Relationship Between Corporate Environmental And Financial Performance Accounting Essay

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The debate on the relationship between corporate environmental performance and corporate financial performance has been continuously disputed and the possibility of 'doing good and doing well' has been questioned over the past century. Klassen and Mclaughlin (1996:1199) suggest that, 'many individuals suggest that profitability is hurt by the higher production costs of environmental management initiatives, while others cite anecdotal evidence of increased profitability.' Majority of the empirical studies including Wu(2006), Stanwick(1998) and Orlitzky et al(2003) authors find 'conflicting' and 'inconclusive' results, failing to find a significant relation between environmental performance and financial performance. This on-going debate draws on two major views, win-win perspective and win-lose perspective. The former represents an optimistic revisionist view supported by the Porter hypothesis which assumes that higher levels of environmental and firm competitiveness can go hand-in-hand. The latter based on neo-classical economics, argues that there is an inherent conflict or trade-off between goals of environmental protection and firms' economic profitability and competitiveness.

In this essay, I will be arguing whether the relationship between environmental performance and financial performance is mutually exclusive or mutually inclusive. Also, I will be providing evidences from various studies relating to various countries to support the theory and outline the variables that were significant regarding the results from the studies.

The relationship between economic or financial performance and environmental performance is argued to be negative or mutually exclusive according to the traditionalist view, where environmental investments are often regarded as an extra cost to the firms and affect their competitiveness. According to Cohen et al (1995:3), improving environmental performance is often viewed as a 'necessary evil'. They are necessary for protecting the public and to control pollution but evil as this diversion of resources to non-productive use lowers profitability. The traditionalist view is rooted in the standard microeconomic theory where pollution abatement measures increase production costs and have decreasing benefits and increasing marginal costs according to Azomahou et al (2001:6).

Friedman (1962), one of the closest advocates associated with the traditionalist view, suggests that business managers have responsibilities to satisfy its shareholders and they have no obligation to take on environmentally friendly or socially responsible projects which does not generate revenue. Friedman (1970:33) concluded that corporate social responsibility is a 'subversive doctrine' as managers 'must act in some way that is not in the interest of his employers.'

Referring to Earnhart and Lizal (2010:11), environmental responsible business decisions may limit a firm's strategic alternatives, thus lowering revenues and increasing costs. For instance, according to Earnhart and Lizal (2010:11), in contrast to cost minimisation, 'complex pollution devices and processes may reduce overall productive efficiency', which in turn may raise production costs.

Hoffman (2005) looks at organisational constraints to undertake in environmental activities. Even before considering how environmental performance can lead to financial performance, denies the possibility of firms to undertake in activities in improving environmental performance. The study (2005:166) mainly emphasizes structural barriers, as companies consider environmental issues as 'something that is outside the realm of basic business concerns' implying issues associated with the environment are not regarded as a primary objective of the firm. As a result of structural limitations, there may be communication breakdowns which can limit acknowledging strategically crucial environmental actions. He also emphasizes the absence of decent indictor of environmental performance.

Furthermore, Hoffman (2005) explains that not only the internal factors but external factors namely, institutions can affect environmental performance. Hoffman (2005) outlines several external factors that can undermine a firm's objective towards meeting its environmental goals. Firstly, Hoffman (2005:185) states that legal standards limit rather than allow organisations to accomplish internally consistent goals. Secondly, he finds (2005:189) that 'economic and environmental value is embedded within the performance measures and used to judge economic performance and success.' This indirectly implies that economic and environmental performance are treated mutually exclusive and can mislead firms' environmental objectives. Thirdly, international regimes tend to treat economic growth and environmental performance as a separate matter. For instance, World Trade Organisation prioritizes free trade over environmental protection. Fourthly, academic programmes have dealt environmental and economic studies separate. Hoffman (2005) argues that this may be one of the indicators that explain the mutually exclusive relationship. However, this is not the case nowadays, as management schools have now included environmental studies in the part of their program. Finally, economic infrastructure according to Hoffman (2005:192), in the form of market rules can 'perpetuate the disconnection between economic growth and environmental protection.' Market incentive structures can often lead to inefficient outcomes for instance the author looks at lack of incentives of a TV manufacturer where they can reduce energy usage in stand-by mode but does not so as they have no incentive to reduce electricity bill of a consumer. This is also ignored by a consumer as the costs are minimal. However, author finds that the aggregate amount of usage accrues as a Chernobyl sized power station. But this argument may be flawed as electronic devices nowadays are energy saving and used as a selling point to consumers.

