Green Screening: Environmental Strategy and Firm Carbon Emissions Amid Regulatory Uncertainty in the European Union

Abstract

Firms face considerable uncertainty in their regulatory environment, including uncertainty regarding whether and how newly passed policies will be implemented, especially in federated government structures. Although firms can wait until the uncertainty is resolved, they will also lose a first-mover advantage if the new policies are strictly enforced while they wait. To address this tradeoff, we propose that amidst policy implementation uncertainty, firms can screen communication between government agencies and their political principals. Such communication signals the agencies’ commitment to their political principals’ policy goals and can be screened by firms for the agency’s intent to implement the new policy. The more costly the communication, the more strongly the firm will believe in the agencies’ commitment to strict implementation of the new policy and the more likely the firm will react, such as investing in new technologies, in compliance with the new policy’s goals, even before the new policy is implemented. In addition, the firm will react even more aggressively when it has greater financial resources, but less aggressively when there is a higher divergence in agency communications across countries where the firm operates. We test these hypotheses using information about electric power generations’ changes in carbon intensity and types of investments in new technologies from 2004 to 2009 in response to the European Union’s resolution for carbon emissions reduction through a greenhouse gas emissions trading scheme, a flexible market-based regulation that allows for alternative compliance approaches.

Keywords: Regulation, uncertainty, signaling, screening, sustainability, climate change

JEL Classification: M10