Environmental & Resource Economics (2006) 33: 425–439 DOI 10.1007/s10640-005-4992-z
Springer 2006
Voluntary Environmental Investment and Responsive Regulation JOHN W. MAXWELL1,* and CHRISTOPHER S. DECKER2 1
Kelley School of Business Indiana University, 1309 E. 10th St, Bloomington, IN, 47405, USA; Department of Economics, University of Nebraska at Omaha, Omaha, NE, USA; *Author for correspondence (e-mail:
[email protected]) 2
Accepted 20 October 2005 Abstract. Instances of corporate voluntary environmental investments have been rising in recent years. Motivations for such activities include corporate image building, regulatory preemption, and production cost savings. While some of these investments arise from industry attempts to set environmental standards where none currently exist, many investments seem to be aimed at reducing the costs of complying with existing regulations. Using a simple gametheoretic model, we investigate firm motivations for, and welfare consequences of, these types of voluntary investments by focusing on the role regulatory enforcement might play. We find that such investments unambiguously increase when an enforcement regulator acts as a Stackelberg follower (a regulatory structure we refer to as responsive regulation) in setting its monitoring and enforcement strategy. These additional investments may be socially undesirable, necessitating a restructuring of non-compliance penalties.
1. Introduction There is a growing academic literature discussing voluntary investments by corporations aimed at improving environmental performance.1 The explanations for these voluntary actions include green consumerism, regulatory preemption by industry, and the so called ‘‘win–win’’ hypothesis of environmental investment.2 While these explanations have merit, each is aimed at explaining environmental investments that are independent of existing regulations. However, many environmental programs focus on providing incentives for firms to voluntarily increase compliance activities with respect to existing environmental regulations.3 In this paper, we investigate the phenomenon of voluntary environmental investments (such as investments in self-audit programs or direct investments in cleaner technologies) by focusing on the behavior of the regulator as an enforcer of existing environmental regulations. In our model, regulatory actions prompt the firm to raise its level of environmental investment voluntarily. Specifically, the regulator offers to respond to these investments by reducing the frequency with which it
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monitors the firm. The firm is motivated to take action because the regulator’s response will lead to a reduction in the firm’s expected fine. While the firm is motivated by the reduction in its expected fine, we show that the firm’s action works to raise its compliance probability. This makes it optimal for the regulator to lower its monitoring frequency, which in turn makes its offer credible. Our model is driven by two key assumptions. First, the regulator’s offer induces the firm to make a sunk investment and, second, that these investments lower the firm’s marginal compliance cost, committing the firm to raise it compliance probability. These two assumptions arise from an examination of a number of recent U.S. EPA voluntary programs, and changes to its auditing practices. For example, under the EPA’s StarTrack program, participating firms are rewarded with being considered ‘‘a lower inspection priority’’ if they establish a self-auditing compliance program, conduct periodic audits, institute plans, and submit progress reports to the EPA and the public.4 The StarTrack program is very much in the spirit of the EPA’s recent changes in its audit practices contained in the publication Audit Policy: Incentives for Self Policing (EPA 1998a). According to this document the changes include encouraging regulated entities to seek monitoring and enforcement relief by voluntarily discovering, disclosing, and correcting violations of existing environmental statutes by investing either in the establishment of self-auditing procedures, or in some cases by investing in new equipment. There is little doubt that a great proportion of these investments are sunk in the sense that documentation of the investments must be made by program participants prior to the granting of any regulatory relief.5 Do these investments commit firms to higher levels of compliance? Firms could install equipment, but fail to operate it. They could also establish self-audit procedures, but fail to follow them. However, the fact that the EPA grants enforcement relief to its voluntary program participants illustrates that it believes that the associated sunk environmental investments do indeed raise compliance rates. Participant reaction to the program is suggestive of the fact that participation does raise compliance. For example, according to a environmental engineering manager at Spalding Sports Corporation, a StarTrack participant, the program provided an opportunity for the company to further develop the system requirements necessary for continuous environmental performance improvement.6 Our model is most closely related to the literature on regulatory responses to environmental capital investments. Stranlund (1997) examines how offering technological aid to encourage installation of superior pollution control equipment reduces enforcement costs. Most EPA voluntary programs, however, offer little in the way of concrete aid. Moreover, in our
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model, we demonstrate that a credible commitment to reduce monitoring and enforcement can achieve this same effect without the need for a side-payment. Amacher and Malik (1996, 1998) examine cooperative bargaining between a firm and a regulator in which the firm agrees to adopt a cleaner technology in exchange for more lenient enforcement. They assume, though, that the regulator precommits to an audit probability. However, as the authors themselves state, it is unclear how this commitment is achieved. In our model the firm and regulator simultaneously and non-cooperatively determine their respective optimal compliance and monitoring decisions, so precommitment is not an issue. In this setting we show that the firm will raise its level of environmental investment when faced with the regulator’s offer, and following through on the offer is credible. The remainder of this paper proceeds as follows. In Section 2 we first provide an overview of the model, and discuss issues related to timing. We then present the model in detail. In Section 3 we examine the regulator’s offer of responsive regulation and examine social cost issues. In Section 4 we offer some concluding remarks and discuss avenues for future research.
