Information Acquisition and Disclosure of Environmental Risk

1 Introduction

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 consumers^[1]. 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 process^[2]. 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 firms^[4]. 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 Inventory^[5]. In this paper, I assume that the firms always truthfully report their environmental risks under mandatory disclosure laws^[6] 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.

2 Model

I consider a market where two ex ante symmetric firms produce a physically homogeneous good at a constant marginal production cost c. The firms face an inverse linear demand p=a−∑j=12qj where qj is the output produced by firm j for all j=1,2. Firms strategically compete in terms of quantities. The production technologies in use^[7] may cause an environmental damage of λqj\ in the future with a positive ex ante strictly positive probability denoted by μj. Here λ>0 is the constant marginal damage per unit of output of a firm. I assume that μj is an independently and identically distributed random variable for all j=1,2 and it follows a uniform distribution U∼0,μ‾\ where μ‾∈(0,1]. I refer μj as the environmental risk of firm j in the rest of the paper. To begin with, firms do not know the actual value of their own risk; however, the probability distribution of the risk is common knowledge among firms.

Firms are subject to some liability rule; firm j will have to pay a compensation equal to tλqj, if the damage becomes observable in the future. Here t>0 is defined as the liability rate per unit of damage^[8]. Firms strategically decide to reduce the marginal damage at the rate αj>0. I assume that the total cost of such preventive action is αjqj22.

The timeline is as follows. First, nature independently draws the type μj (i.e., environmental risk) of the production technology of each firm from a common uniform distribution U∼0,μ‾\ where μ‾∈(0,1], and this is common knowledge.\ The realization of a firm’s type, denoted by μˆj,\ remains unknown to the firm as well as to the rival. In the next stage, each firm (strategically) invests resources to acquire scientific evidence to evaluate the actual environmental risk of its own existing production technology. In other words, firms strategically decide whether to invest a fixed amount F to find out the actual value of the risk of future environmental damage. If firm j invests then it finds out its actual environmental risk i.e., μˆj for sure. I consider two exogenously given information regimes; under mandatory disclosure (MD) firms reveal their own risks to each other, whereas such information remains privy to the firm under no disclosure (ND) . Under the latter information structure, I separately examine the case where the firms manage to observe each other’s investment decisions as well as the state where such decisions are not at all observable. Finally, the firms simultaneously choose their own output and degree of prevention per unit of output. I solve the three-stage full information (in Section 3) as well as incomplete information Bayesian game (in Section 4) by backward induction.

There are three possibilities after firms decide whether to invest, namely (1) both firms invest (II) , (2) only one firm invests (denoted by NI when the firm does not invest and by IN if the rival does not invest) and (3) no firm invests NN. I use superscript on variables to denote the disclosure regime and subscripts to specify one of the three possibilities after the investment stage. For example, πj,IIMD denotes the equilibrium profit of a firm j (after the second stage) when both firms invest (II) and reveal their environmental risks to each other under mandatory disclosure MD.

In this paper, the unilateral incentive UI to invest in risk evaluation is defined as the difference between ex ante expected profit of an investing firm\ when the rival does not invest and the expected profit of the firm when both firms do not invest whereas the reciprocal incentiveRI\ to invest is the ex ante expected profit of an investing firm when both firms invest minus the ex ante expected profit of a non-investing firm\ when the rival invests. If UI≥0\ then a firm has an incentive to invest in the research of its own environmental risk evaluation even if the rival does not invest; moreover if RI≥0 then a firm has reciprocal incentive to invest. In equilibrium, at least one firm invests if the unilateral incentive to invest is at least as high as the fixed cost UI≥F, and both firms invest when the reciprocal incentive to invest exceeds the fixed cost of investment RI≥F.

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 j for all j=1,2 reveals its own evaluated risk μˆj to the rival firm −j for all −j=1,2 where j≠−j. Firm j maximizes the profit

with respect to qj and αj for any possible realization of environmental risks μˆj,μˆ−j. The equilibrium output and prevention rate of an investing firm are given by

respectively. Since the firms are symmetric the rival (firm −j) has the same equilibrium output and rate of prevention. I get the equilibrium profit πj,IIMDμˆj,μˆ−j by substituting eq. (2) into eq. (1) . The ex ante (prior to a firm’s investment decision) expected profit of firm j is given by

Case (2): Suppose only one firm invests i.e., firm j invests but the rival −j\ does not. Firm j publicly discloses its environmental risk. Thus, firm −j knows the exact value of μj but it does not know its own actual risk μˆ−j. The investing firm j’s maximization problem is given by eq. (1), while non-investing firm −j solves

The equilibrium market outcomes are^[9]

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 j maximizes the profit

The equilibrium output and rate of prevention\ of a non-investing firm are

Since the firms are symmetric the rival (firm −j) has the same equilibrium output and rate of prevention. The ex ante expected profit is given by

The unilateralUI\ and reciprocal RI incentives of a firm to invest in the research under public disclosure are

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.

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 F=0. If the liability rate is sufficiently low i.e., t<tMD=3Fμ‾2λ29+18 for strictly positive fixed cost F≠0, then, in equilibrium, no firm invests, to find out the actual risk of a future environmental damage.

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.

5 Conclusion

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.