Financial Frictions and Policy Uncertainty Matter for Pollution Abatement Investment 

By | April 19, 2023

Due to market and regulatory failures, production activities often result in excessive pollution, which can cause damage to human health, property, and nature. According to the 2005 Survey of Pollution Abatement Costs and Expenditures, the US manufacturing sector invested $26.6 billion in pollution abatement activities. However, this amount is less than 1% of other investments, such as research and development (R&D) and physical capital. This suggests that corporate investment in pollution abatement may still be below the social optimum. This is particularly concerning, given recent estimates that pollution was responsible for 16% of all global deaths in 2015. 

Corporate investment in pollution abatement is subject to economic, regulatory, and other conditions. Such investment is vital for firms’ long-term survival, as such firms must mitigate potential penalties and reputation costs due to pollution (e.g., fines, legal liability, damage to brand image). However, firms may underinvest in pollution control because of financial constraints and cash flow volatility. Moreover, corporate decisions in pollution abatement are also subject to uncertainty in environmental regulation. In our recent paper, we examine how firms’ pollution abatement investment is affected by financial constraints and policy uncertainty. 

We begin by collecting data on US firms’ pollution abatement investments, financial conditions, policy uncertainty conditions, and production activities. Our key measure is each facility’s pollution prevention activities and its annual toxic emissions since 1991, which is calculated from the Environmental Protection Agency’s Toxic Release Inventory database. Using data from various sources, we show that when firms are financially more constrained, their facilities report fewer pollution prevention activities, particularly after a close gubernatorial election or an increase in uncertainty revealed in their earnings conference calls. These findings suggest that financial constraints hinder firms’ investment in pollution abatement, particularly under conditions of high policy uncertainty. We also find that facilities of financially constrained firms report a higher number of released toxic chemicals when policy uncertainty increases, and firms’ debt growth decreases with their financial constraints after considering both policy uncertainty measures. These findings suggest that it is the increased borrowing constraints resulting from policy uncertainty that cause firms to reduce their investment in pollution abatement and therefore increase their emission releases. 

To explain our empirical findings, we propose a model that demonstrates how financial constraints and policy uncertainty lead to underinvestment in pollution abatement. In our model, firms need to weigh the cost and benefit of pollution abatement investment. On the cost side, investment incurs a cost that increases with firms’ financial constraints and policy uncertainty. On the benefit side, the benefits from mitigating potential pollution penalties and reputation costs in the future decreases with firms’ financial constraints and political uncertainty. This trade-off explains our empirical results and has policy implications. 

We further develop a state-of-the-art quantitative macro-finance model to determine how changes in policy uncertainty could affect the aggregate impact of environmental regulation on abatement and pollution. The quantitative model indicates that a doubling of policy uncertainty regarding environmental regulation leads to a 6% decrease in aggregate abatement investment. Importantly, our calculations show that financially constrained firms are three times more susceptible to uncertainty shocks than their less constrained counterparts. These results underscore that financial constraints and policy uncertainty can hamper the effectiveness of environmental regulations.  


Min Fang is an Assistant Professor of Economics at the University of Florida Department of Economics. 

Po-Hsuan Hsu is a Tsing Hua Chair Professor and Yushan Fellow at the National Tsing Hua University College of Technology Management.   

Chi-Yang Tsou is an Assistant Professor of Accounting and Finance at the University of Manchester Alliance Manchester Business School.   

This post is adapted from their paper, “Pollution Abatement Investment under Financial Frictions and Policy Uncertainty” available on SSRN.   



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