Yale SOM’s Frank Zhang and Jacob Thomas suspected that firms might increase their pollution when they’re struggling to meet earnings targets—and in new research, they and their co-authors found that indeed they do. What surprised them was who was most likely to engage in this pattern: the firms with a history of environmental responsibility.
The short-term pressure on companies to hit quarterly and annual earnings targets can drive their leaders to acts of desperate accounting. It’s called real earnings management, or REM—companies might cut prices to increase sales, slash advertising or research and development budgets, or attempt various other financial maneuvers in an effort to meet or beat their targets.
The factors fueling this desperation are no mystery. Companies receive swift and harsh market punishment when they report a miss. In April, Amazon announced a first-quarter revenue figure that narrowly missed consensus analyst estimates, and its stock price promptly dropped by 10%.
A growing body of research suggests this short-term-fixated accounting can be harmful for firm stakeholders, like investors and employees. Frank Zhang, a professor of accounting at Yale SOM, and Jacob Thomas, the Williams Brothers Professor of Accounting and Finance, suspected that the detrimental impacts of real earnings management might extend all the way into the physical environment.
In a new paper, Zhang, Thomas, and their co-authors—Wentao Yao of Xiamen University and Wei Zhu of the University of Illinois Urbana-Champaign—investigate whether the short-term threat of missed earnings targets can override companies’ long-term efforts to reduce their pollution.
The researchers’ analysis of records from the EPA’s Toxic Release Inventory database revealed that, indeed, firms significantly increased toxic chemical pollution in the years when they just barely hit annual earnings targets, suggesting that they cut back on pollution-abatement measures as part of a larger effort to shunt funds from the costs column to the earnings column in close-call years.
But in a twist that surprised even the researchers, it turned out that the companies most likely to increase pollution when faced with a possible missed earnings target were those companies rated most environmentally responsible overall. In other words, companies with a recognized long-term focus on their own environmental sustainability were especially likely to cut corners to serve their short-term financial goals.
“Many hope that this type of long-term focus would curb managerial short-termism, and our paper shows that it’s not going to help,” says Zhang. “When companies want to meet or beat short-term earnings targets, they will pollute more to do that.”
Pollution-abatement activities—which might include recycling, energy recovery from waste, and pollutant treatment—can have a high cost. To pay for these activities, companies must cover employee wages, materials and supplies, energy costs, and much more. And, of course, if companies don’t incur these costs, their reported earnings are higher.
To investigate whether companies cut these pollution-fighting protocols in the years when they might be suspected of managing earnings to beat targets, the researchers collected data on companies’ release of toxins—all the way down to the individual plant level—for the period between 1994 and 2018 from the EPA’s TRI database.
They tagged as “suspect” the years when companies narrowly met or beat consensus analyst earnings forecasts—that is, in the years when a company’s reported earnings-per-share was within two cents of the average of all recent analyst forecasts.
Zhang says he wasn’t surprised by the team’s finding that toxin releases in suspect years were 15% higher than years when a company missed or comfortably beat forecasts.
“I would expect companies to try all kinds of things to beat earnings targets,” he says.
The second set of findings, however, did run counter to the expectations of Zhang and his colleagues, who had hypothesized that companies with worse environmental track records would be more inclined to lean into these accounting tricks and pollute more when they felt it necessary. In fact, the opposite was true: firms with higher environmental ratings from MSCI released more toxins in close-call years.
The researchers conducted analyses to determine whether the MSCI environmental ratings accurately capture companies’ overall sustainability track records, and concluded that they do; higher-rated companies were, over time, associated with less toxic pollution, fewer EPA enforcement cases, and smaller EPA enforcement penalties.
How to explain, then, the higher propensity to pollute in close-call years among companies with otherwise strong environmental track records? The researchers propose a “pollution slack” explanation: companies with historically higher environmental ratings may have built up some wiggle room—whether with regulators or in the public perception—which they can then exploit by polluting more when they decide they need to in order to meet an earnings target.
Supporting this theory is the team’s finding that the association between high environmental ratings and increased pollution in suspect years holds all the way down to the individual plant level. In other words, not only do the companies with the most pollution slack release more toxins in suspect years, but so too do the plants with the most pollution slack.
Zhang believes his study’s findings illuminate the potentially overriding power of short-term incentives in corporate culture—and reveal a common pattern extending beyond earnings targets and toxin releases that is cause for concern.
“A big implication of this is that when a company is focused on short-term targets, it can distort firm behavior,” Zhang explains. “Earnings targets are just one example. Broadly speaking, when managers and executives are focused on the short term, they lose sight of the big picture and long-term goals. That’s the alarm bell we want to sound.”
He adds that awareness of this pattern is key to solving it. For example, if regulators and ratings agencies were aware of the association between annual pollution and close-call earnings-target years, they could better monitor and call out those who pollute in order to meet or beat targets.
“If ratings companies were to assign a lower rating to such companies,” Zhang says, “I’m pretty sure those companies would change their behavior.”
SOM’s Frank Zhang and Jacob Thomas