Breaking Environmental Regulations Hurts Company Stock Price

Regulations cause polluting companies to lose investors, new research shows.

Simon Xu is a PhD candidate in Finance at the Haas School of Business, University of California, Berkeley. He won the 2022 Ivey-ARCS PhD Academy Best Paper Award for this research.

It’s no secret that hefty fines motivate companies to change their behaviour. That’s why government often mandates penalties when companies break the rules, in areas from health and safety to air pollution. 

But regulations have a power beyond their immediate financial impact. My recent research shows that lack of compliance with environmental regulations also causes polluting firms to lose investors.

That means that polluting companies actually pay a double cost in the face of regulation. They foot the bill for direct regulatory costs, even as their investors also drop them.

I’ve focused my PhD on understanding how environmental regulation impacts investor behaviour and the implications for climate change. In this article, I describe what I learned about how investors react to regulation and what that means for companies, regulators, and investors.

Investors Sell Stock When Polluting Companies Are Penalized

My research studied a core American environmental regulation, the National Ambient Air Quality Standards (NAAQS). NAAQS set ozone pollution standards for geographical regions within the US.  If ozone exceeds NAAQS limits, ozone-emitting facilities in that region face regulatory penalties. The costs include mandatory investments in pollution abatement technology, operating permit purchases, and fines. 

I studied how investors responded to revisions of NAAQS over the years. Each revision made NAAQs tougher and put more companies out of compliance. How did investors react when a new revision meant companies they held stock in would now be out of compliance? 

Institutional investors, such as mutual funds, often have research teams that track the pollution activities of the companies they invest in. When environmental regulations, such as the NAAQS, come into effect, investors know it means their companies will take a hit – so, they divest! 

This sell off can be big! For example, if all of a company’s plants emit ozone and suddenly become regulated at the same time, the average mutual fund will sell off 9.8% of their stock in that company. Smaller or more concentrated funds may sell off even more. 

Certain characteristics of the company can also lead to higher selloff rates, such as whether the company’s plants are located in close proximity to air pollution monitors.

For Investors, Selling Makes Financial Sense

When I saw these results, I wondered if the selloff was coming primarily from ESG investors (investors who care about the environmental, social, and governance performance of the firms they hold.) Maybe once they realized a company was polluting, they deemed it misaligned with their environmental values.

But that wasn’t the case. I found no difference in divestment behaviour between ESG mutual funds and more traditional funds. Traditional investors were just as eager to sell off polluters. That’s because selling polluting companies in response to stronger environmental regulations is a smart financial and strategic decision.

Look at the Sharpe Ratio, which measures a fund’s earnings relative to its risk. It’s the most commonly used statistic to describe the performance of mutual fund managers. When a mutual fund sells the companies most affected by environmental regulation, the fund’s Sharpe Ratio goes up by 21% over the following two years. In other words, funds that sell off polluters make more money.

Investors Shouldn’t Hesitate to Sell Polluting Firms

These findings are important for investors. It means fund managers should know about the polluting activities of companies they invest in. That includes breaking down activities by region, in case new regulations impact facilities different regions in different ways. 

Then, let that information guide profitable decisions – like divesting from polluting firms before the regulation costs the firm money. 

The Hartford Climate Opportunities Fund offers an example of actively managing portfolios to address climate change risk. Much of the fund’s assets are invested in low-carbon companies — addressing climate-related risks that may arise in the future.

Regulators Should Embrace Financial Penalties

There are important lessons for regulators, too. Firstly, the research re-affirms that costly regulation is a great tool to change corporate behaviour. Don’t shy away from using it! 

My research findings should generalize to other contexts and types of regulations as well. Fundamentally, violating regulations increases a business’ operating risk – which investors and companies want to avoid.

Here are some more lessons for regulatory design:

For regulations to be effective, they must also be enforceable. If a company knows they won’t actually get dinged, they are less likely to change. And if investors know regulation won’t be enforced, they’re less likely to penalize violators. 

To improve enforceability, ‘easy to understand’ is key. It should be easy for companies to understand how the regulation works. It should also be easy for inspectors to identify violations. Additionally, elected officials need to publicly back the regulations, in order for inspectors to have the legitimacy required for enforcement.

Green Funds Can Support Companies

The lesson for companies can seem clear – stop polluting! But that’s not necessarily easy. The transition to greener operations requires capital investments in new technology, facilities, and employee training. 

Regulators can help ease the transition by creating “green funds.” These can be loans or grants that help companies make the change. After all, if government regulations cause investors to pull their money out of polluting firms, it may be even harder for those firms to make the necessary investments.

Here’s an example: The US Inflation Reduction Act (IRA) provides $27 billion for creating “green banks” nationwide. These banks will provide low-interest loans to corporations and non-profits for technology investments that reduce greenhouse gas emissions.  

Government, Investors, and Companies Make a Difference

These findings show that regulation with enforceable financial penalties may be an even more effective tool than previously thought. That’s exciting to me, as climate change is one of the most pressing issues of our time and we need effective tools to drive meaningful emission reduction. As I continue my career, I plan to continue researching key economic questions to help combat climate change.

About the Author:

I am currently a Finance PhD candidate at the Haas School of Business, UC Berkeley. I will be joining the Climate and Sustainability Impact Lab at the Harvard Business School as a postdoctoral fellow in the Fall of 2023. My research interests include sustainable finance and corporate social responsibility, with links to financial intermediation, corporate finance, and banking. My work focuses on the interplay between environmental regulations and firm pollution, and their impact on mutual funds’ portfolio choices, shareholder wealth, and corporate philanthropy. You can contact me at simon_xu@haas.berkeley.edu.