The information structure of society about the relationship between the natural environment and economic activities is an important factor affecting the perception of environmental risk. Such information determines the incentives of stakeholders and eventually the incentives of society to regulate the actions of agents that contribute to environmental risk. The existing literature in environmental economics assumes that firms are more likely to have better and private information about their own environmental performance as well as the likelihood of any future environmental disaster caused by their own production process. Thus, the literature primarily focuses on the incomplete information problem between firms and regulators or between firms and consumers1. However, a firm might lack appropriate scientific evidence to predict an almost accurate probability of occurrence of an environmental accident due to its own production process2. In this paper, I refer the probability of occurrence of an environmental accident/disaster associated with a firm’s production process as the environmental risk of the firm. Moreover, strict liability rules require firms to pay a penalty once the environmental damage becomes observable (in the future). Thus, one can argue that firms may have a strategic incentive to invest in scientific research to evaluate their own environmental risk and consequently, decide whether to adopt necessary preventive measures.
If firms invest in scientific research to accurately evaluate their own environmental risks then an immediate question is whether the policy makers should make it mandatory for firms to truthfully disclose such acquired information. There are few mandatory policies (such as Toxic Release Inventory (USA), Environmental Reporting Decree (the Netherlands), Green Accounts (Denmark), Pollutant Release and Transfer Register (UK) etc.) that make firms truthfully disclose their environmental performances. Moreover, concerned shareholders often pressurize firms for sufficient environment (climate) risk disclosure, as stock prices tend to crash once an environmental disaster becomes observable. The US Securities and Exchange Commission (SEC) was recently “criticized for lax enforcement of climate risk disclosure” under federal security laws. The main contribution of this paper is to critically examine the role of more effective and stringent implementation of mandatory disclosure laws to promote strategic environmental risk evaluation by firms.
I consider a market where two ex ante identical firms produce physically homogenous products and engage in quantity competition a la Cournot. I find that both firms, prior to choosing output and preemptive care to avoid environmental damage, may strategically invest in research to evaluate their actual risk of future environmental damage (associated with their own production process). Both firms have higher strategic incentive to invest under mandatory disclosure laws when firms are subject to public disclosure of their evaluated environmental risk, compared to the situation where such information remains privy to the individual firms 3. Surprisingly, I find a trade-off between a firm’s strategic incentive of environmental risk evaluation and the expected environmental damage. Though, better scientific information about the likelihood of potential future damage could be beneficial (since it allows firms to fine tune their prevention efforts), strategic risk evaluation and disclosure also induce higher output, and consequently, more pollution. Therefore, for a regulatory authority that primarily focuses on emission reduction, implementation of a mandatory disclosure rule of environmental risk might not be a good choice, because there is a rebound effect; the information about rival’s evaluated environmental risk encourages the firm to produce more output and this, in turn, creates higher expected environmental damage.
Our paper builds on the literature of environmental performance disclosure in environmental economics and accounting. However, most of the papers focus on the issue of voluntary risk disclosure by firms4. Critics argue that firms often tend to misreport their environmental performance; there are, in fact, plenty of empirical evidence to support this accusation of “green washing”. Note that the issue of strategic (voluntary disclosure) is beyond the scope of this paper; here, I consider two exogenously imposed information structures, namely truthful mandatory disclosure and no disclosure. Unfortunately, the existing mandatory disclosure policies do not necessarily get a clear pass either. The environmental accounting literature provides mixed evidence on the role and effectiveness of mandatory disclosure policies. Peters and Romi (2013) critically examine the effectiveness of existing mandatory environmental accounting disclosure required by Environmental Protection Agency (EPA) in the United States. Mobus (2005) finds that the mandatory environmental performance disclosure in financial reports has helped firms in the US oil refining industry to improve their subsequent environmental compliance (between 1992 and 1994). There is a substantial body of literature in empirical environmental economics that critically evaluates the performance of Toxic Release Inventory5. In this paper, I assume that the firms always truthfully report their environmental risks under mandatory disclosure laws6 so that I can focus primarily on the strategic interactions among firms (i.e., firms’ strategic incentives to invest in environmental risk evaluation). Further, unlike this paper, most of the existing literature assumes that firms do not need to make any investment in research because firms already possess all the necessary scientific information to evaluate their environmental risks. To the best of my knowledge, this paper is one of the first attempts to analyze firm’s strategic incentive to invest in the evaluation of environmental risk (since the firms currently lack the required scientific evidence) under exogenously imposed information structures viz., mandatory disclosure as well as no disclosure. This adds to the debate of need for more stringent and effective mandatory disclosure laws by public authorities to encourage strategic preemptive care by firms against environmental disasters.
