Is the Financial Market a Mechanism for Environmental Overcompliance?

Climate change legislation is financially and politically costly. Financial markets have the capacity to encourage companies to do more than what is required by law (i.e. overcomply), and this could lead to socially optimal outcomes without the costs. First, I examine how the responses of Canadian companies to a voluntary survey regarding carbon emission levels affect those companies' valuations. I employ a signaling framework where companies choose between two signals - disclosure and nondisclosure - and where investors are uncertain about the likelihood of legislation in addition to company type. I test the prediction of the model that disclosure increases company value only when investors believe legislation is likely. I find that withholding emissions information resulted in average daily abnormal returns of 3 basis points, and that disclosure resulted in average daily abnormal returns of -11 basis points in the days surrounding the submission of survey responses. The level of emissions disclosed is found to be irrelevant. Second, I examine the credibility of green legislative threat. The economic climate impacts the government's ability to credibly threaten new environmental law, and so I model a company's pollution decision as a function of the economic climate. In times of recession, companies may choose to pollute heavily since they believe that the likelihood of legislation is low. As a first step in evaluating the model empirically, I use differences-in-differences regressions to estimate the effect of legislative threat during recession on company value. Although the value of carbon-intensive companies decreased initially in reaction to legislative threat, the relative value of these companies increased as the depth of the recession becomes more apparent. I find that on average the legislative threat of an emission trading scheme reduced Tobin's Q by 18% in the initial stages of the recession, but as the recession deepened the legislative threat effect was eliminated. My results suggest that financial markets combined with a credible threat of legislation could provide encouragement to companies to overcomply with current regulations, possibly to the extent that is socially optimal. More research on factors affecting company carbon emissions levels and intensity is required.Ph