Corporate Environmental Policy and Shareholder Value: Following the Smart Money

Chitru S. Fernando is the Rainbolt Chair and Professor of Finance at the Price College of Business, University of Oklahoma; Mark P. Sharfman is the Puterbaugh Chair in American Enterprise and Professor of Strategic Management at the Price College of Business, University of Oklahoma; and Vahap B. Uysal is Associate Professor of Finance at the Driehaus College of Business, DePaul University. This post is based on a recent paper by Professor Fernando, Professor Sharfman, and Professor Uysal.

The headline of Milton Friedman’s 1970 New York Times Magazine article: “The social responsibility of a business is to increase its profits” reflects a widely held view that only “socially responsible” investors benefit directly from corporate actions that are deemed socially responsible. However, not all socially responsible policies are equivalent. For example, socially responsible corporate actions that mitigate the likelihood of “bad” outcomes may reduce the risk exposure of firms to accidents, lawsuits, fines, and so forth, and thereby appeal to all investors. In contrast, investments that enhance the firm’s perceived corporate social responsibility beyond both legal requirements and risk management rationales may decrease value and be shunned by investors whose sole objective is profit maximization. However, the current literature does not focus on such nuances in socially responsible policies, nor does it provide much insight into how the form of corporate social responsibility influences the breadth and depth of ownership and firm value.

In our paper, we study the relation between corporate environmental performance, institutional ownership, and shareholder value in a sample of U.S. firms. Investors scrutinize corporate environmental policies more closely than they do other corporate actions that have social implications. The financial costs and consequences of corporate environmental policies dwarf other socially relevant corporate decisions, as exemplified by recent episodes such as the 2010 British Petroleum (BP) gulf oil spill, which has cost BP well in excess of $50 billion to date in losses, damages, and fines. Because institutional investors are widely recognized as being better informed and more sophisticated than individual investors, [1] our institutional investor perspective follows the smart money.

We classify corporate environmental practices into two categories: (a) actions that mitigate the likelihood of “bad” outcomes by reducing the exposure of firms to environmental risk (we label this type of exposure as “toxicity”); and (b) actions that enhance the firm’s perceived “greenness” through investments that go beyond both legal requirements and any conceivable risk management rationale. Examples of the former include deploying safer petroleum drilling technologies or investments that mitigate the risk of hazardous chemical releases. Investments in clean technologies or renewable energy sources serve as examples of the latter.

Although both groups of environmental practices are likely to be viewed as socially responsible, our bifurcation enables new insights into the costs and benefits for investors who are not constrained by socially responsible investing (SRI) norms. Firms pay substantial legal penalties and suffer corresponding market value losses following violations of environmental regulations. [2] Consequently, investments that reduce toxic firms’ exposure to the risk of losses arising from environmental accidents, lawsuits, and fines can create value for all shareholders by lowering expected costs of financial distress, financing costs, and underinvestment. [3] Thus, sophisticated investors will have decreased interest in toxic firms, an effect that should be even more pronounced if a sophisticated investor is norm-constrained.

Regarding investments in greenness, going beyond legal limits in corporate environmental policies may be value-decreasing, causing sophisticated shareholders to shy away from these stocks. Furthermore, if shareholders do not adhere to SRI norms, they are even less likely to invest in stocks of green firms that spend corporate resources on such environmentally friendly practices. Collectively, these criteria imply that institutional investors will be more likely to invest in stocks of environmentally neutral firms rather than toxic firms or green firms. Additionally, the negative effect of toxic stocks will be stronger in the subset of SRI norm-constrained institutional investors, whereas the negative effect of green stocks will be stronger in investments of SRI norm-unconstrained institutions.

We use the KLD Research & Analytics, Inc. (KLD) social performance dataset to assess corporate environmental policy. For each stock, the KLD data enables us to calculate positive scores based on six sub-indicators for environmental strengths and negative scores based on seven sub-indicators for environmental concerns. Firms that have higher negative scores have higher environmental risk exposure to losses due to accidents, lawsuits, and fines, relative to firms with lower negative scores. A firm that takes actions to decrease its negative KLD score (for example, by reducing toxic emissions, minimizing regulatory violations, or mitigating hazardous waste exposure) is engaging in environmental risk management efforts that potentially reduce its financial costs. In contrast, actions that increase a firm’s positive KLD score (for example, increasing recycling activity, switching to clean energy, or increasing environmentally relevant communications) are likely to produce tangible social benefits that elevate the firm’s standing in the eyes of green investors. We categorize the firms in our sample that have positive net environmental scores (positive minus negative) as “green,” and firms that have negative net environmental scores as “toxic.” Firms that have zero net environmental scores are classified as “neutral.”

Our first major finding is the evidence we provide of a non-monotonic relationship between environmental performance and institutional ownership. Both green and toxic firms have significantly lower institutional ownership than neutral firms. The difference is made up by individual shareholders, who own green and toxic firms in significantly greater numbers than neutral firms. Collectively, these findings are consistent with our conjecture that environmental performance influences institutional investors’ decisions. Consistent with our results for aggregate institutional ownership, we also find lower numbers of institutional investors investing in green and toxic firms for all institutional investor types in our sample, including investors constrained by SRI norms. Our findings help illuminate the role of social norms in investor behavior.

Our second major finding is the evidence we provide on the relation between environmental risk management and shareholder value. We examine the relation between corporate environmental performance and Tobin’s Q. Tobin’s Q values are significantly lower for toxic stocks than for neutral stocks. This finding is in line with the view that toxic firms are more prone to environmental disasters, lawsuits, and other costly disruptions. Firms that alleviate their environmental risk exposure benefit from higher valuations, which is consistent with the predictions of risk management theory. We also find lower values of Tobin’s Q for green firms, indicating that corporate expenditures to enhance greenness beyond the mitigation of environmental risk exposure do not increase firm value. This is consistent with our finding regarding institutional investors’ lower propensity to invest in both toxic and green stocks.

The complete paper is available for download here.


1Shleifer, A., and R. W. Vishny. “Large Shareholders and Corporate Control.” Journal of Political Economy, 94 (1986), 461–488.(go back)

2Karpoff, J. M.; J. R. Lott; and E. W. Wehrly. “The Reputational Penalties for Environmental Violations: Empirical Evidence.” Journal of Law and Economics, 48 (2005), 653–675.(go back)

3 Smith, C., and R. Stulz. “The Determinants of Firms’ Hedging Policies.” Journal of Financial and Quantitative Analysis, 20 (1985), 391–405; Froot, K.; D. Scharfstein; and J. Stein. “Risk Management: Coordinating Corporate Investment and Financing Policies.” Journal of Finance, 48 (1993), 1629–1658.(go back)

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