The paper is organized as follows. The next section depicts the basic model. In Section 3, I study a firm’s strategic incentive to invest in environmental risk evaluation under mandatory disclosure laws. Section 4 examines firms’ investment behaviors when there is no disclosure rule and discusses the relevant policy implications. The final section concludes.
I consider a market where two ex ante symmetric firms produce a physically homogeneous good at a constant marginal production cost
Firms are subject to some liability rule; firm
The timeline is as follows. First, nature independently draws the type
There are three possibilities after firms decide whether to invest, namely (1) both firms invest (II) , (2) only one firm invests (denoted by
In this paper, the unilateral incentive
3 Mandatory Disclosure
In this section, I examine whether firms have any strategic incentive to invest in scientific research to evaluate its own environmental risk when firms are subject to mandatory public disclosure of such information. To solve the three-stage (full information) game backwards, I consider the aforementioned three possible cases that can arise after the strategic investment decisions by the firms and subsequent full disclosure of the findings (evaluated environmental risks).
Case (1): If both firms invest, each firm
with respect to
respectively. Since the firms are symmetric the rival (firm
Case (2): Suppose only one firm invests i.e., firm
The equilibrium market outcomes are9
The ex ante expected profits of the investing and non-investing firm are given by
Case (3): Since no firm invests, both firms remain unaware of the actual value of the risk of future environmental damage. Firm
The equilibrium output and rate of prevention\ of a non-investing firm are
Since the firms are symmetric the rival (firm
Note that the unilateral incentive to invest in the risk evaluation is exactly equal to that of the reciprocal incentive. The following proposition depicts the investment equilibrium under mandatory disclosure.
Under mandatory disclosure rule, both firms invest in research to evaluate future environmental risk if the fixed cost of investment does not exceed a certain threshold i.e.,
The proof follows by simply comparing eqs (11) and (12). An alternative interpretation of the proposition is that both firms invest in research to evaluate future environmental risk for any liability rate
and for all possible liability rate if
4 No Disclosure
In the absence of any mandatory disclosure laws as well as any credible voluntary disclosure mechanism, which seems to fit the reality well, the evaluated environmental risk remains privy to the firm in the second stage of the investment game described in the previous section. I consider two possibilities in relation to the observability of a firm’s investment decision after the second stage and solve the three-stage (incomplete information)\ Bayesian game backwards like before.
4.1 Observable Investment
In this subsection, I discuss the case where firms can observe each other’s investment decisions but evaluated risk remains private information.
Case (1): When both firms invest then each firm
with respect to
The ex ante expected profit
Case (2): In this case, only one firm, say firm
whereas the non-investing firm
The ex ante expected profits of the investing and non-investing firms are given by
Case (3): When no firm invests
The unilateral and reciprocal incentives of a firm to invest in the research under no public disclosure are
The following Proposition summarizes the investment equilibrium when firms observe each other’s investment decisions but the evaluated environmental risk remains private knowledge.
