The Reputational Penalties For Environmental Violations - Empirical Evidence

The Booth School of Business, University of Chicago
The Reputational Penalties for Environmental Violations: Empirical Evidence

Authors(s): JonathanM. Karpoff, JohnR. Lott,Jr. and EricW. Wehrly
Source: The Journal of Law & Economics, Vol. 48, No. 2 (October 2005), pp. 653-675
Published by: The University of Chicago Press for The Booth School of Business,
University of Chicago and The University of Chicago Law School
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THE REPUTATIONAL PENALTIES FOR

ENVIRONMENTAL VIOLATIONS:
EMPIRICAL EVIDENCE*
JONATHAN M. KARPOFF,
University of Washington
JOHN R. LOTT, JR.,

American Enterprise Institute
and
ERIC W. WEHRLY
University of Washington
Abstract
This paper examines the sizes of the fines, damage awards, remediation costs, and
market value losses imposed on companies that violate environmental regulations.
Firms that violate environmental laws suffer statistically significant losses in the
market value of firm equity. The losses, however, are of similar magnitudes to the
legal penalties imposed, and in the cross section, the market value loss is related to
the size of the legal penalty. Thus, environmental violations are disciplined largely
through legal and regulatory penalties, not through reputational penalties.
I.
Introduction
o firms that pollute the environment hurt their reputations? Many researchers believe they do. Michael Porter and Claas van der Linde claim that
environmental insensitivity lowers a firms sales and increases its costs.1
Similarly, Sheoli Pargal and David Wheeler, Seema Arora and Timothy Cason, and Shameek Konar and Mark Cohen claim that community pressure
* Jonathan M. Karpoff is the Norman J. Metcalfe Professor of Finance and Eric W. Wehrly
is a Ph.D. candidate at the University of Washington Business School; John R. Lott, Jr., is a
resident scholar at the American Enterprise Institute. We thank an anonymous referee, Sam
Peltzman (the editor), Mike Barnett, and seminar participants at the University of Washington
and the 2002 Environmental Protection Agency conference Economics and the Environment
for helpful suggestions, Graeme Rankine for collaboration in an earlier version of this paper,
and Elvis Ziu for research assistance. Karpoff received support from the Deans Discretionary
Fund at the University of Washingtons School of Business.
1
Michael E. Porter & Claas van der Linde, Toward a New Conception of the EnvironmentCompetitiveness Relationship, J. Econ. Persp., Fall 1995, at 97.
[Journal of Law and Economics, vol. XLVIII (October 2005)]
2005 by The University of Chicago. All rights reserved. 0022-2186/2005/4802-0024$01.50
653
654
the journal of law and economics
and informal sanctions can penalize environmental violations.2 As an example, the Exxon Valdez oil spill so angered many consumers that it triggered
boycotts of Exxons retail outlets.3 Konar and Cohen argue that environmentally conscious investors can penalize polluting firms by increasing their
costs of capital and decreasing their market values, a notion that is modeled
by Robert Heinkel, Alan Kraus, and Josef Zechner.4
In this paper, we measure the extent to which market-imposed sanctions
what we label reputational penaltiesimpose significant costs on firms
that violate environmental regulations. Along the way, we provide the first
large-sample estimates of the share valuation impact on firms that violate
environmental regulations. We also examine the sizes of the legal penalties
imposed on violating firms.
The existence and size of any reputational penalty is important for public
policy. Optimal penalty theory, as discussed by Gary Becker, requires that
the expected total penalty for an illegal activity equals the activitys total
social cost.5 The total penalty consists of explicit legal sanctions imposed
through regulatory, civil, and criminal proceedings, plus reputational penalties. If reputational penalties are large, then legal penalties optimally should
be small. Conversely, small reputational penalties imply a more important
role for legal penalties in an optimal framework.
Using data from 478 environmental violations by publicly traded companies for 19802000, we find that allegations or charges that a firm violated
environmental regulations correspond to economically meaningful and statistically significant losses in the firms share values. Initial press announcements containing allegations of a violation are associated with an average
abnormal stock return of 1.69 percent. When the initial announcement
indicates that the firm formally has been charged with a violation, the average
abnormal stock return is 1.58 percent.
It turns out, however, that these losses are similar in size to these firms
legal penalties. In a subsample of 148 firms on which we have information
on the legal penalties, the mean fine or damage award (in constant year 2000
dollars) is $13.2 million, and the mean forced compliance or remediation
cost is $93.6 million. The combined legal penalty equals 2.26 percent of
2
See Sheoli Pargal & David Wheeler, Informal Regulation in Developing Countries: Evidence from Indonesia, 104 J. Pol. Econ. 1314 (1996); Seema Arora & Timothy Cason, Why
Do Firms Volunteer to Exceed Environmental Regulations? Understanding Participation in
EPAs 33/50 Program, 72 Land Econ. 413 (1996); and Shameek Konar & Mark A. Cohen,
Why Do Firms Pollute (and Reduce) Toxic Emission? (Working paper, Vanderbilt Univ., Owen
Grad. Sch. Mgmt. 1998).
3
Philip Shabecoff, Six Groups Urge Boycott of Exxon, N.Y. Times, May 3, 1989, at A17.
4
Shameek Konar & Mark A. Cohen, Does the Market Value Environmental Performance?
83 Rev. Econ. & Stat. 281 (2001); and Robert Heinkel, Alan Kraus, & Josef Zechner, The
Effect of Green Investment on Corporate Behavior, 36 J. Fin. & Quant. Analysis 431 (2001).
5
Gary S. Becker, Crime and Punishment: An Economic Approach, 76 J. Pol. Econ. 169
(1968).
reputational penalties
655
these firms share values, on average. Thus, while environmental violators