Walley and Whitehead (1994) doubt the possibility of win-win, revisionist view of the relationship and claim that the relationship is mutually exclusive. They do not question the existence of a win-win situation but suggest that it is unrealistic as responding to environmental challenges is costly, complicated and gives little economic payback and neglect the idea. The authors claim that environmental challenges are getting more and more difficult to meet due to skyrocketing environmental compliance costs with tighter regulation. They find that (1994:49) 'environmental costs of stubbornly continued to outpace both inflation and economic growth' and 'total annualized environmental protection costs for the US tripled as a percentage of GDP' between 1972 and 1992. In addition they add that (1994:49) 'managers are realising that all their relatively easy environmental problems have already been solved.'

Azomahou et al (2001) look at the relationship between environmental performance and financial performance in the European paper manufacturing industry. The mutual relationship is addressed using simultaneous equation systems and Azomahou et al (2001:42) find that 'for the system with return on capital employed as economic performance variable, only- were more consistent with the traditionalist view.' But using return on sales and return on Equity as indicators of economic performance, they find do not find any relationship.

Cordeiro and Sarkins (1997) look at the relationship between firm-level environmental pro-activism and financial performance using the toxic releases inventory data. They find that there is a significant negative relationship between firm performance and environmental performance when firm performance is measured by industry analyst 1 and 5-year earnings per share forecasts.

The conventional misperception that environmental protection comes at an additional cost on firms and that may worsen firms' position in the global competition has been challenged especially by the Porter Hypothesis and the revisionist view which assume that environmental and financial performance can go hand in hand. Ambec and Lanoie (2007) came up with various reasons how a better environmental performance can lead to an increase in revenues and cost reductions. Consequently, this will lead to improvements in financial performance as argued by Margolis et al (2007).

Firstly, they argue that better environmental performance can give better access to certain markets by improving the image of the company and would allow firms to meet the environmental performance criteria as it is becoming more and more apparent that the public administration forces private firms to meet the environmental standards. However, Ambec and Lanoie (2007) argue there is little evidence to support this hypothesis.

Secondly, they suggest that better environmental performance can give a possibility to differentiate products by quoting that (2007:6) green products allow companies to 'exploit niches in environmentally conscious market segments.' This suggests that even if the costs are high, there is a market in which the consumers are willing to pay for the product at a higher price and the costs can be passed onto the consumers. Toyota is one of the followers of this strategy and has seen an increase in sales of Prius by 139% from 2004 to 2005. [ii] But, FGCAQ (2004) and Parsons (2005) found no significant difference between a bio milk producer and a regular milk producer.

Thirdly, it may be possible that research and development in the area of pollution control technology in order to meet environmental standards can lead to technological improvements that other firms may be interested to purchase. Ambec and Lanoie (2007:8), provides an example where a company, Ciba, 'patented its new dye Cibacron LS that could be sold to other companies under licencing agreements.'

Environmental performance can lead to cost reductions according to Ambec and Lanoie (2007) firstly by continuous compliance. This means lower liability cots, avoiding fines and litigation. Less pollution will mean lower taxes and fewer permits necessary for purchase. In the case of a tightening regulation this can also give them a first mover advantage.

Secondly, Ambec and Lanoie (2007:9) state that 'reducing pollution can generate a reduction of expenditures on raw material, energy or services.' This is under the assumption of Porter hypothesis which suggests pollution is due to inefficient use of resources and that reducing pollution is correlated with improving productivity. The hypothesis assumes that regulation enhances innovation and increases in productivity where Ambec and Lanoie (2007) find a weak but positive relationship between environmental performance and innovation. However, looking at the impact of on productivity, most of their results from different results show a negative correlation. But, studies such as Alpay et al (2002) show that productivity increases with environmental regulation. However, Ambec and Lanoie (2007) argue that these cost reduction opportunities are seen where there is a firm has a flexible production process, face high competition and where market based instruments are implemented.

Thirdly, greener firms now have easier access to the capital markets due to the rising phenomenon of socially responsible investment and socially screened funds. This view is shared by Margolis et al (2007:8), where they argue 'appearance of doing good', generates positive image to customers and investors and in turn improve relations with investors and bankers to gain easier access to capital.

Finally, they argue that a better environmental performance leads to lower cost of labour by higher productivity and better atmosphere by improved image of the company. Evidences from Grolleau et al (2006) show that improving human resource management is a significant motivation for the decision to obtain ISO certification.

