What does it take for a polluting firm to take responsibility for its role in, say, increasing local particulate matter or sulfur dioxide emissions, and invest in pollution abatement programs?
Altruism or pangs of guilt may help, but they are not reliable indicators of how the firm might take steps to remedy the pollution. In fact, much of what leads a firm to “internalize its externalities” in pollution depends on its ownership distribution among small and large shareholders, according to a recent paper titled “Firm Ownership and Pollution” by Wharton professor of business economics and public policy Arthur van Benthem and his co-authors Tsz Chun Kwok and Daniel Spiro from Sweden’s Uppsala University.
Using a theoretical micro foundation, van Benthem and his colleagues contend that small shareholders, compared to larger ones, would want the firm to spend more on avoiding pollution because they suffer less in terms of loss in profit for the same environmental benefit that they all more or less equally enjoy as citizens. Their financial loss, in terms of lower dividends or share price, is however directly tied to how many shares they own.
The pollution abatement policies of that firm will be driven by the “weighted-median shareholder,” or one in the middle of the shareholding distribution from the lowest to the highest. “If this shareholder is small — for example, if a firm has many owners — then pollution will be lower,” the paper stated. In particular, the small shareholder’s preferences align with those of a social planner who would design policies to curb pollution, it added.
On the flip side of that theory, firms with more concentrated ownership pollute more. Larger shareholders have less incentive than small shareholders to goad their firm to invest in pollution abatement policies because they pay a larger share of the abatement cost for the same benefits. “Everyone receives the same personal benefit from, say, healthier kids and cleaner air, and it doesn’t matter much whether you’re rich or poor,” van Benthem said.
Uneven Gains From Pollution Abatement
The model in the paper assumes a disconnect between pollution abatement investments and how the benefits accrue to small and large shareholders. “If we assume green investments are value-adding to the firm in the long term, then there’s no tradeoff, and everyone should vote yes on every green proposal,” van Benthem said. “But what we’re talking about here implicitly is that a firm wouldn’t make those investments — at least in the short run — because there’s some opportunity cost of doing that.”
Van Benthem explained how that would play out with an illustration: “Let’s say the median shareholder owns 20% of a firm — it’s a pretty big shareholder. That means the firm will not internalize much pollution, because the median shareholder is massive and will pay a lot to implement green projects, but only gets the same environmental benefit as everyone else.”
“Ownership concentration leads to more emissions,” the paper declared. Such concentration could occur in closely held firms that a few shareholders own and control, or in firms with widely distributed ownership where large investors own most of the shareholding.
“At the core of the environmental issue is [the reality] that firms aren’t owned by millions of tiny shareholders,” van Benthem said. “Many firms are owned by a few people that have enormous amounts of money to lose when they would be forced to invest in, say, projects with negative net present value, even though society as a whole might gain quite a bit from the environmental benefits.” He noted that many firms in the U.S. have large shareholders. “They get some small environmental benefit for whatever the firm does in terms of pollution abatement, but they stand to lose enormous amounts of money because they are the ones bearing a sizeable percentage of the cost.”
At a country level, those with concentrated corporate wealth holdings and/or more individualized firm ownership will pollute more, the paper pointed out. Put another way, “inequality degrades the environment,” according to the paper. In fact, pollution is high even with complete wealth equality, if each individual firm is owned by a few people or a single person. The implication is that in a setting where a firm’s shares are held in equal shares by the entire population, the firm would invest in pollution abatement policies, much like what social planners would do. This, of course, is far from reality.
“Everyone receives the same personal benefit from, say, healthier kids and cleaner air, and it doesn’t matter much whether you’re rich or poor.”— Arthur van Benthem
Takeaways for Investors, Policy Planners, and Regulators
Van Benthem set his paper’s relevance against the backdrop of the “backtracking on regulation” that is occurring in many countries, including the U.S. “I’m a big believer in regulation being much more effective than voluntary shareholder action,” he said. “But when it is being rolled back, it becomes important to think strategically about how to involve these masses of small shareholders that might in fact want to vote green, but face cognitive and time costs of doing so.
One takeaway from the paper for activist investors who want to push for green investments is “to mobilize a large mass of very small shareholders instead of only targeting big owners,” said van Benthem. Yet, that isn’t an easy option because in reality, just about 30% of small retail shareholders actually take the effort to vote on their firms’ resolutions, he added.
But innovation has started to find a way out of that situation: van Benthem pointed to a firm called Broadridge that makes voting a lot easier for retail shareholders who sign up with it. Another workable alternative is to apply pressure on pension funds, which typically have large holdings in firms that represent small shareholders, he suggested.
When Pollution Is an Export Commodity
The cost-benefit equation gets misaligned when a firm’s shareholders live in a separate society altogether. That happens when firms in developed countries with tight regulation direct their polluting operations to another country, as this New York Post story on petroleum coke explained. “In such cases, the shareholders receive zero environmental benefit from the cleanup. So, they have the worst incentives ever to vote for green proposals,” van Benthem said.
The paper also noted that firms engaged in FDI (foreign direct investment) will internalize their pollution externalities less than others. “This relates to the pollution haven effect, which is the hypothesis that countries with lax environmental policies will attract dirty industries,” it noted, citing research by others on that topic.
“A firm wouldn’t make those investments [in pollution abatement] — at least in the short run — because there’s some opportunity cost of doing that.”— Arthur van Benthem
Broader Relevance of the Paper
According to the authors, their model and findings could be applied to any setting where a firm’s behavior leads to positive or negative externalities — and not just pollution. This includes, for instance, investment in R&D and social responsibility, they noted. The model applies more to local air and water pollution than to climate change, the paper pointed out. “For carbon dioxide, the benefits accrue to the world population, and individual shareholders only enjoy a minimal fraction of those,” it explained. Therefore, even firms with many small shareholders may not have strong incentives to internalize the climate externality.
According to the paper, its theoretical model offers a new way to think about the link between corporate governance and environmental impact. It is especially significant in an environment where more and more investors include environmental and social factors in their investment decisions and convey their preferences through their shareholder votes.
In recent years, more and more small shareholders have put pressure on firms to become greener, the paper noted. Small activist groups such as Follow This have introduced several green shareholder resolutions at companies including ExxonMobil, Royal Dutch Shell, and Occidental Petroleum, the authors added.
