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Market response to expected regulatory costs related to haze

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Abstract

One of the consequences of rapid industrialization and urbanization of China has been a significant increase in air pollution, frequently at levels that are hazardous to health. On 2 December 2013, pollution reached new levels, with the air quality index crossing the threshold from “very unhealthy” into “hazardous”. We take this exogenous event, along with related increases in outrage and governmental attention, as an opportunity to explore market valuation of expected regulatory costs. Contrary to research indicating government protection of state-owned enterprises (SOEs) (e.g., Berkman et al., 2010), we find evidence supporting market expectations of larger haze-related regulatory costs for SOEs versus non-state-owned enterprises (NSOEs). We also find evidence that the market initially expected firms that provide corporate social responsibility (CSR) reports and firms in high polluting industries would be relatively shielded from higher regulatory costs. However, this changed following increased outrage and government attention to haze, with resulting larger expected regulatory costs. Our evidence is also consistent with initial market expectation that firms located closer to Beijing would be shielded, but this expectation changed over time. Overall, expected regulatory costs appear to have increased over time, reducing the market valuation of SOEs, CSR reporters, and firms in polluting industries over the longer term. Increased occurrence of haze events in other countries (e.g., more recent events in India, Indonesia) will likely result in similar expected increases in regulatory costs. Further, our study underscores the existence of material impacts on firms related to environmental events that are beyond firms’ control.

Introduction

Over the past few decades, the rapid industrialization and urbanization of China has occurred at the expense of environmental protection. Air pollution levels and haze have increased, particularly in China’s largest cities (Chang et al., 2009). On December 2, 2013, pollution reached new levels, with the air quality index crossing the threshold from “very unhealthy” into “hazardous” with an air quality index (AQI) of 317 (Zhang, 2013).1 As air quality deteriorated further over the next few days, some of the worst polluting factories in Shanghai were told to limit or stop production. Building and road construction were halted, flights were cancelled, and nearly a third of government cars were forbidden to operate (Chen, 2013). The haze event impacted cities in several Eastern provinces and drew both national and international attention. A few days after the event, the number of times that the word “haze” appeared in the Chinese press skyrocketed to over 30,000 per day, indicating increased sensitivity to the issue. In addition, local governments started discussing the haze issue during their annual provincial political conferences, which took place shortly after the event; for the first time, haze had a prominent place on the agenda for 29 of the 31 annual provincial conferences in China.

Unlike environmental disasters typically examined in the accounting literature (e.g., Blacconiere and Patten, 1994, Bowen et al., 1983), this series of “haze events” was not initiated by the actions of a specific firm. There was no specific physical damage to any facilities, nor was the event caused by illegal activities or carelessness. Instead, the event was due to an unexpected confluence of weather patterns and ongoing industrial and commercial activities.

Other than the immediate impact of the temporary stoppage of industrial activities, the primary effect on firms should be in the form of future regulation to reduce pollution. Haze in China is arguably driven by the government’s economic policies, which have neglected environmental protection in favor of economic growth (Wong, 2011). However, with an increasing number of haze events and growing sensitivity to environmental issues worldwide, there is increasing domestic and international pressure on the Chinese government to implement stronger environmental regulation, necessarily imposing regulatory costs on firms. Because the haze event we study was the first such event in China and thus was unanticipated, it provides an interesting setting in which to examine market perceptions of expected regulatory costs.2

In alignment with our argument that the primary impact of haze on firm value will be related to the market’s perception of future regulatory costs, we further argue that expected regulatory costs should vary according to firm characteristics, including industry, state ownership, corporate social responsibility (CSR) disclosure, and firms’ geographic proximity to Beijing. Firms in more polluting industries arguably have played a larger role in producing the pollution that relates to haze, so regulation can have a more significant impact on future levels of pollution. Firms that have higher CSR disclosure may be viewed as better “citizens” and thus, shielded from regulation. Firms that are closer in proximity to the central government in Beijing are more likely to be of concern to regulators (both from the perspective of regulator familiarity with the firm and the local impact of pollution stemming from firm operations). However, given that the Chinese government has historically prioritized industrial activities over environmental and health concerns, the nature and extent of resulting regulatory costs for firms with these characteristics are uncertain. Thus it is an empirical question how the market views the probability and magnitude of expected regulatory costs resulting from haze-related events.

We investigate market returns surrounding three periods related to this dramatic environmental event: (1) the first time that the haze was stated to have exceeded the “hazardous” threshold; (2) a subsequent period of intense discussion in the Chinese media about haze; and (3) a period encompassing increased government discussions of haze issues during the provincial conferences that occurred soon after the initial haze event. Our cross-sectional tests investigate whether the level of government scrutiny impacts market expectations of regulatory costs. While we find an overall negative market reaction on the day of the initial haze event,3 companies in more heavily-polluting industries, non-state-owned enterprises (NSOEs), and companies issuing CSR reports experienced a relatively less negative reaction. As further events unfolded, however, we find evidence that these categories of firms experienced continuing negative cumulative abnormal returns (CARs). Market valuation tests indicate lower longer-term valuations for all of these categories of firms relative to the rest of the market. In addition, we find that firms located more closely to Beijing, and thus potentially facing different levels of government scrutiny, initially had negative CARs following the haze event. This disadvantage does not appear to have continued in the longer term.

