Is Pollution Value Maximizing?

Roy Shapira is Associate Professor at IDC Herzliya Radzyner Law School; Luigi Zingales is Robert C. McCormack Distinguished Service Professor at University of Chicago Booth School of Business. This post is based on their recent paper.

Why do firms pollute even when polluting is socially inefficient (i.e., the harm caused greatly exceeds the cost of curbing the toxic emissions)? Is this undesirable outcome the result of corporate myopia, bad internal governance, or weak external constraints? In our new working paper, we study DuPont’s emissions of a toxic chemical dubbed C8 to shed some light on these questions. C8 was used in DuPont’s West Virginia plant in the process of manufacturing Teflon®. In February 2017, DuPont settled a C8-related litigation for $670M. Thus, it may seem that the system works and legal liability should deter firms from polluting. However, by using evidence discovered during the C8-litigation we show that it was perfectly rational for DuPont to pollute ex ante, in spite of the costs it ended up paying ex post, and the costs it imposed on society.

Two unique aspects of the C8 pollution case make it worth studying. First, the firm involved, DuPont, is not a fly-by-night company. It is one of the most respected American companies (as Chief Justice Strine details in a paper profiled on this blog), consistently scoring good marks on corporate governance indices, and a known leader in toxicological and occupational safety research. Understanding how such a company continues to pollute for several decades can improve our understanding of what works and what does not work in deterring pollution. Second, the litigation against DuPont unearthed a trove of internal company documents that allow us to reconstruct when key decisions were made and what were the costs and benefits of such decisions.

The key decision point for DuPont came in 1984, when alarming information about the potential consequences of C8 emissions caused the company to call a top-executives meeting. By 1984 DuPont was aware that C8 is toxic, associated with birth defects, does not break down in the environment, and accumulates in human blood over time. Essentially, by 1984 C8 could already be considered a perennial red flag. DuPont’s executives acknowledged that the legal and medical departments would recommend stopping the usage of C8 altogether in light of the new alarming information. Yet, the business side overruled these recommendations and opted to continue C8 emissions (in fact they doubled them). Importantly, DuPont’s decision-makers also opted against investing in abatement options that were on the table, such as building an incineration device that would greatly reduce C8 emissions.

Was this a myopic managerial decision? An agency problem? The internal documents allow us to conduct a cost-benefit analysis, showing that even a shareholder-value-maximizing manager would have chosen to pollute. Our calculation shows that even if DuPont managers could have forecasted all future legal liabilities, they would have preferred to pollute as long as they thought that the probability of getting caught was less than 19%. Given the extreme set of unlikely events that led to the payment of heavy legal fines, and given the fact that other C8 users (like 3M) have escaped such heavy legal liability, we conclude that at that time polluting without abating was a reasonable bet by DuPont’s decision makers. Thus, it was value-maximizing for DuPont to pollute, in spite of the fact that—as we show—the costs C8 pollution imposed on society greatly exceeded DuPont’s own estimates of abatement costs.

Our paper then moves to examine why no system of control was successful at mitigating the gap between company’s incentives and social welfare. In spite of the magnitude of fines paid (close to a billion dollars), legal liability was not a sufficient deterrent because of the time lag between the decision and the actual payment: DuPont is scheduled to pay the bulk of its liability in 2017, more than thirty years after they made their decisions.

Regulation was not enough either. The Toxic Substances Control Act grandfathered in existing chemicals, making it difficult for regulators to obtain information about possible health risks. Even when regulators receive alarming information, large chemical companies can pull levers to soften regulatory enforcement, such as revolving door offers.

Finally, reputation was also insufficient, in spite of the fact that DuPont’s managers explicitly considered the risk of adverse publicity. One reason to discount the threat of reputational sanctions comes from the time lag: the decision was taken in 1984, while the actual environmental costs became public (as in the first time critical media coverage of the emissions surfaced) only in 2003. By then most people involved in the initial decision were already dead or retired. Labor-market reputation concerns could not have affected them. And the few managers who were still in business in the 2000s were not named in negative media coverage when bad news broke.

Importantly, we should not think of the time lag as an exogenous factor. Time lags can actually be the result of a concerted effort by chemical companies to delay liability, fend off regulators, and cast doubts in ways that limit a reputational sanctioning process. Toxic pollution cases, in particular, fall into a category whereby the producers have a unique informational advantage that they can use to water down external systems of control.

What can be done then, to realign private and social incentives in such cases? Jacking up the fines does not address the informational gap, and it may bankrupt the few companies that are caught, reducing the political support for any environmental protection.

We propose instead a couple of straightforward remedies that address the information problem, without increasing the regulatory burden. First, we propose creating monetary rewards for employees (whistleblowers) or organizations that reveal the damage caused by toxic substances knowingly released into the environment. Such awards can be financed with the fines paid by the companies that are caught.

Second, we propose imposing a heavy tax on so-called gag settlements in environmental cases, that is, settlements banning any release of information about the underlying case. Gag settlements are very convenient for companies, helping them avoid the risk of further legal and reputational liability. As a result, they are very lucrative for plaintiffs, who are able to extract more from the settlement. But they can be very detrimental to society in general, because they limit what we can learn from the litigation. After all, if it was not for litigation, the dangers and costs of C8 could have still gone unnoticed until this day. Finding a way to encourage open information flows—from regulatory settlements or from private settlements—can go a long way toward mitigating the information asymmetry problem.

The full paper is available for download here.

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