lose market value, the losses reflect these firms legal penalties. Marketinduced reputational penalties, on average, are negligible. We therefore conclude that legal penalties, and not reputational penalties, are the primary
deterrents to environmental violations.
This paper is organized as follows. Section II describes the controversy
about the existence and size of a reputational penalty for environmental
violations. Section III describes the data, and Section IV reports on the share
value effects for firms investigated for or charged with environmental violations. Section V reports on the sizes of the legal penalties for violations,
and Section VI investigates the importance of reputational penalties. In Section VII, we investigate the determinants of cross-sectional differences in the
market value losses. Section VIII concludes the paper.
II.
The Reputational Cost Controversy

A.
Details of the Controversy
As Benjamin Klein and Keith Leffler argue, reputation disciplines certain

types of wrongdoing because market transactions internalize their costs.6
Companies that defraud customers, for example, lose sales. Those that cheat
employees or other suppliers face higher input costs or lost trade credit. The
cost of the illegal activity is internalized because the cheating firm loses at
least some of the gains that accrue from repeat business with consumers,
employees, or suppliers. Consistent with such arguments, previous research
indicates that reputational costs are large for false advertising,7 product recalls,8 lack of safety,9 deceptive bidding practices,10 punitive damages lawsuits,11 defense procurement fraud,12 and financial misrepresentation.13 Jonathan Karpoff and John Lott find that over 90 percent of the penalties imposed
6
Benjamin Klein & Keith B. Leffler, The Role of Market Forces in Assuring Contractual
Performance, 89 J. Pol. Econ. 615 (1981).
7
Sam Peltzman, The Effects of FTC Advertising Regulation, 24 J. Law & Econ. 403 (1981).
8
Gregg Jarrell & Sam Peltzman, The Impact of Product Recalls on the Wealth of Sellers,
93 J. Pol. Econ. 512 (1985).
9
Mark L. Mitchell & Michael T. Maloney, The Role of Market Forces in Promoting Air
Travel Safety, 32 J. Law & Econ. 329 (1989).
10
Clifford Smith, Jr., Economics and Ethics: The Case of Salomon Brothers, 5 J. Applied
Corp. Fin. 23 (1992).
11
Jonathan M. Karpoff & John R. Lott, Jr., On the Determinants and Importance of Punitive
Damages Awards, 42 J. Law & Econ. 527 (1999).
12
Jonathan M. Karpoff, D. Scott Lee, & Valaria Vendrzyk, Defense Procurement Fraud,
Penalties, and Contractor Influence, 107 J. Pol. Econ. 809 (1999).
13
Jonathan M. Karpoff, D. Scott Lee, & Gerald S. Martin, The Cost of Cooking the Books
(Working paper, Texas A&M Univ. & Univ. Washington 2004).
656
on firms committing private frauds reflects lost reputation.14 Only a small

