. But the lack of agreement over whether to impose higherpenalties for environmental crimes than for other business crimes has pre-

vented the commission from adopting any of the proposals.21 At the heart

of this disagreement, we propose, is the lack of evidence over whether en-

vironmental noncompliance imposes significant reputational costs.22

B. Related Research

A substantial body of research examines how regulators should set legal

penalties for environmental harms.23

Empirical evidence on the actual sizesof such penalties, however, is limited. Several papers examine the regulatoryfines imposed for single types of environmental discharges using relatively

19 Karpoff & Lott, supra note 14; Alexander, supra note 14.20 Julie Doonan, Paul Lanoie, & Benoit Laplante, Environmental Performance of Canadian

Pulp and Paper Plants: Why Some Do Well and Others Do Not? (unpublished manuscript,École des Hautes Études Commerciales, Montréal 2002).

21 See, for example, the U.S. Sentencing Commission, Report from Advisory Group onEnvironmental Sanctions (1993) (http://www.ussc.gov/publicat/environ.pdf). The U.S. Sen-tencing Guidelines as amended on November 1, 2003, reflect several cumulative amendmentsto the environmental provisions. See the U.S. Sentencing Commission, 2003 Federal SentencingGuidelines Manual, chap. 2, part Q (http://www.ussc.gov/2003guid/tabcon03_1.htm). But theGuidelines for Organizations (chap. 8) contain no provisions for environmental violations.

22 See Paul E. Fiorelli & Cynthia J. Rooney, The Environmental Sentencing Guidelines for

Business Organizations: Are There Murky Waters in Their Future? 22 B.C. Envtl. Aff. L. Rev.481 (1995).23 See Jean-Philippe Barde, Environmental Policy and Policy Instruments, in Principles of

Environmental and Resource Economics: A Guide for Students and Decision-Makers 157 (Henk Folmer & H. Landis Gabel eds. 2000); Dennis W. Carlton & Glenn C. Loury, The Limitationof Pigouvian Taxes as a Long-Run Remedy for Externalities, 95 Q. J. Econ. 559 (1980); andDennis W. Carlton & Glenn C. Loury, The Limitation of Pigouvian Taxes as a Long-RunRemedy for Externalities: An Extension of Results, 101 Q. J. Econ. 631 (1986).



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small samples.24 Our data on legal penalties therefore establish a baseline of information on the sizes of the legal penalties imposed for environmentalviolations.

Our investigation also is related to several papers that examine the sharevalue impacts of specific types of unfavorable environmental news, such asoil or chemical spills. Michael Muoghalu, H. David Robison, and John Glas-cock, James Hamilton, and Robert Klassen and Curtis McLaughlin concludethat unfavorable environmental news is associated with significant losses inshare values, whereas Lanoie and Laplante, Richard Harper and StephenAdams, Laplante, Lanoie, and Roy, Alexander, and Kari Jones and Paul Rubinfind that the share value losses are insignificant.25 We attribute these dis-crepancies to the relatively small samples examined in most of these studies.

For example, Klassen and McLaughlin examine 22 events, and Lanoie andLaplante examine 47 events.26 Our sample of 478 violations for 1980–2000,in contrast, is sufficiently large to construct a powerful test of the share valueimpact.

Several papers examine stock market reactions to news about a firm’senvironmental sensitivity, such as an investment in pollution prevention ora positive environmental rating from a nongovernmental environmental or-ganization.27 The authors of these papers interpret a stock market reaction

24 James T. Hamilton, Going by the (Informal) Book: The EPA’s Use of Informal Rules inEnforcing Hazardous Waste Laws, in 7 Advances in the Study of Entrepreneurship, Innovation,and Economic Growth 109 (Gary D. Libecap ed. 1996), examines hazardous waste violations.Mark A. Cohen, Optimal Enforcement Strategy to Prevent Oil Spills: An Application of aPrincipal-Agent Model with “Moral Hazard,” 30 J. Law & Econ. 23 (1987), examines oil

spills. Neda Oljaca, Andrew Keeler, & Jeffrey Dorman, Penalty Functions for EnvironmentalViolations: Evidence from Water Quality Enforcement, 14 J. Reg. Econ. 255 (1998), examineswater pollution infractions in the state of Georgia. Cohen, supra note 16, examines a broadervariety of environmental violations. For an excellent review of research on the monitoring andenforcement of environmental policy, see Mark A. Cohen, Monitoring and Enforcement of Environmental Policy, in 3 International Yearbook of Environmental and Resource Economics44 (Tom Tietenberg & Henk Folmer eds. 1999).

