Research Agenda on Capital Markets and Environmental Performance (Revised)

Overriding issues

The relationship between capital markets and environmental performance is a complex topic requiring interdisciplinary research.  It is also one that often lacks adequate data and that is evolving rapidly over time.  These factors combine to make the topic both interesting and elusive as a research area.  With that background in mind, several overriding issues were addressed that researchers need to keep in mind when developing research agendas:

(1)  There is a need to get other academic colleagues on board that this area is worthy of their attention and an important topic of research.

(2)  More work needs to be done in relating research findings to practical applications in the securities industry.

(3)  We need to keep in mind the motivation of stakeholders (governments, investors, NGOs, etc.) when conducting research.

(4)  Due to data availability, much of the empirical work to date has focused on U.S. companies, despite the fact that the issues are global and many of the more innovative programs are coming out of Europe.  Thus, there is a need expand research beyond U.S companies.  In addition, we need to recognize and take into account the work of other researchers being conducted outside the U.S.

(5)  Attention needs to be placed on the government policy implications of this line of research.  Thus, more study needs to be done on the appropriate role of government in an era of vast information disclosure and capital markets that respond to this information.  Should government mandated disclosure programs be expanded, reduced, or modified?

(6)  When researchers find a linkage between environmental and financial performance of firms, these relationships are primarily between social benefits (reduced pollution) and private benefits (improved financial performance). Presumably, the private costs are less than the private benefits, or firms would not behave in this manner.  However, we do not know whether the social benefits exceed the social costs.  For example, what are the costs and benefits of information disclosure programs?

(7)  It is important to keep political views out of research and not to presume that there is general knowledge or agreement on controversial environmental issues.

Specific Research Needs

Research needs have been identified in three broad areas: (1) data and metrics, (2) studies of corporate behavior, and (3) studies of financial markets.  Although these are listed as mutually exclusive categories, there are considerable interactions between them.  For example, most data and metric issues will ultimately have an impact on studies of corporate behavior or financial markets.  Thus, the categories are somewhat arbitrary.

Data and Metrics

• What data are most valuable from an environmental and financial perspective? Are these data currently being measured and disclosed?  Are items that are currently being disclosed valuable?
• First, in terms of EPA data, it would be valuable to survey research on what specific changes EPA could make in their data collection and/or dissemination programs that would enhance the value of their data for research purposes.
• On a broader scale, it would be useful to identify those data that would be of most value to researchers.

• There are numerous qualitative measures used by researchers to characterize the environmental performance of companies (e.g., existence of ESM, well articulated corporate environmental policy, environmental auditing).  There is a need for a “meta-analytic” study that characterizes these various measures and attempts to derive common measures to guide future studies.
• Despite numerous government, NGO and private corporate information disclosure programs and efforts, little is known about the information needs of the potential users of environmental information.  Thus, there is a need for “market research” studies to identify the needs and format for dissemination of information to various stakeholders, including the public, environmental groups, academics, and financial analysts.
• Unlike many areas of government-sponsored data collection and dissemination, there is no “one-stop” shopping for environmental data.  Researchers must often collect their own data or use primary data sources from EPA that requires considerable “cleaning” or manipulation in order to put it into a useable format.  Subsequent researchers are often forced to reinvent the wheel.  This results in both wasted resources and lack of comparable results across studies.  It also stifles the academic interest in these topics, since the pressure to publish and research publication lags prompt researchers to use data that are easy to obtain and work with.  Thus, there is a need for a central repository of data sets developed by government agencies and researchers willing to share their data.
• Explore more permanent mechanisms (revive EPA-SEC link) to make environmental performance data available to researchers and financial analysts; could be independent (for profit) entity (IRRC comes to mind).
• Continued study and dissemination on the current state of reporting in the U.S. and other countries.
• This is somewhat of a routine task, yet one that can have enormous value in terms of benchmarking and moving the state-of-the-art forward.  It was noted that there are currently several studies and websites devoted to this topic.  However, some of these studies are proprietary and only available by subscription, while others are only sporadically maintained.  A central repository and ongoing attention, coupled with broader dissemination would be of value.
• There is a need for more data on small companies that might have as much or more impact on environment.  There is also a need to study small and medium sized enterprises to determine if they will be put at an advantage or disadvantage by increased reporting standards.
• Existing studies tend to focus on one pollutant or media even though there might be offsetting increases in pollution elsewhere.  For example, studies of TRI that suggest companies have significantly reduced emissions might not capture offsetting increases in other emissions as companies switch from “listed” chemicals to others that are not subject to TRI reporting.  Similarly, companies might sell off facilities that are among the worst polluters and purchase the products from the same facility as a way to avoid being tagged with those TRI emissions.  Studies need to begin to take into account these interactions.
• Can we develop a precise, quantifiable definition of sustainability that can be explicitly employed in this process?  Although there’s agreement about the general meaning of sustainability, there is no consensus definition of the term or concurrence on how it translates into a bottom line implication for a company.  Analysts would be more convinced of the relevance of sustainability if they knew how it could be measured.  Research studies would also be more comparable if a common metric and definition were available.