Under no disclosure with observable investment decision, both firms invest in research to evaluate future environmental risk if the fixed cost of investment
Alternatively, I can say that both firms invest in research to evaluate future environmental risk for any liability rate
and for all possible liability rate if
4.2 Unobservable Investment
Here I discuss the case where firms do not observe each other’s investment decisions. I evaluate the investment equilibrium by proposing a Nash equilibrium and then derive the conditions under which no firm has an incentive to deviate from the proposed Nash equilibrium.
I propose a Nash equilibrium where both firms invest. I have to examine whether a firm has any incentive to deviate (i.e., not invest) given that the rival invests. Since the investment decision of the firms remain unobservable to each other, if a firm deviates the rival cannot observe this deviation and makes the output decision with the belief that the firm has indeed invested (and thus is aware of the actual risk), and the firm knows this, \ and so on so forth. In particular, the question is given that the rival
The profit maximizing output and abatement of the deviating firm are
The ex ante expected profit of the deviating firm is given by
then the investing firm deviates from the proposed investment equilibrium where both firms invest.
I now check whether a strategy profile where only one firm invests is a Nash equilibrium. If the investing firm decides to deviate given that its rival
The profit maximizing output and abatement of the deviating firm are
The ex ante expected profit of the deviating firm
an investing firm deviates. The following proposition summarizes the possible investment equilibria when firms cannot observe each other’s investment decisions as well as do not know its rival’s evaluated environmental risk.
Under no disclosure with unobservable investment decisions, both firms invest in research to evaluate future environmental risk if
Note that firms’ ex ante expected profits and strategic (unilateral as well as reciprocal) incentives to invest in risk evaluation remain the same irrespective of the observability of investment decision by firms.
Finally, observe that
In equilibrium, both firms invest in future risk evaluation only under mandatory public disclosure for any fixed cost of investment
The effectiveness of mandatory disclosure laws over no disclosure in promoting strategic research in information acquisition is supported by the previous work on duopolistic firms’ incentives to disclose private information11. In particular, duopolistic firms competing in terms of quantity find it profitable to share information about their own cost. Note that in our model the environmental risk of a firm (i.e.,
It is perhaps not surprising that a firm
I focus on a form of incomplete information where firms are not aware of the risk of future environmental damage that can be caused by their own production process (example, oil spill, nuclear disaster, chemical plant explosion to name a few). I find that firms have strictly positive strategic incentive to invest in research to evaluate the actual risk of future environmental damage of the existing production process, irrespective of whether or not regulation requires such information about environmental risk to be disclosed. The incentive is higher under mandatory disclosure (e.g., federal security laws). In equilibrium, both firms invest when the fixed cost of investment is sufficiently low (alternatively, when the strict liability rate is moderately high). However, the net expected environmental damage of an investing firm is lower if there is no public disclosure.
[Ex ante output under mandatory disclosure] Recall that under mandatory disclosure as well as no disclosure regime, in equilibrium either both firms invest or no firm invests. The latter equilibrium outcomes are same under both regimes. I calculate ex ante expected output (when both firms invest) under mandatory disclosure
and when there is no disclosure
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Examples of such environmental disasters are Exxon Valdez oil spill in Alaska, BP oil spill in Gulf of Mexico, nuclear power plant disasters in Chernobyl and recently in Fukushima, etc.
“No disclosure” of environmental risk can be justified under the trade secret laws; especially, in the United States, the state authorities can choose to modify the Uniform Trade Secret Acts (1979) to protect the firms from keeping their evaluated environmental risks secret.
This is because a credible independent third party (for example, public or private research laboratory/institution, research unit of any university etc.) is responsible for the costly scientific research to evaluate environmental risk of the firm’s production technology. Moreover, one can think of a credible and real threat of exposure of misreporting in the near future.
Firms may differ in their respective production technologies in use but incur the same marginal cost of production.
The analysis of equilibria under specific liability structures is beyond the limited scope of this paper. Nevertheless, note that in case of the strict liability rule (where the firms have to compensate for the exact value of the damage), the parameter
Note that, since firm