Environmental Reputation

Does a firm’s pollution harm its reputation? Many people think so, arguing that customers and suppliers are less willing to do business with companies that are not environmentally responsible. But recent research by Jonathan Karpoff, John Lott Jr., and Eric Wehrly (2005) presents compelling evidence that this is not so: The only adverse consequences suffered by firms who violate environmental regulations stem from the ensuing legal penalties and cleanup and compliance costs.

Conventional wisdom argues that when firms violate environmental rules, customers and suppliers who value environmental amenities will punish the polluters through the marketplace. Some customers, for example, will stop doing business with polluters, while potential employees may refuse to work for them, and suppliers may even decline to sell their goods to them. Hence, it is argued, polluters will face lower revenues and higher costs. The resulting lower profits are called a “reputational penalty.” For a publicly owned polluter, any such reputational penalty should be manifest in a lower share price for the company’s stock (Klein and Leffler 1981).

To determine whether firms suffer reputational penalties when they violate environmental laws and regulations, Karpoff et al. examined the consequences of 478 environmental violations by publicly traded companies for the years 1980 to 2000. They found that although the companies’ share prices dropped measurably (about 1.5 to 2 percent) when the companies were charged with such violations, all of this decline is attributable to the direct legal penalties and the remediation and compliance costs imposed on them by regulators. Because the firms’ stock prices did not fall in excess of the legal penalties, the researchers concluded that the firms’ reputations were unsullied.

At first blush, the finding that firms suffer no lasting reputational damages when they violate environmental laws seems at odds with other research showing that many types of illegal activity (and even mistakes) can have serious adverse consequences for firms’ reputations. For example, false advertising, the sale of unsafe products, fraud, and financial misrepresentation all have been shown to damage firms’ reputations, as manifest in sharply lower stock prices (see, for example, Peltzman 1981). Why is it that firms seemingly can violate one set of laws without reputational damage, even though violating other laws has serious adverse reputational effects? Karpoff et al. suggest that the answer has to do with who is harmed when the rules are broken.

When a firm sells unsafe products, its current and prospective customers are harmed. These customers have clear self-interested motives in protecting themselves by withdrawing business from the firm. Similarly, when suppliers are defrauded or employees are exposed to unsafe working conditions, they have compelling self-interest to stop doing business with the miscreant, or at least to insist on prices or wages that are higher to compensate them for the risks they face.

In contrast, most violations of environmental regulations have no direct adverse effect on customers, suppliers, or employees. There is no doubt that the Exxon Valdez oil spill was devastating for the birds, mammals, and sea life in and around Prince William Sound. But the only Exxon customers who might have been harmed were a few hundred local fishermen, and no employees were injured, nor were any Exxon suppliers harmed. As a practical matter then, no one had any reasons of direct self-interest to withdraw patronage from Exxon.

Of course many people might have withdrawn their business in this and other cases of environmental damage, as a matter of principle. But the key finding of Karpoff et al. is that whatever people might have done, there is no evidence of them having done it in fact.

Several striking implications follow from this research. First, if we are going to rely on environmental rules and regulations to protect the environment, we must recognize that firms can be expected to respond only to legal penalties, including compliance and cleanup costs. There should be no reasonable expectation that environmentally conscious customers, employees, or suppliers will influence environmental outcomes. Second, these results also suggest that the popularity of “green” buildings and “green” products over the last few years is likely to be short-lived, except to the extent that such items offer direct financial benefits to purchasers. People do not seem willing to pay much for principles.

Finally, and perhaps most importantly, these results remind us once again that what matters for decision making are the consequences for the parties making the decisions. It is pleasant to imagine that people might do the right thing because it is the right thing, rather than because it is in their self-interest to do it. But this research reminds us that pleasant thoughts typically are lousy foundations for good public policy. If we want firms to take into account the full costs of their decisions, they must bear those costs.

REFERENCES Karpoff, Jonathan M., John R. Lott, Jr., and Eric W. Wehrly. 2005. The Reputational Penalties for Environmental Violations: Empirical Evidence. Journal of Law & Economics (October): 653 – 75.

Klein, Benjamin, and Keith B. Leffl er. 1981. The Role of Market Forces in Assuring Contractual Performance. Journal of Political Economy (August): 615 – 41. Peltzman, Sam. 1981. The Effects of FTC Advertising Regulation. Journal of Law & Economics (December): 403 – 48.