When the Environmental Effort Pays off. And How to Convince Firms to Persist

The relationship between a firm's environmental outcomes and its financial performance is dependent on the amount of effort the firm puts into environmental impact reduction. In fact, firms that exert high levels of effort are more likely to have high levels of financial performance when the firm either has very high or very low levels of environmental performance. However, when firms have a moderate level of environmental performance (i.e. carbon emissions close to the average of the industry), lower levels of effort result in the highest financial performance.

Nicola Misani and Stefano Pogutz (Department of Management and Technology) reach these conclusions in an article that has been published in Ecological Economics, and is entitled Unraveling the Effects of Environmental Outcomes and Processes on Financial Performance: A non-linear approach (Volume 109, January 2015, pp. 150-160, doi: 10.1016/j.ecolecon.2014.11.010). In this article, they examine a sample of 127 firms from multiple countries and multiple industries that disclosed their GHG emissions through the Carbon Disclosure Project.

The authors measure financial performance with the Tobin's Q ratio, which measures the extent to which the market values the firm differently than the book value of its assets, so that a higher valuation is related to the expectation that the firm can do well in the future. Environmental performance is measured with the amount of CO₂ emissions, while environmental management is measured using the scores by Thomson Reuters in their Asset4 database. They run several regression analyses to understand how Tobin's Q is related to CO₂ emissions, and how this relationship depends on the amount of effort into environmental impact reduction.

They expect that financial performance is best for those firms that have either very high or very low CO₂ emissions. On the one hand, high emission firms can outperform competitors on costs, as they do not have to invest in expensive emission reducing technology. On the other hand, low emission firms get a "carbon premium" in that environmentally conscious stakeholders will be more likely to invest in the firm, and to sell to or buy from it. Firms that have moderate emissions will not receive a carbon premium, but will incur the costs of emission reducing technology, and thus perform less well.

However, this result is only supported for those firms that put a high amount of effort into environmental impact reduction. The authors explain this by stating that for firms that have very high CO₂ emission, an increase in effort to reduce these emissions increases their legitimacy, and stakeholders appreciate the fact that the firm is trying to improve. For firms that already have very low CO₂ emission, this is associated with some best-in-class performance that allows the firm to get high amounts of stakeholder support.

The authors are the first to show a non-linear relationship between Tobin's Q and CO₂ emissions. These results have important implications for both businesses and policy makers, as they show that firms might be likely to put some initial effort into environmental impact reduction when they have very low environmental performance, but they might not be willing to do so when they reach a moderate amount of performance and the effects on performance disappear. Then, if policy makers desire better environmental performance, they might have to incentivize firms to reduce their environmental impact even further.