25 See Michael Muoghalu, H. David Robison, & John L. Glascock, Hazardous Waste Law-suits, Stockholder Returns, and Deterrence, 7 S. Econ. J. 357 (1990); James T. Hamilton,Pollution as News: Media and Stock Market Reactions to the Toxics Release Inventory Data,28 J. Envtl. Econ. & Mgmt. 98 (1995); Robert D. Klassen & Curtis P. McLaughlin, The Impactof Environmental Management on Firm Performance, 42 Mgmt. Sci. 1199 (1996); Paul Lanoie& Benoit Laplante, The Market Response to Environmental Incidents in Canada: A Theoreticaland Empirical Analysis, 60 S. Econ. J. 657 (1994); Richard K. Harper & Stephen C. Adams,CERCLA and Deep Pockets: Market Response to the Superfund Program, 14 Contemp. Econ.Pol. 107 (1996); see Laplante, Lanoie, & Roy, supra note 18; Alexander, supra note 14; andKari Jones & Paul H. Rubin, Effects of Harmful Environmental Events on Reputations of Firms, in 6 Advances in Financial Economics 161 (Mark Hirschey, Kose John, & Anil Makhijaeds. 2001).

26 Klassen & McLaughlin, supra note 25; Lanoie & Laplante, supra note 25.27 See Seema Arora, Voluntary Abatement and Market Value: An Event Study Approach

(unpublished manuscript, Stanford Inst. Econ. Pol. Res. 2001); Susmita Dasgupta, BenoitLaplante, & Nlandu Mamingi, Pollution and Capital Markets in Developing Countries, 42 J.Envtl. Econ. & Mgmt. 310 (2001); and Shreekant Gupta & Bishwanath Goldar, Do Stock



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to firm-specific environmental news as evidence that capital markets dis-courage environmental misconduct. Our investigation, however, is very dif-ferent from these. We use the stock price reaction as a measure of the presentvalue of the net costs to a firm accused of violating an environmental reg-ulation. We then partition this cost into components that reflect legal penaltiesand reputational penalties.

III. Data

We examine 478 cases in which publicly traded firms were investigatedfor, accused of, or settled charges of environmental violations for 1980–2000.The sample is obtained from a search of the Wall Street Journal index underits “environment” and “environmental crime” listings. Additional information

on many events is obtained from the Factiva database,28 including follow-up information on the sizes of penalties imposed that was published after2000. To be included in the sample, the defendant firm must be listed on the2002 Center for Research in Security Prices (CRSP) daily returns file on theday of the earliest Wall Street Journal report of its environmental violation.Because the Exxon Valdez oil spill resulted in an extremely large penalty,we exclude it from our sample. The spill occurred in March 1989 and resultedin a 1994 jury award of $5.3 billion in compensatory and punitive damages.29

Our sample consists of a wide variety of actions involving different typesof environmental harm and initiated by different regulatory agencies or pri-vate parties. The following examples illustrate typical cases:

1. In 1980, FMC Corporation was indicted for providing false data to the

Environmental Protection Agency (EPA) about the amount of carbon tetra-chloride the firm had released in the Kanawha River in Charleston, WestVirginia.

2. In 1986, a Kerr-McGee Corporation storage tank ruptured and distrib-uted radioactive uranium hexaflouride gas over a part of eastern Oklahoma,prompting a civil lawsuit from a group of nearby residents.

3. In 1997, Santa Monica, California, city officials charged in a lawsuitthat Mobil allowed methyl tertiary butyl ether to seep in to the city’s wells.

4. In 1998, six Rochester, New York, families sued Eastman Kodak al-leging that film factory chemicals caused brain cancer in their children.

The wide diversity of events in the sample provides insight into the typesof environmental violations that occur and are reported in major newspapers.

Markets Penalise Environment-Unfriendly Behaviour? Evidence from India (unpublished man-uscript, Delhi School Econ., Ctr. Dev. Econ. 2003).

28 Dow Jones & Reuters, Factiva (http://www.factiva.com).29 Including the Exxon Valdez event would further support our conclusion of no reputational

effect. This is because the legal penalties far exceed the loss in firm share value at the timeof the event. The 2-day abnormal return for Exxon is .67 percent, which represents a lossin market value of only $398 million.