2. The Model 2.1. OVERVIEW AND TIMING
We present a two-stage game consisting of two players: a risk neutral regulated firm, motivated to minimize its expected compliance costs, and a risk neutral regulator, motivated to minimize environmental damage. The firm has two choice variables. The first is a level of environmental investment, z 2 [0, 1), that reduces compliance effort costs (e.g., investment in a new technology or the creation of an environmental audit department). The second is an investment in compliance effort that captures labor resources devoted to conducting an internal compliance audit, or making sure that abatement technologies are kept in working order, and is reflected through a choice of compliance probability, p 2 [0, 1]. The crucial difference between the firm’s two choice variables is as follows. The environmental investment is assumed to be fixed and observable prior to the regulator’s choice of monitoring resources, while the compliance probability is not observable prior to the regulator’s decision. We examine two different policy regimes. In the first, the firm minimizes its compliance costs by choosing its compliance effort and an observable environmental investment. At the same time, the regulator chooses its optimal level of monitoring and enforcement effort, reflected through a choice of monitoring and enforcement probability, m 2 [0, 1]. Thus, the regulator does not, by construction, subsequently respond to the firm’s investment decision. We characterize this regulation as unresponsive. The second regime, which we
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characterize as responsive, is modeled as a two-stage game. In Stage I, the firm determines an optimal level of environmental investment taking into consideration the regulator’s optimal Stage II response. In Stage II, the regulator establishes its monitoring and enforcement effort, taking into account the firm’s Stage I choice, and the firm determines its optimal compliance effort. Since the primary motivation for the firm to undertake voluntary investments is the offer of responsive regulation, it is worth noting that we do not explicitly model the regulator’s decision to adopt such regulation. As we shall see, in our model the regulator benefits from offering a responsive enforcement policy. To be sure, the regulator may incur some costs to make such responsiveness credible (e.g., establishing and promoting such a program). If these costs exceeded the expected benefits (e.g., higher firm compliance and lower environmental damage), then a responsive policy would not be offered. 2.2. MODEL DETAILS
2.2.1. The Firm’s Objective As stated, our regulated firm minimizes expected environmental compliance costs by choosing p and z: min EðCfirm Þ ¼ ð1 pÞmf þ wðp; zÞ þ z: p;z
ð1Þ
These costs are simply the sum of the expected fine, the costs of compliance effort, and the cost of the environmental investment. The fine, f=F+c, embodies both a pure monetary component, F (assumed to be set exogenously by the legislative or judicial branches of government) as well as cleanup costs, c. Indeed, many penalties require that, in addition to monetary fines, violating firms pay for remediation and restoration which can be quite costly (see, e.g., EPA 1998b) .7 The firm’s compliance cost function, w(p, z), is assumed to be twice differentiable with: wp> 0, wpp>0, wz 0, wpz
