Short-term revenue targets lead to more pollution, especially for green businesses » FINCHANNEL

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Frank Zhang and Jacob Thomas of Yale SOM suspect that companies could increase their pollution when they are struggling to meet their profit targets – and in new research they and their co-authors have found that this is indeed the case. What surprised them was who was most likely to engage in this model: companies with a track record of environmental responsibility.

The short-term pressure on companies to meet their quarterly and annual profit targets can push their managers into desperate acts of accounting. It’s called real profit management, or REM – companies may cut prices to increase sales, cut advertising or research and development budgets, or attempt various other financial maneuvers in an attempt to meet or exceed their goals.

The factors that fuel this desperation are not a mystery. Companies receive a swift and severe punishment from the market when they report failure. In April, Amazon reported first-quarter revenue that narrowly missed consensus analysts’ estimates, and its stock price quickly fell 10%.

A growing body of research suggests that this short-term fixed accounting can be detrimental to business stakeholders, such as investors and employees. Frank Zhang, a Yale SOM accounting professor, and Jacob Thomas, a Williams Brothers accounting and finance professor, suspected that the adverse effects of real-world profit management could extend to 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 – study whether the short-term threat of missed profit targets can prevail over long-term business goals. efforts to reduce their pollution.

The researchers’ analysis of records from the EPA’s Toxic Release Inventory database found that, indeed, companies dramatically increased toxic chemical pollution in years when they barely reached their annual revenue targets, suggesting that they have scaled back pollution reduction measures as part of a larger effort to move funds from the cost column to the revenue column over the years closing.

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 revenue target were those that were the most environmentally friendly overall. environment. In other words, companies with a recognized long-term focus on their own environmental sustainability were particularly likely to take shortcuts to meet their short-term financial goals.

“Many hope that this kind of long-term orientation will limit managerial short-termism, and our paper shows that won’t help,” Zhang says. “When companies want to meet or exceed their short-term profit targets, they will pollute more to achieve this.”

Pollution reduction activities, which may include recycling, energy recovery from waste and treatment of pollutants, can have a high cost. To pay for these activities, companies must cover employee salaries, materials and supplies, energy costs, and more. And, of course, if companies do not incur these costs, their reported revenues are higher.

To determine whether companies cut these pollution-control protocols in years when they might be suspected of managing profits to exceed targets, researchers collected data on companies’ release of toxins – down to the level of the individual plant – for the period between 1994 and 2018 from the EPA TRI database.

They called “suspicious” years when companies met or narrowly exceeded analysts’ consensus earnings forecasts—that is, years when a company’s reported earnings per share were at less than two cents from the average of all recent analyst forecasts.

Zhang says he was not surprised by the team’s finding that toxin releases in suspect years were 15% higher than years when a company missed or greatly exceeded forecasts.

“I would expect companies to try all sorts of things to beat profit targets,” he says.

The second set of results, however, went against the expectations of Zhang and his colleagues, who had hypothesized that companies with poorer environmental records would be more likely to lean into these accounting tricks and pollute. more when deemed necessary. In fact, the opposite was true: companies with higher environmental ratings from MSCI released more toxins during the years of shutdown.

Researchers conducted analyzes to determine whether MSCI environmental ratings accurately reflect companies’ overall sustainability track records, and concluded that they did; higher-rated companies were, over time, associated with less toxic pollution, fewer EPA enforcement cases, and lower EPA enforcement penalties.

How, then, to explain the higher propensity to pollute in the proximity years among firms with otherwise strong environmental histories? Researchers offer an explanation for ‘pollution loosening’: Companies with historically higher environmental ratings may have accumulated some leeway – either with regulators or in public perception – which they can then exploit by polluting more when they decide that they need it to reach a remuneration objective.

In support of this theory, the team found that the association between high environmental ratings and increased pollution in suspect years holds true down to the individual plant level. In other words, not only do the companies with the most pollution release release more toxins in suspect years, but so do the factories with the most pollution release.

Zhang believes the results of his study shed light on the potentially predominant power of short-term incentives in corporate culture and reveal a common pattern extending beyond profit targets and toxin releases that is concerning.

“A big implication of this is that when a company focuses on short-term goals, it can distort company behavior,” says Zhang. “The profit targets are just one example. Generally speaking, when managers and executives focus on the short term, they lose sight of the big picture and long-term goals. This is the alarm bell we want to ring.

He adds that awareness of this pattern is key to resolving it. For example, if regulators and rating agencies were aware of the association between annual pollution and years of near earnings targets, they could better monitor and call those who pollute in order to meet or exceed targets.

“If rating companies were to downgrade these companies,” Zhang says, “I’m pretty sure these companies would change their behavior.”

Frank Zhang and Jacob Thomas of SOM

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