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TABLE 1

Environmental Violations Sample

Event Classification Number

Type of environmental harm:Air 127Surface or drinking water 121CERCLA/contaminated site 167Miscellaneous or multiple media 63

Total 478Type of action:

Criminal lawsuit 28Civil lawsuit 197Regulatory fine/action 146

Consent order 31Product recall 38Liability assignment 38

Total 478Party bringing the action:

State or local agency 101Environmental Protection Agency 221Justice Department 86Environmental group 8Individuals or class-action lawsuits 62

Total 478

Note.—Distribution of 478 environmental violation events iden-tified from the Wall Street Journal and Factiva database during theperiod 1980–2000. CERCLAp Comprehensive Environmental Re-sponse, Compensation, and Liability Act.

Table 1 provides summary information about the sample. It classifies eventsaccording to the type of environmental harm, the type of lawsuit or regulatoryaction, and the party bringing the action.

Type of Harm. The breakdown of the sample by the type of environ-mental harm reveals that, of the 478 events in the total sample, 127 involveair emissions, including violations of the 1970 Clean Air Act and its 1977and 1990 amendments. A total of 121 cases involve water contamination.Of these, 89 involve surface water contamination, including violations of the1977 Clean Water Act and the Water Quality Act of 1987, and 32 involvecontamination of drinking water supplies and possible violations of the SafeDrinking Water Act of 1974. An additional 167 events involve contaminatedsites and/or subsurface water contamination, typically involving violations

under the Resource Conservation and Recovery Act of 1976 or the Com-prehensive Environmental Response, Compensation, and Liability Act of 1980. The types of environmental harm in the remaining 63 events eitherinvolve two or more of the preceding categories or are classified as miscel-laneous. The miscellaneous group includes violations under the Toxic Sub-stances and Control Act of 1976, charges of improper storage of hazardous



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materials, and several cases in which the specific violation is not discerniblefrom the available press articles.

Type of Action. Table 1 shows that only 28 events involve criminallawsuits. Many more (197) involve civil lawsuits filed by either private partiesor such agencies as the EPA. State and federal regulatory fines or actionscompose 146 events, and in 31 events the initial announcement indicatesthat the firm and regulatory agency agreed to a court-sanctioned consentorder. In 38 events, a firm recalled a product to avoid environmental sanctions.As an example, in May 1986 General Motors recalled more than 86,000automobiles that violated emission standards. A final 38 events are classifiedas liability assignments. These involve situations in which the initial WallStreet Journal press announcement reveals that the defendant firm had been

assigned liability for a previously reported environmental violation. For ex-ample, in January 1993, a California appellate court upheld most of a juryverdict requiring Shell Oil, rather than its insurers, to pay the company’sestimated $1 billion cost of a toxic-waste cleanup near Denver.

Party Bringing the Action. Forty-six percent (221) of the events involvelawsuits or regulatory actions brought by the EPA. An additional 86 eventsinvolve civil or criminal lawsuits filed by the Department of Justice. In manyof these 86 events, the Justice Department acted in cooperation with or reliedin part upon EPA investigations. In 101 events, the action was brought bya state or local environmental agency. Environmental groups, such as theSierra Club Legal Defense Fund, were directly involved at the beginning of only eight of the events (typically as plaintiffs in lawsuits), and 62 otherevents were initiated by individuals. This last category includes several class-

action lawsuits.

IV. Market Value Effects of Environmental

Violation Announcements

In this section we investigate the effects on firm values when news abouta violation is first announced. In 108 of the 478 events, the initial pressreport indicates that an environmental violation may have occurred. We labelthese allegation announcements. For example, in January 1995 a WCI Steelplant discharged contaminated water into a nearby stream. The firm even-tually settled with the EPA by paying an undisclosed fine, but the initialannouncement revealed only that a violation might have occurred. In 136events, the initial press report indicates that charges were filed against the

defendant company by a government agency or private party. In the remaining234 cases, the initial press report indicates settlement of the case. Settlementsinclude agreements between the defendant firm and the initiating party, con-sent orders, trial outcomes, and announcements of fines by regulators. Notethat the events classified as settlement announcements are still the first re-corded public record of the violation. While these news events report that



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TABLE 2

Abnormal Stock Returns Associated with the Initial Press Announcements of

Environmental Violations, by Type of Environmental Harm

Announcement Type Air

Surface orDrinking

Water

CERCLA/ Contaminated

Site

Miscellaneousor Multiple

Media Total

Allegation:Mean 1.56 1.75 2.33 .49 1.69Median .81 .01 .78 .42 .66t -statistic 2.08* 1.55 1.99 .68 3.25**Observations 30 28 34 16 108