Similarly, Orlitzky et al (2003) as well support the Porter Hypothesis and also offer an explanation. They look at the effects of Corporate Social Performance (CSP) on Corporate Financial Performance (CFP), including environmental factors performance as one of the factors of CSP. The author firstly looks at the stakeholder theory which suggests a positive relationship between CSP and CFP. This theory according to Orlitzky et al (2003), suggest that stakeholder-management relationship can be served a monitoring and enforcement mechanism which can allow managers to concentrate on their organisational financial goals. Orlitzky et al (2003:407) argue that CSP process can lead to efficient utilisation of resources as CSP 'increases managerial competencies and knowledge about the firm's market, social, political, technological and other environments.' Also, the relationship is argued to be bidirectional according to the slack resources theory proposed by Orlitzky et al (2003), suggesting that availability of excess funds can determine initiation of social and environmental policies.

Financial performance looking at the stock market, empirical study from Ambec and Lanoie (2007:28) find that 'a large majority of the portfolio analyses, event studies and long-term studies show that a better environmental performance is associated with a better financial performance' and long-term studies support that lower environmental performance leads to lower financial performance. They conclude that better environmental performance does not lead to an increase in the cost of capital but reduces cost of capital although the relationship of the latter is weaker.

Orlitzky et al (2003:412) look at the relationship between CSP and CFP. In the study environmental performance is included the conceptualisation of CSP and the meta-analysis show that CSP is positively correlated with CFP and bidirectional. However, findings display that environmental performance has a weaker relationship with CFP than all other measures of CSP. This argument clarifies that conceptualisation of CSP is essential in finding a relationship between the two. Also, in line with Wu (2006), they claim that different indicators can lead to different results and find that CSP was highly correlated with accounting based measures than with market based and more highly with reputation indices.

Looking at another meta-analysis from Margolis et al (2007), the relationship between CSP and CFP were weak but positive suggesting there is no financial penalty for undertaking CSP. Also, they find that 28% of their finding is positive where only 2% were negative and confirm the bidirectional relationship. Looking specifically at their dimensions of CSP and concentrating on environmental performance, they have found that the association is even stronger. This is contrasting to the finding from Orlitzky et al (2003).

Different statistical analysis represented different results in Salama (2004) where the study finds that relationship between environmental performance and CFP is positive and stronger when median regression are used compared to OLS analysis. Results from OLS regression showed no statistically significant relationship between CEP and CFP.

However, some studies find no significant relationship between them. For instance,

Margolis et al (2007) find 58% of the results were insignificant. Susi (2005) finds that environmental performance is not correlated with financial performance but with company size, stock exchange listing and ISO 14001. Darnall and Ytterhus (2005:9) look at whether industry sectors differ in their ability to derive financial benefits from environmental actions and find that 'there is no empirical support to suggest that there are differences among industry sectors.'

Environmental performance and financial performance is mutually exclusive if we consider the traditionalist view. The main arguments were that high costs affects profitability, managers have no interest in non-income generating activities, organisational as well as institutional constraints and environmental performance is costly to achieve with sky rocketing costs. However, in the second part of the essay regarding the revisionist view, we have seen that the relationship between environmental performance is positive and bidirectional. Ambec and Lenoie (2007) and Orlitzky et al (2007) offer theoretical explanations for the relationship and statistical evidences from various authors were positive. However, in both cases the statistical results differed with regards to statistical techniques (Salama (2004)), indices (Wu (2006), Orlitzky et al (2006)), different measures for performances (Azomahou et al (2001), Cordeiro and Sarkins (1997)) and different conceptualisation of CSP ((Margolis et al (2007), Orlitzky et al (2003)). Also, we cannot ignore the existence of sampling and measurement errors.

As the majority of the findings from statistical practices especially meta-analyses suggest although inconclusive, in my opinion, the relationship between the two is positive, bidirectional implying that they can go hand-in hand. However, win-win cases are not easy to achieve as Walley and Whitehead (1994) correctly argues. As Ambec and Lenoie (2007) claim, cost reductions can only be seen if firm has a flexible production process, face high competition and where market based instruments are implemented and Hoffman (2005) states that success of win-win situation depend on organisational constraints and institutions. However, if all conditions are satisfied and with effective planning of commitments, as Little (1997) (Little (1997) in Hoffman 2005:241) argues 'companies that can gain first-mover advantage by anticipating or driving the market transition caused by sustainability will enjoy a business environment more aligned with their core business strategies.'