The prevailing wisdom says that it pays to be green. However, some research has demonstrated negative market consequences to companies’ voluntary emissions reductions. Why is this? One answer may lie in “regulator discretion.”

In “Self-Regulation and Regulatory Discretion: Why Firms May Be Reluctant to Signal Green,” Thomas Lyon, faculty member of the Erb Institute and John Maxwell found that “self-regulation is a double-edged sword: It can potentially preempt legislation, but it can also lead regulators to demand higher levels of compliance from greener firms if preemption fails.” Companies that signal green actually may be treated less favorably because regulators may assume that their abatement costs are low and therefore expect better performance from them.Regulator discretion

The paper explores both companies’ and regulators’ strategic actions. Previous literature has covered why companies self-regulate but has largely ignored the fact that regulators have the ability to act strategically—through being flexible in their enforcement. For example, regulators can reduce penalties for companies that agree to take further actions, as well as be flexible with small- and medium-sized enterprises and companies whose compliance costs are high.

Regulators also may assign different tiers and standards for different company sizes, and alter inspection frequency, fines, exemptions, waivers and reporting requirements.

Companies with low compliance costs face a tradeoff: “They can blend in with the rest of the industry, and take few self-regulatory steps. This reduces the risk of regulation somewhat, and preserves their ability to obtain regulatory flexibility should regulation be imposed,” Lyon and Maxwell explain. “Alternatively, they can step up with substantial self-regulation. This better mitigates the risk of regulation, but at the risk of signaling low costs and becoming a target for stringent enforcement should regulation pass.”

A Game Theoretic Model

Lyon and Maxwell built a game theoretic model to explore whether a company should signal green through substantial self-regulation. The researchers’ model includes two strategic players: a polluting firm that aims to minimize costs and a regulator that aims to maximize environmental quality. It assumes that the firm has environmental impacts in two domains (such as two different pollutants or plants). Because the regulator is trying to reduce environmental damage, it may forgive firms for noncompliance in one dimension if they comply in the other.

The model looks at the regulator’s decisions about how to enforce the law and how much effort to put into passing the law, as well as the firm’s incentives to self-regulate. The firms’ costs of abating their emissions differ: Firms with low costs comply with regulations in both domains, and high-cost firms do not comply in either—unless they are offered regulatory flexibility. Flexibility can allow a firm to comply in one domain, but not both. This may sound like a surrender on the part of the regulator, but it may be better than the alternative. “Flexibility allows the high-cost firms to escape the full burden of the regulation while still inducing some compliance,” Lyon and Maxwell wrote.

Regulators are inclined to be flexible with companies that have high costs but not with those that have low costs. “Intuitively, a firm that is known to have low costs will face more stringent enforcement of regulation, and thus has stronger incentives to try and preempt that regulation. A high-cost firm can expect more flexible and lenient treatment by the regulator, and thus has less incentive to preempt,” the researchers wrote.

They found that when a low-cost firm strategically signals green through substantial self-regulation, this signaling benefits the entire industry by making legislation less likely.Implications

Empirical evidence shows that many self-regulatory efforts are modest, and this paper suggests that one reason is that companies avoid too much self-regulation because they are worried this will put them at risk for more stringent enforcement.

“Our results are consistent with the long-held notion that strong regulatory threats are needed to induce high levels of self-regulation,” Lyon and Maxwell wrote, but they indicate a need to reconsider what constitutes a strong regulatory threat, because the threat can change based on what companies do. Companies’ self-regulation “may alter both the form and the likelihood of regulation. As a result, firm decisions shape rather than simply respond to the regulatory threat.”

 “Our analysis highlights the differences in strategic behavior when legislators and regulators take into account that regulation has differential cost impacts on firms, and therefore tailor regulations to avoid politically unacceptable costs on certain classes of firms,” the researchers wrote. They explained that low-cost firms sometimes self-regulate and thereby signal that costs are low—in the hope that regulations will be imposed on their competitors whose costs are higher—but that these low-cost firms might not benefit from this strategy, because their competitors may be held to weaker standards.

They noted that, for low-cost companies, a more flexible regulation (which gives them a private advantage) might be more attractive than a reduced probability of regulation (an industry-wide benefit). Their findings help to explain why bold environmental leadership is the exception rather than the rule in most industries: Leaders are often held to higher standards by regulators, as well as by civil society. The model focused on government regulations, but the researchers noted that the findings may apply to potential societal sanctions and civil regulation as well.

Read the research here.