Charges filed:Mean .32 2.48 1.16 1.97 1.58Median .51 1.09 .88 .68 .72

t -statistic

.39

3.29**

2.87**

1.12

3.80**Observations 20 41 51 24 136

Settlement:Mean .17 .57 .43 .20 .35Median .26 .20 .20 .03 .11t -statistic .48 1.09 1.30 .49 1.72

Observations 77 52 82 23 234All:

Mean .52 1.49 1.04 .95 1.00Median .48 .41 .43 .16 .43t -statistic 1.69 3.45** 3.30** 1.42 5.12**Observations 127 121 167 63 478

Note.—Average 2-day cumulative abnormal returns for environmental violations reported in the WallStreet Journal or Factiva database during the period 1980–2000, categorized by the type of environmentalharm and the announcement type. Allegation announcements contain information that a violation may haveoccurred. Announcements of charges filed contain information that formal charges were filed against thedefendant company. Settlement announcements are events in which information about a settlement isincluded in the initial press report about the violation. Returns are expressed as percentages. CERCLApComprehensive Environmental Response, Compensation, and Liability Act. Indicates statistical significance using a two-tailed test at the .10 level.* Indicates statistical significance using a two-tailed test at the .05 level.** Indicates statistical significance using a two-tailed test at the .01 level.

the firm settled an environmental charge, they also contain the first pressmention indicating that there was an environmental violation in the first place.

Table 2 reports on the average 2-day abnormal stock returns for the initialpress announcements of environmental violations for all 478 cases and foreach announcement type. The 2-day event window consists of the day beforeand the day of the initial press report. Abnormal returns are calculated asthe actual 2-day return minus a forecast return from a one-factor market

model. We estimate the market model using trading days

230 through

31relative to the initial press date, and we measure market returns using theCRSP equal-weighted index with dividends. Test statistics are calculatedusing the mean and standard error of the cross section of abnormal returns.Different procedures to calculate the test statistics—for example, the pro-cedure discussed by Wayne Mikkelson and M. Megan Partch—yield quali-



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tatively identical results.30 The empirical results also are similar when weuse size-adjusted abnormal returns using the method described by ElroyDimson and Paul Marsh.31

For all 478 initial press announcements, the average 2-day abnormal stock return is 1.00 percent, with a t -statistic of 5.12. The share price effectdepends on the type of information contained in the initial announcement.Announcements of allegations and charges filed result in mean abnormalstock returns of 1.69 percent and 1.58 percent, respectively, and arestatistically significant at the 1 percent level. The mean abnormal stock returnfor settlement announcements, in contrast, is smaller in magnitude (.35percent) and insignificant at the 5 percent level.32

Nonparametric test statistics (not reported in the table) yield the same

inferences as those in Table 2. For example, the Wilcoxon signed-rank statisticfor all 478 events is 4.77, which indicates that the average abnormal returnis negative. Furthermore, the average abnormal return is negative for eachcategory of environmental harm. Differences in the average abnormal returnacross types of harm are not statistically significant (the F -statistic equals1.06, with a p-value of .37).

For 55 of the 478 cases, other potentially confounding news about thedefendant company was announced in the Wall Street Journal the day before,the day of, or the day after the initial press announcement about the envi-ronmental violation. Many of these are routine announcements regardingdividends or earnings reports. Others involve nonroutine announcements re-garding asset sales or potential takeover rumors. Omitting these 55 eventsfrom the sample does not materially affect the results. The average abnormalreturn for the remaining 423 events, for example, is

1.15 percent (t p

5.36).We believe that this is the first large-sample study to examine different

types of events to document that news about an environmental violation isindeed costly for firms. Furthermore, the stock value losses are similar fordifferent types of environmental harm, including air emissions, water dis-charges, and site contamination.

30 Wayne H. Mikkelson & M. Megan Partch, Withdrawn Security Offerings, 23 J. Fin. &Quantitative Analysis 119 (1988).

31 Elroy Dimson & Paul Marsh, Event Study Methodologies and the Size Effect: The Caseof UK Press Recommendations, 17 J. Fin. Econ. 113 (1986).

32 Settlement announcements can result in relatively small share value losses for three reasons.

First, violations that settle quickly may result in smaller penalties than those that do not settlequickly. Second, settlement announcements may not be the first news of the violation to reachfinancial markets. By construction, all announcements in our sample represent the first pressmention of the violation. But it is possible that information about some of our events leakedbefore the initial press announcement, particularly when the first press announcement is of asettlement. And third, settlement announcements contain information that severely reducesinvestors’ uncertainty about the size of the penalty. Such information is not released when theinitial press announcement is about allegations or charges filed.



