In a new study, we examine whether climate-related uncertainty leads to increased managerial short-termism. “Climate-related uncertainty” refers to managers’ inability to predict the scale and costs of climate change on their firm’s operating environment. Managers, policy makers, and institutional investors have all expressed increased concern about climate-related uncertainty, especially uncertainty stemming from exposure to natural disasters and other weather events. Natural science researchers have examined climate-related factors in detail, and this stream of research has accelerated in recent years as climate change increases the frequency and intensity of costly weather events. While climate-related uncertainty is a focal point of natural science research, relatively little is known about the effects of this form of uncertainty on financial reporting and managerial decision-making.
Theory and Expectations
Given that weather events are one of the most direct and costly manifestations of climate change, we use firms’ exposure to weather events to capture increases in climate-related uncertainty. Our approach is also consistent with prior researchand anecdotal evidence suggesting that incidences of extreme weather significantly increase long-run uncertainty. When individuals are faced with heightened long-run uncertainty, they often doubt potential long-term gains and benefitsbecause of a perceived increased risk of the positive outcomes not occurring. Consequently, this often results in individuals resorting to short-termism to realize more immediate and certain short-term benefits. Accordingly, we expect that in the presence of greater climate-related uncertainty, managers will become more focused on short-term outcomes.
This expectation is consistent with recent commentary from corporate executives and prominent investors suggesting that managers may be pressured to respond to weather events by manipulating real activities (e.g., cutting discretionary spending on R&D or advertising). Jamie Dimon (Chairman and CEO of J.P. Morgan Chase) and Warren Buffett (Chairman and CEO of Berkshire Hathaway) state in a recent Wall Street Journal article that firms’ focus on the short term leads firms to “hold back on technology spending, hiring, and research and development to meet quarterly earnings forecasts that may be affected by factors outside the company’s control,” including the weather. In addition, responses from over 3,500 chief executives surveyed by PricewaterhouseCoopers (PwC) indicate that weather events introduce significant uncertainty to corporate operations, which likely affects managers’ decision-making. In summarizing the survey’s findings, PwC’s chairman Bob Moritz states that this type of uncertainty “can be an excuse to take essentially defensive actions that may make tactical sense but are strategically counterproductive,” such as “reducing investment in people, pulling back from new technologies, shying away from big challenges.”
Echoing a similar theme, Larry Fink (Chairman and CEO of Blackrock) notes in a recent letter to CEOs that “climate change has become a defining factor in companies’ long-term prospects” and that “we are on the edge of a fundamental reshaping of finance.” Fink goes on to discuss the risks posed by natural disasters, as well as the potentially value-destroying actions companies may take in response to these disasters. Fink encourages companies to respond to climate risk by taking a long-term approach and to avoid taking short-term focused actions that “damage shareholder value.” Collectively, this commentary further suggests increased managerial short-termism as a plausible consequence of extreme weather exposure given financial markets’ fixation on short-term earnings targets.
We use managers’ manipulation of real activities (i.e., real earnings management (REM)) to capture managerial short-termism. REM refers to the practice of deviating from the normal level of real activities to inflate short-term earnings, and REM includes activities such as cuts to discretionary expenditures, overproduction, and channel-stuffing (i.e., shipping excess inventory to downstream channels to artificially inflate short-term sales). In our analyses, we examine whether the incidence of extreme weather events leads to increased REM using two composite measures of REM formulated following prior work. Because REM is used by managers to meet short-term earnings benchmarks in a way that is often detrimental for firms in the long run, these strategies are often characterized as managerial short-termism. Thus, consistent with the theory outlined above, we expect that managers increase their use of REM to meet short-term earnings expectations in the presence of greater exposure to extreme weather events.
Our measurement of a firm’s exposure to weather events relies on a comprehensive database from the National Oceanic and Atmospheric Administration (NOAA) that catalogues the timing and location of these events (e.g., floods, hurricanes, tornadoes, wildfires) occurring in the U.S. over the past two decades. These events have accelerated in frequency and magnitude in recent years, likely due to changes in climate patterns. Because the timing and impact of natural disasters are difficult to predict for managers, these events provide a strong setting to examine unexpected changes in climate-related uncertainty.
Using a broad panel dataset, we document a strong positive relation between exposure to extreme weather and REM after controlling for firms’ information environments, earnings management incentives, financial performance, and other firm-specific factors. In economic terms, our results suggest that a one standard deviation increase in exposure to extreme weather corresponds to an increase in REM of approximately $4.3 million to $5.0 million (based on the median firm’s total assets). This finding is consistent with managers responding to heightened climate-related uncertainty by increasing short-termism.
We perform several additional analyses to provide further insights into our results. First, we find that the relation between extreme weather events and REM varies predictably with several cross-sectional factors. We find that our results are stronger when firms are more susceptible to climate-related uncertainty and when managers have more incentives to manage earnings, but the impact of climate-related uncertainty on short-termism weakens as firms’ external monitoring increases (i.e., as institutional ownership and analyst coverage increase). Second, we examine whether greater extreme weather exposure leads to an increased likelihood of a firm “just meeting” earnings benchmarks and find that the likelihood of just meeting benchmarks is significantly higher for firms exposed to more weather events. This result supports our primary assertion that managers increase REM in response to extreme weather to meet short-term market expectations.
We conclude our analyses by investigating a potential long-term real effect of climate-related uncertainty. Our prior results suggest that natural disasters lead to managers making significant discretionary cuts to R&D spending and corroborate the concerns of prominent investors and other stakeholders related to the long-term consequences of managerial short-termism. Given these results, along with evidence from prior work suggesting that R&D cuts harm firm innovation, we examine whether greater extreme weather exposure results in reductions to firms’ innovation outputs. We find consistent evidence that innovation outputs decrease as firms are exposed to more weather events, and we document that the economic cost of this innovation decline is substantial.
Implications of Our Study
This study contributes to the literature examining the consequences of climate-related uncertainty by providing new evidence on the impact of extreme weather events on managerial short-termism and firm innovation. Our study complements prior studies on the effects of weather on financial analysts and investors by documenting the relation between extreme weather exposure and managers’ financial reporting-related decisions. Given that extreme weather events are one of the most direct and costly manifestations of climate change, our findings also contribute to the growing literature on the financial reporting consequences of climate change. Our findings suggest that climate-related shocks significantly influence firms’ accounting and resource-allocation decisions. The collective evidence we present in the paper is timely since these impacts are likely to grow in severity as the incidence of extreme weather events continues to rise.
This study also contributes to the broader literature on managerial short-termism. Our findings suggest that managers increase their use of REM in the face of extreme weather and provide empirical evidence consistent with the aforementioned concerns regarding the potential influence of weather events on short-termism. As such, our study should be of interest to a wide range of stakeholders, including investors (who ultimately bear the long-term costs of managers’ short-termism) and regulators charged with protecting investors and adapting to the new risks presented by climate change. Relatedly, we answer recent calls for more research to inform investors and boards on the risks of extreme weather to firm operations and financial reporting. Finally, our study provides new evidence on the determinants of REM, a managerial strategy that has become significantly more prevalent in recent years.
James (Justin) Blann is a Postdoctoral Research Scholar at the W. P. Carey School of Business at Arizona State University.
Tyler J. Kleppe is an Assistant Professor at the Gatton College of Business and Economics at the University of Kentucky.
This post is adapted from their paper, “Climate-Related Uncertainty and Managerial Short-Termism,” available on SSRN.