By Qiping Xu, University of Illinois Urbana-Champaign and Taehyun Kim, Chun-Ang University


In modern production processes, firms often generate by-products that adversely impact the environment and public health. For example, US firms produced 12.35 billion kilograms of toxic chemicals generated in production-related processes in 2015 alone.

Researchers have documented costly adverse outcomes from exposure to pollutants and toxicants, including higher rates of infant mortality and neurodevelopment disorders, lower educational attainment, reduced labour-force participation, and lower earnings in later life (for a review, see Currie et al. 2014).

A better understanding of firms’ environmental decisions and how they connect to financial-market frictions and regulatory settings will better inform and thereby generate more fruitful discussions of environmental protection.

In our study, we seek to understand how financial frictions, in particular financial constraints, affect corporate environmental policies.

Environmental abatement is exorbitantly expensive because it requires substantial inputs of energy, labour, contracted services, and raw materials in a process deeply integrated into every aspect of corporate decision making. We find that firms strategically choose when and where to pollute, depending on their financial constraints.

The bottom line vs environmental protection

As financial constraints restrict firms’ resources and drive up the cost of environmental protection, they cut abatement expenditures and increase toxic emissions. Unfortunately, a surge in pollution imposes additional costs on the environment, society, and public health.

The tension between environmental protection and a firm’s bottom line lies precisely in the fact that clean waste management methods are more expensive, while less costly practices such as direct disposal are harmful to the environment. Figure 1 illustrates this conflict of interest:

Financial Constraints and Corporate Environmental Policies-02

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Figure 1: The bottom line vs. environmental protection. Source: Environmental Protection Agency (EPA)


Panel (A) presents the a waste management hierarchy, which intuitively outlines the US Environmental Protection Agency’s waste management guidelines.

Source reduction (also referred to as pollution prevention), the EPA’s preferred method of waste management, aims to reduce or eliminate pollutants generated during the production process. Recycling, treatment, and disposal are activities used to manage pollutants after their generation by the production process.

However, direct disposal, the less preferred method within the EPA guidelines, is often least costly for firms and the most popular practice observed in the data.

Panel (B) breaks down US firms’ actual waste management activities and presents the average percentage of generated toxic pollutants across the categories of recycling, recovery, treatment, and direct release for plants in the United States. The vast majority (65.1%) of toxic pollutants end up being directly disposed to the environment, with treatment, recovery, and recycling accounting for the remaining 25.1%, 4.4%, and 5.3%, respectively.

Investigating toxic emissions

To rigorously investigate firms’ toxic emissions, we capitalise on firm-level microdata from the EPA’s Toxics Release Inventory program for the period running from 1990 through 2014.

Firms’ financial constraints are captured by two text-based measures (developed by Hoberg and Maksimovic (2014) and Bodnaruk, Loughran, and McDonald (2015)) that extract qualitative information from corporate disclosure documents.

Our analysis uncovers a significant correlation between the volumes of toxic chemicals released and these two financial-constraint measures for publicly listed firms in the United States.

We look further into three cases that substantially – and positively – altered the financial status of the firms in question, thereby easing financial friction and confirming this relationship:

  • The American Jobs Creation Act (AJCA) of 2004 created a positive cashflow windfall by lowering the tax rate from 35% to 5.25% for firms that repatriated foreign earnings previously held by foreign subsidiaries.
  • The collateral value of firms’ real estate assets, where higher collateral value reduces lending frictions and facilitates financing through higher debt capacity.
  • Mutual fund flow-induced price changes, where large inflows generate temporary price appreciations and induce additional equity financing.

Our analyses reveal consistent results across these cases, indicating that relaxing financial constraints reduces toxic chemical discharges. The reductions range from 8% to 18%, with the average effect being approximately 14%.

The social costs of reducing environmental abatement

Conversely, when firms are financially constrained, they reduce their spending on environmental abatement by 14%, which in turn has a major impact on social welfare. We conduct a back-of-the-envelope calculation to demonstrate this. The EPA’s prospective report on the Clean Air Act (CAA, 1990–2020) estimates that every environmental abatement dollar that firms reduce generates a welfare loss of US$60 to the public and society.

Assuming that abatement expenditures are cut by 14% due to financial constraints, representing a US$7.14 million reduction for an average firm-year in our sample, it imposes an additional US$428 million cost on society for toxic chemicals governed by the CAA alone.

This estimate translates to around an US$8 billion welfare loss to society for all firms during our sample period, indicating that financial constraints exacerbate the costly negative externalities of environmental pollution.

Financial constraints and corporate policies

Lastly, we explore several differences in financial constraints and corporate environmental policies. For example, if a geographic region is designated as a non-attainment zone by the EPA, it is considered to have worse air quality than national standards. Consequently, environmental laws and regulations mandate enhanced monitoring and have costly ramifications.

Firms located in non-attainment areas produce 30% less toxic releases on average, relative to firms in attainment areas. Firms shift financial resources to non-attainment areas to increase their abatement activities, because polluting in these areas will result in hefty regulatory penalties. Consequently, they reduce abatement in attainment areas, where environmental regulations are looser.

In addition, we study polluter size, as large polluters are typically the focus of EPA monitoring and enforcement activities. Small polluters are much more responsive to financial constraints than large polluters that face more stringent regulatory oversight.

Overall, the firms in our sample are opportunistic: they are keenly aware of the costs and benefits associated with environmental protection and strategically choose when and where to pollute.

In summary, our evidence demonstrates that variations in toxic releases are closely tied to a firm’s financial strength, pointing to the externalities of financial constraints in the form of environmental pollution.

Our results also indicate that, when regulatory oversight and enforcement are resource-constrained, policy makers might adopt a non-random auditing policy that focuses on scenarios in which violations of environmental regulations are most likely to occur.




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