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Only the initial press report of a violation causes a significant stock pricereaction. For 102 of the 478 events in our sample, we identified a subsequentarticle in the Wall Street Journal or Factiva database that contained sub-stantially new information about the matter. The average abnormal 2-daystock return for these 102 subsequent announcements is 1.20 percent, witha t -statistic of 1.00. For 34 of these 102 events, the Wall Street Journalreports a third news story with significant new developments. The 2-dayabnormal return for the 34 third announcements is .39 percent, with a t -statistic of .58. In collecting the data, we also found 21 announcements thatindicated that pending environmental charges against a defendant companyhad been dropped. The mean 2-day abnormal return for these 21 events ispositive but not significantly different from zero.

V. Legal Penalties for Environmental Violations

Firms violating environmental rules face several forms of legal penalties,including fines, payments to damaged parties, compliance costs, and cleanupexpenses. The amount paid in settlement of a violation frequently is notdisclosed. But by searching the Factiva electronic database and hard copiesof the Wall Street Journal, we found data on the legal penalties for 148 of the 478 events in the sample. We base our examination of legal penalties onthese 148 events. In 107 of these events, the offending firm was fined orordered to pay monetary damages to an injured party. In 70 events, the firmpaid the costs to comply with regulations or remediate prior damage. In 29events, the firm paid both a fine and a cleanup cost.

The top section of Table 3 reports data from the 107 events in which fineswere imposed or monetary damages awarded to victims. Although we usecurrent dollar amounts in citing specific examples, the summary statistics inTable 3 are in constant year 2000 dollars. The mean amount awarded is $13.2million, although most amounts are substantially smaller. The median, forexample, is $1.52 million. Although the mean payment levels vary by thetype of environmental harm, a one-way analysis of variance indicates thatthe differences are not statistically significant. The F -statistic from the analy-sis of variance is 1.24, with a p-value of .30.33

Defendant companies frequently pay large amounts in fines and damageclaims. A typical air emission case, for example, is a $990,000 fine paid byInternational Paper in 1989 for violations of the Clean Air Act at a Mainepaper pulp mill. Examples of fines for water violations include a 1982 Mobil

33 Clean-air violations are associated with the largest mean penalty, $31.7 million. This mean,however, is affected by two settlements that are not typical among the air emission cases anddo not reflect actions taken under the Clean Air Acts. The first is Union Carbide’s $350 millionsettlement of claims stemming from the December 3, 1984, leak of poison gas from the firm’sBhopal, India, pesticide plant, and the second is Monsanto’s $81.9 million settlement of claimsarising from the use of Agent Orange during the Vietnam War. When these unusual cases areomitted, the mean assessed penalty for air emission cases is $4.5 million.



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TABLE 3

Sizes of the Legal Penalties Levied for Environmental Violations,

by Type of Environmental Harm

Penalty Air

Surface orDrinking

Water

CERCLA/ Contaminated

Site

Miscellaneousor Multiple

Media Total

Actual fines anddamage awards:

Mean 31.7 4.0 11.0 6.1 13.2Median 1.2 .8 3.0 1.5 1.5Observations 26 32 32 17 107

Actual complianceand cleanup costs:

Mean 123.0 36.7 108.0 102.0 93.6

Median 27.9 5.7 18.8 17.8 13.5Observations 12 16 33 9 70

Note.—Data on the legal penalties imposed for 148 events in our sample for which penalty data areavailable in the Wall Street Journal or Factiva database, 1980–2000. Twenty-nine cases appear in the topand bottom sections because they have both fine and cleanup cost data. Amounts are in millions of constantyear 2000 dollars. CERCLAp Comprehensive Environmental Response, Compensation, and Liability Act.

Oil agreement to pay the state of Alabama $2 million for illegally dischargingdrilling fluids into state waters and a 1998 agreement by Shell Oil to pay$1,500,000 to settle Justice Department civil charges arising from the com-pany’s chemical discharges into the Mississippi River.