Corporate Behavior

An overriding theme is that there is a critical need for better theory in order to guide empirical work.

Industry level

• What industries or collections of firms are most useful to study now?  (Perhaps it’s useful to look at firms at the extremes of the spectrum of environmental footprints across industries rather than concentrating on industries per se.)
• What is the influence of standards on competitive advantage within industries?
• More case studies related to the above questions.
• Include “global” studies in the above.  (Explore “race to the bottom” hypothesis; expand analysis beyond the factory to include impacts on society more broadly—for example maquiladoras in Mexico.)

• Define sustainable scenarios for various industry sectors.

Firm level

• Relationship between management practice and environmental performance.
• Role of information disclosure on environmental management, programs and performance (transparency; mandatory vs. voluntary; external vs. internal drivers).
• Is public sentiment surrounding environmental performance driving the bottom line, is environmental performance just a proxy for good management, or is there real value being created by improved environmental performance?
• How can we measure the upside opportunities (as opposed to incremental improvements)? 
• Need to examine other aspects of the organization that might help or hurt environmental performance (e.g. organizational design, industrial ecology).
• How do businesses themselves value environmental programs and performance?  (Explore interfirm linkages—supply chains, trade organizations; causal pathways.)

• Look at the distinction between managing existing assets versus developing new competencies with respect to environmental products, processes, and programs.

Financial Markets

The overriding question in need of an answer is:  How do we provide financial analysts with the tools to understand the impact of environmental decisions on corporate cash flow?

At least three different types of financial analysts can be identified:  1.  Buy and sell side equity analysts, 2.  Credit analysts such Robert Morris Associates, (now The Risk Management Association) and 3.  Insurance underwriters and providers of risk-based information for insurance companies such as Insurance Services Office, Inc.  Each type of analyst is likely to have a different view of the risk inherent in an environmental liability or the benefits from proactively adopting environmentally benign processes.

In the process of answering this basic question, several ancillary questions arise which must also be answered:

• What are these tools that assess the impact of environmental performance on cash flow?  They must be more than studies showing a positive correlation between environmental and financial performance.  Precise linkages between the environmentally sensitive operating procedures and the predictability of cash flow must be identified.
• How will they be provided to the analysts?  One possibility would be to incorporate an environmental component into the curriculum for Certified Financial Analysts.  A necessary condition for this to occur would be establishing a compelling case for the importance of a financial analyst being able to assess environmental performance.

Other items on the research agenda:

• Establishing the direction of causality between environmental and financial performance.  There is some evidence that environmental management “explains” financial performance, but more work is required before the issue becomes resolved.
• If improved environmental performance leads to improved financial performance for one set of firms, how do we know this will be true for all firms?  Moreover, will the positive relationship between environmental and financial performance continue to hold true in the future for those firms currently viewed as enjoying financial benefits from environmental performance?  What role do other factors such as industry concentration, trade associations, or first mover advantage play in the link between environmental and financial performance?
• The finance profession has not reached a consensus regarding the appropriate equilibrium model for assessing financial performance.  How is the relationship between environmental and financial performance affected by alternative asset pricing models?
• One effect of socially responsible investing (SRI) is a reduction in the companies’ costs of capital.  In terms of a reallocation of resources from less to more environmentally proactive companies, how does SRI compare with consumption-based programs (e.g., consumer boycotts) as a driver of sustainability?
• How environmental and financial performance is related in capital markets outside of the U.S. and how this relationship compares with found in the U.S. is another area of potential study.