Signaling Social Responsibility: On the Law and Economics of Market Incentives for Corporate Environmental Performance
Jason Scott Johnston
University of Virginia - School of Law; PERC - Property and Environment Research Center
May 11, 2005
U of Penn, Inst for Law & Econ Research Paper 05-16
This article analyzes the law and economics of market internalization: the capability of markets to both penalize and reward firms for their environmental, health and safety performance.
As for market sticks, the article maintains that market transactions - both private and public sales of corporate assets as well as transactions in publicly traded securities - are an important avenue through which firms realize comparative advantages in regulatory compliance, and that such transactions have the potential to significantly enhance corporate environmental and social performance. Asset transactions tend to drive environmental cleanup and transfer assets to firms that are better able to know about and comply with relevant regulatory directives. On public securities markets, the very fact that traders are imperfectly informed about firm-specific regulatory risk causes disproportionately large market reaction to the revelation of such risks. The incentive to avoid such large, negative market reactions to the revelation of negative information leads may induce a higher level of compliance than were no such market reaction anticipated. Incentives for voluntary disclosure of negative information are complex, but as is true of financial disclosure, mandatory disclosure requirements may be crucial in allowing firms to make such credible commitments.
As for the potential positive rewards (in the form of price premia) that SR consumers and investor offer to firms that they perceive to be pursuing CSR, the fundamental problem is that CSR cannot be directly observed by consumers and investors. Unless firms can find a credible signal of CSR, the positive potential of the market may go unrealized. Inevitably, much corporate communication regarding CSR is (from a game-theoretic point of view) cheap talk. There is likely to an uninformative, pooling equilibrium in which only firms in industries with well-recognized, large SR impacts are likely to engage in CSR cheap talk, so that such reports do not generate information on the relative economic and social performance of firms within the category of firms that report.
The article's policy conclusions include the following:
- The SEC's standard requiring the disclosure only of those environmental regulatory costs and liabilities that are "probable" and "reasonably estimable" is sensible as tracking the market's limitations in coping with risk versus uncertainty, but the SEC's almost complete failure to enforce its rules regarding the disclosure of environmental risks has made it impossible for corporate managers to credibly commit to being one of the "good guys" by voluntarily disclosing such bad news.
- As for the potential for legal liability for false assertions of CSR to deter "bad" companies from pretending to be "good" ones via their CSR communications (thus destroying the uninformative (or babbling) market equilibrium, the optimal liability system involves potential liability (because it gives plaintiffs access to civil discovery that allows for the discovery of information regarding corporate labor and environmental practices that otherwise would be asymmetrically available only to the corporate speaker), but liability that is strictly limited in amount. The market alternative of private, third party certification of CSR disclosures and assertions - a market response to SR consumers' and investors' demand for credible, reliable firm-specific information - is effective only if itself credible. While market reputation clearly helps ensure the truthfulness and credibility of private auditors' CSR reports, the risk of collusion between audited companies and their auditors is just as great when it comes to CSR as it is in the traditional area of financial report auditing. Just as with financial reports, the threat of holding auditors legally liable for intentionally or negligently false CSR audit reports may be necessary for private CSR auditing to generate credible information.
Number of Pages in PDF File: 127
Keywords: Environmental Regulation; Market Incentives; Environmental Performance; Corporate Social Responsbility; Transactions; Environmental Disclosure; Environmental Liability; Cheap Talk Games;
JEL Classification: D62, D82, G18, H41, K22, K23, K32, L21, L51
Date posted: May 17, 2005