The bottom section of Table 3 reports on the 70 events for which we haveinformation on firms’ estimated costs to comply with regulatory or court-imposed mandates or to clean up environmental damage. In general, com-

pliance and cleanup costs are substantially higher than fines and damageawards. In the 1989 International Paper case, for example, in addition to its$990,000 fine, the firm also agreed to spend $4.2 million to install air pollutioncontrol equipment at its Maine plant. In the 1998 Shell Oil case, the companyalso agreed to perform environmental projects valued at over $10 millionalong the Mississippi River. As another example, in 1981 Ohio Edison wasfined $1.55 million for sulphur dioxide and other emissions at its coal-burningpower plants. At the same time, the firm agreed to spend an estimated $367million to comply with Clean Air Act requirements.

Overall, the mean compliance or cleanup cost is $93.6 million, with amedian of $13.5 million. Once again, although the mean values differ ac-cording to the type of harm, the differences jointly are not statistically sig-nificant (the F -statistic is .40, with a p-value of .75).

VI. Reputational Costs for Environmental Violations

In this section, we combine data on market value losses with data on thelegal penalties to derive a measure of the reputational cost imposed on en-vironmental violators. To compute the reputational cost, we assume that the



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initial change in market value is investors’ unbiased estimate of the total lossto the firm from its environmental violation. This is consistent with ourfinding, reported in Section IV, that the stock price reaction to the initialannouncement captures most of the firm’s total loss in market value. Someof this loss is attributable to investors’ expectations that legal penalties willbe imposed on the firm. Using a rational expectations assumption, we usethe legal penalty eventually imposed as an unbiased estimate of the size of the legal penalty expected at the time of the initial press announcement. If the initial market value loss is no greater than the legal penalty, we inferthat the market value loss reflects investors’ expectations of the legal penalty.If the market value loss exceeds the legal penalty, then we attribute thedifference to lost reputation.

The null hypothesis in these tests is that there is no reputational effect.The alternative is that the reputational effect is negative. We thus conductone-tailed t -tests to test the null.

We have data on legal penalties for 148 of the 478 violations in our sample.The top section of Table 4 reports on the reputation effects in these 148events and for subsets of these events partitioned by the type of environmentalharm. The mean 2-day abnormal stock return for all 148 events is .62percent. The mean legal penalty for these 148 events is 2.26 percent of thefirms’ market value of equity. That is, the legal penalties by themselves implya loss of 2.26 percent in market value. The difference between the observedloss and the implied loss from the legal penalties is 1.64 percent. This is ourpoint estimate of the mean reputational effect. The point estimate is positivebecause the legal penalty, on average, more than explains the market value

loss.The point estimate of the reputational effect also is positive for three of

the four types of environmental harm. Only for water-related violations isthe mean reputational effect negative. Even here, however, the low t -statisticof .18 indicates that we cannot reject the null hypothesis that the reputationalloss is zero.

The data in the top section of Table 4 include many events in which theinitial press report of the environmental violation is of a settlement. Asreported in Section IV, the mean stock price reaction to settlement an-nouncements is smaller in magnitude than when the initial press announce-ment is of an allegation or charges filed. It is possible that, for some settlementannouncements, information about the violation was previously available toinvestors. Including these events could bias downward our estimates of the

stock price effect of the violation and the reputational loss.In the bottom section of Table 4, we therefore exclude events in which

the initial press announcement is of a settlement. For the remaining 50 cases,the mean 2-day abnormal stock return is 1.95 percent. The mean legalpenalty for these 50 cases is 1.55 percent of the market value of equity. Thedifference, .4 percent, is the point estimate of the reputational effect. Using



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TABLE 4

Reputational Costs for Environmental Violations, by Type of Environmental Harm

AirSurface or

Drinking WaterCERCLA/

Contaminated SiteMiscMu

All 148 observations with data on both stock returns and legal penalties:Mean % change in market value .69 .52 1.01 Mean implied % change from the legal penalty imposed 3.9 .43 1.8 Mean reputational effect (as % of market value) (row 1 row 2) 3.21 .09 .79 Reputational effect t -statistic 1.76 .18 .85 Number of observations 32 41 54

Excluding initial announcements that include settlement information:Mean % change in market value 2.79 1.57 3.26 Mean implied % change from the legal penalty imposed 1.46 .77 3.46 Mean reputational effect (as % of market value) (row 1 row 2) 1.32 .80 .20 Reputational effect t -statistic 1.10 .86 .06 Number of observations 9 17 14

Note.—This table compares firms’ market value losses to their legal penalties. The t -statistics test the null of no reputational effect againsteffect is negative (that is, that there exists a reputational loss). CERCLA p Comprehensive Environmental Response, Compensation, and Li



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this estimate, we would conclude that, on average, the reputational penaltyaccounts for .4/ 1.95 percent, or 20.5 percent, of the losses experiencedby firms investigated or charged with environmental violations.