This paper contributes to the literature in a number of ways. We explore market perceptions of regulatory costs in a unique setting, where expected regulatory costs result from an exogenous event, which is not triggered by any unique firm. This characteristic of the event provides us an opportunity to explore the implication of expected regulatory costs for a much broader cross-section of firms and underscore the existence of material impacts on firms related to environmental events that are beyond firms’ control.4 Further, because of the Chinese government’s approach to environmental issues, the nature and extent of regulatory costs are particularly uncertain. This allows us to explore how the market’s perception of expected regulatory costs changes over time. Our results also extend our understanding of how developing markets outside of the U.S. view CSR disclosures and environmental events, since China is frequently omitted from cross-country analyses (e.g., Dhaliwal et al., 2014) due to its many institutional differences from other countries.

Our investigation broadens our understanding of the relation between the Chinese government and state-owned enterprises (SOEs). Berkman et al. (2010) find that the Chinese government is viewed as being less likely to enforce regulation against SOEs. In our setting, we document opposite findings, that is, the market expects SOEs to suffer greater regulatory costs associated with haze. These results are not necessarily inconsistent with Berkman et al. (2010), who find lower expected enforcement for SOEs of regulation regarding related-party transactions. In their setting, regulation was not focused on an issue that directly affects public welfare, so the SOEs were viewed as the focal stakeholder. In our setting, however, the haze events attracted both national and international attention to a serious public health hazard, leading to demands on the government from a wide range of non-SOE stakeholders. Our results indicate that market perceptions of the government’s focal stakeholder in this case shifted away from the SOEs, with an expectation that SOEs would face higher future regulatory costs from additional environmental regulation. Our results provide evidence that the market’s perception of the government’s relationship with SOEs is perhaps more nuanced than has been discussed in prior literature.

Our study also contributes to the geographic proximity literature, which builds on the notion that geographic distance increases information search costs and as such, decreases the monitoring on firms (Coval and Moskowitz, 1999, Ivković and Weisbenner, 2005, Lerner, 1995, Loughran and Schultz, 2005). Our results indicate that firms located closely to Beijing, which hosts the regulatory power and political elites of China, exhibited a more negative share price reaction to the first haze-related event, although this disadvantage did not persist over time as events unfolded.

Section snippets

Haze in China

During December 2013, a severe haze shocked the Eastern part of China and attracted widespread attention from the public. The haze covered six provinces (i.e., Hebei, Shandong, Jiangsu, Anhui, Henan, and Zhejiang) and two municipalities (i.e., Shanghai and Tianjin), affecting a combined population of almost 500 million people (National Bureau of Statistics of China, 2014). During the event, not only were schools closed and people told to stay in their homes, but industrial and other activities

Polluting versus non-polluting firms

The most likely cost related to haze is due to increased regulation. On the haze event dates, there was no physical impact on any of the companies (e.g., no hurricane damage, spills to be cleaned up, etc.). Litigation risk should not become any higher because there was no specific act that led to the haze event that could be accredited to an individual company. Regulatory costs stemming from the haze event could be either direct (e.g., the cost of additional resources necessary to comply with

Haze event timing

We examine stock market cumulative abnormal returns (CARs) for three event windows relating to the December 2, 2013 haze event. We designate the window length as [t1,t2], where t1 indicates the start of the event window and t2 indicates the end of the event window. The ti are stated relative to the beginning of the haze event (t = 0), which occurred on December 2, 2013. Fig. 3 provides a timeline for the event windows. On December 2, the AQI climbed over 100 points from the prior day as air

Descriptive statistics

Table 2 reports descriptive statistics of main variables. Panel A presents data about the distribution of our variables of interest and control variables. Panel B presents bivariate correlations among the variables. Regardless which method to calculate CARs, the mean and median values of CAR in [0, 0] and [0, 1] are negative, indicating that overall, investors reacted negatively to the haze event. Although a portion of the negative reaction may be due to shutdown of operations for some firms in

Conclusion

The sudden increase in particulate pollution on December 2, 2013 caught China and the rest of the world by surprise. While the East coast of China had experienced haze in the past, pollution levels had never been as extreme. During the worst of the pollution, schools were closed and many commercial activities were curtailed. Over the next few weeks, media attention increased dramatically, and regional and municipal governments began to include environmental issues in their political agendas.

Acknowledgments

The authors thank Wen He, Xue Jia, Lu Yang, and conference participants at the 2016 JAPP Conference held at the IE Business School and AFAANZ 2016 for helpful comments. Luo acknowledges financial support from the National Natural Science Foundation of China (Grant no. 71572160).

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