The t -statistic for the mean reputational effect, however, is only .40. Soeven for the subsample of events included in the bottom section of the table,the data cannot reject the null hypothesis that the reputational effect is zero.Furthermore, none of the estimates of reputational effect are statisticallysignificant for any of the four types of environmental harm.

The lack of evidence of a reputational penalty is even more notable con-sidering that our measure of the legal penalty ignores some of the explicitcosts many firms face. Such costs typically include attorneys’ fees, courtcosts, managers’ time, and any lost profits from forgoing the activity that

triggered the environmental charges in the first place. If we were to includesuch costs, the portion of the market value loss that we could attribute tolost reputation would be smaller than reported in Table 4. The fact that ourestimates of the reputational effect are not significantly different from zero—even excluding these other explicit costs—serves further to support the con-clusion that firms do not on average experience reputational losses whenthey violate environmental regulations.

These results are notable also because they differ from the estimates of large reputational losses reported for product recalls, false advertising, unsafeservices, frauds, punitive damages lawsuits, defense procurement frauds, andfinancial misrepresentation (see the footnotes in Section II A). The fact thatreputational penalties are found for other types of corporate wrongdoingindicates that our results are not due to low-powered tests. Rather, the results

indicate that environmental violations differ from other types of wrongdoingin one important respect: firms that violate environmental regulations typi-cally do not impose direct harms on their customers, employees, suppliers,or other stakeholders. Reputational penalties are negligible in such casesbecause there are no repeat market transactions through which the violations’costs are internalized by the firm.

VII. Extensions

A. The Cross-Sectional Relation between Abnormal Returns

and the Legal Penalty

In this section, we investigate whether cross-sectional differences in the

stock price reactions are related to the legal penalty. Table 5 reports theresults of robust least squares regressions using White-corrected standarderrors to correct for the presence of heteroskedasticity. The dependent variableis the firm’s 2-day abnormal stock return. The independent variables includedummy variables for allegation and charges filed announcements (leavingsettlement announcements to be reflected in the intercept term), plus (1) a



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dummy variable set equal to one if we have information that a fine wasimposed on the company, (2) the amount of the fine when a fine is imposed(this variable is zero for firms for which we do not have fine data), (3) adummy variable set equal to one if we have information that compliance orremediation costs were imposed on the company, and (4) the amount of thecompliance or remediation cost (this variable is zero for firms for which wedo not have cleanup cost data).

The results using data on all 478 events in the sample are reported inmodel 1 of Table 5. The coefficients for allegation and charges filed an-nouncements are negative and statistically significant, consistent with ourprevious findings that abnormal returns are most negative for these types of announcements. The negative coefficient for the fine amount (t -statistic p

2.81) indicates that the abnormal stock return is significantly and negatively

related to the size of the fine. The abnormal stock return is not significantlyrelated to the size of the cleanup cost imposed on the firm.

Model 2 reports the results using data from only the 148 events for whichwe have data on the legal penalties. The results are similar to those in model1. Thus, firms’ losses in share values are related to the size of the fine ordamage award eventually imposed by regulators or the courts. This is con-sistent with our finding that legal penalties are important in discipliningenvironmental violations. Not only is the average share value loss explainedby the average legal penalty, but in the cross section, the share value loss isrelated to the legal penalty at the firm level. Furthermore, it is the fine amount,not the cleanup cost, that seems to matter in explaining the share value loss.

In results not reported, we find that the abnormal stock return is notsignificantly related to other characteristics of the violation, including thetype of environmental harm, the type of action, or the identity of the partybringing the action. In all of these tests, the abnormal stock return is sig-nificantly related to the size of the fine or damage award eventually imposedon the company. This is consistent with the conclusion that firms’ share valuelosses reflect primarily their expected future legal penalties.

B. Potential Legal Penalties

Information on the legal penalties is available for only 148 of the 478events in the sample. For many additional events, however, press reportsprovide information on the sizes of penalties that could be imposed. For

example, in 1987 the U.S. Justice Department filed a civil lawsuit seekingdamages from Browning-Ferris Industries for hazardous waste violations ata Louisiana facility. Press reports at the time speculated that Browning-Ferriscould pay $70 million in damages. We found speculation on such potentialpenalties for 212 events in our sample. As might be expected, the potentialpenalties are much higher than the actual penalties reported in Table 3. The



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TABLE 5

Cross-Sectional Relations between Share Value Losses

and Legal Penalties

Independent Variable Model 1 Model 2

Allegation announcements (#102) 1.33(2.19)*

2.29(1.53)

Charges filed announcements (#102) 1.19(2.50)*

1.70(2.22)*

Type and cost of legal penalty imposed:Dummy variable equal to 1 when fine or

damage award information is available .00353(.76)

.00207(.17)

Dollar amount of the fine or damage awarddivided by the market value of firm equity .2660

(

2.81)**

.0275

(

3.01)**Dummy variable equal to 1 when compliance

or cleanup cost information is available .00118(.19)

.00541(.44)

Dollar amount of the cleanup cost dividedby the market value of firm equity .0217

(1.06).0179

(.93)Intercept .0041

(1.28).0053

(.37)F -value 3.69 2.84

p-value .001 .012 R2 .028 .079

Note.—Least-squares estimates in which the dependent variableis the2-day announcementperiodabnormal stock return. Model 1 data consist of all 478 events in the sample. Model 2 data consistof 148 events for which we have information on legal penalties. Values in parentheses are t -statistics,calculated using White’s robust estimator to correct for heteroskedasticity.

* Indicates statistical significance using a two-tailed test at the .05 level.** Indicates statistical significance using a two-tailed test at the .01 level.

mean potential fine or damage award is $122 million, and the mean potentialcleanup cost is $120 million.

The effect of using these data on potential penalties is to further undermineany empirical basis for a reputational cost. This is because the potentialpenalties are much larger than the firms’ losses in share values.

Hardly ever, however, is the actual penalty as large as the potential penalty.In the Browning-Ferris case cited above, the firm eventually paid $2.5 million,not $70 million. For 28 events in our sample, we have data on both the sizeof the potential penalty, as it was discussed in press accounts, and the sizeof the actual penalty when it subsequently was reported. The mean reported

potential fine for these 28 cases, in constant year 2000 dollars, is $3.14 billion,whereas the mean actual fine eventually imposed is only $33.7 million. Themedian potential fine is $9.5 million, and the median actual fine is $4.0million. These data suggest that it is inappropriate to use potential penaltiesas proxies for investors’ expectations of the actual penalties imposed.



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C. Sample Selection Bias

Our sample is selected from environmental violations reported in the WallStreet Journal, with follow-up information collected from the Factiva da-tabase. This biases our sample toward violations that the Wall Street Journaleditors deem newsworthy. Anecdotal evidence—for example, the tendencyto include the stock price change in the story—suggests that events withlarge valuation consequences are likely to be deemed newsworthy. Thus, thesample is likely to be slanted toward events with large stock price reactions.These are precisely the events for which we would expect to measure largerreputational costs. The fact that we do not find evidence of large reputational

costs further supports the inference that such costs are not significant for

environmental violations.

VIII. Conclusions

Debate over environmental policy frequently occurs amidst a vacuum of

empirical evidence. Little is known about the sizes of the penalties imposed

on firms that violate environmental regulations and whether such penalties

are imposed by regulators or market forces. If significant penalties are im-posed by the market—for example, through customers or suppliers—then

legal penalties can be redundant and more easily lead to overdeterrence.

In this paper we address these issues by providing empirical evidence on

the market and legal penalties imposed on companies that violate environ-mental regulations. Our data cover a total of 478 events for 1980–2000 in

which firms were investigated, convicted, or cited for environmental viola-tions. We find that firms investigated or charged with violating environmental

rules experience statistically significant and economically meaningful de-creases in common share values. For announcements of alleged environ-

mental violations, the average abnormal stock return is 1.69 percent, with

a t -statistic of 3.25. For announcements that charges have been filed against

the firm, the average abnormal stock return is 1.58, with a t -statistic of

3.80. This constitutes the first large-sample evidence that news of an en-vironmental violation corresponds to a loss in share value.

The loss in share value, while significant, is not on average larger than

the legal penalties imposed on the violating firm. This implies that the share

value losses are due to prospective legal penalties rather than to any repu-

tational costs. Thus, unlike such other types of corporate wrongdoing ascriminal fraud and product safety problems, reputational concerns are not a

sizeable deterrent to environmental violations. Rather, the primary deterrence

occurs through regulatory and legal penalties. Consistent with this interpre-

tation, we also find that the size of the initial stock price reaction is relatedto the regulatory fine that eventually is imposed.



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The Reputational Penalties for Environmental Violations - Empirical Evidence