portion of the financial penalties imposed on such firms is due to criminal
or civil penalties and other court-imposed costs.
Many researchers argue that reputational concerns motivate, or should
motivate, firms to comply with environmental rules. As an example, Christopher Decker finds that firms that comply with environmental rules receive
new construction permits from environmental agencies more quickly than
do firms with many instances of noncompliance.15 Cohen argues that evidence
of an environmental violation might adversely affect customers perceptions
about the safety or quality of the firms products.16 Paul Downing and James
Kimball suggest that managers comply with environmental regulations because they care about their companies imagesa notion that is supported
by survey evidence reported by Irene Henriques and Perry Sadorsky and by
Piotr Zerbe.17 According to these arguments, the firms customers, employees,
and suppliers can be motivated by environmental concern to change their
reservation prices in doing business with the firm. Environmentally costly
activities that attract unfavorable attention could then lower demand for the
firms products or increase the firms costs. Using similar arguments, Shakeb
Afsah, Benoit Laplante, and Wheeler, and Laplante, Paul Lanoie, and Maite
Roy suggest that pressure by nonshareholder stakeholders can motivate firms
to control pollution emissions.18
The counterargument holds that reputational penalties are small for environmental violations. Environmental violations differ from frauds and other
types of wrongdoing in that they impose costs on parties other than those
with whom the polluting firm does business. As an example, downstream
fishermen are damaged if an electroplating company dumps toxic chemicals
into a municipal storm sewer. But the fishermen do no business with the
14
Jonathan M. Karpoff & John R. Lott, Jr., The Reputational Penalty Firms Bear from
Committing Criminal Fraud, 36 J. Law & Econ. 757 (1993). Cindy Alexander obtains similar
results using a sample of purely criminal cases. Cindy R. Alexander, On the Nature of the
Reputational Penalty for Corporate Crime: Evidence, 42 J. Law & Econ. 489 (1999).
15
Christopher S. Decker, Corporate Environmentalism and Environmental Statutory Permitting, 46 J. Law & Econ. 103 (2003).
16
Mark A. Cohen, Environmental Crime and Punishment: Legal/Economic Theory and Empirical Evidence on Enforcement of Federal Environmental Statutes, 82 J. Crim. Law & Criminology 1054 (1992).
17
See Paul B. Downing & James N. Kimball, Enforcing Pollution-Control Laws in the
United States, 11 Poly Stud. J. 55 (1982); Irene Henriques & Perry Sadorsky, The Determinants
of an Environmentally Responsive Firm: An Empirical Approach, 30 J. Envtl. Econ. & Mgmt.
386 (1996); and Piotr M. Zerbe, Evaluation of Predominant Environmental Management Practices in the Canadian Pulp and Paper Industry (Working paper, Univ. British Columbia, Dept
Resource Mgmt. & Envtl. Stud. 1997).
18
See Shakeb Afsah, Benoit Laplante, & David Wheeler, Controlling Industrial Pollution:
A New Paradigm (Policy Research Working Paper No. 1672, World Bank 1996); and Benoit
Laplante, Paul Lanoie, & Maite Roy, Can Capital Markets Create Incentives for Pollution
Control? 26 Ecological Econ. 31 (1998).
657
firm, and the firms customers have no direct incentive to lower their demands
for the firms products if the dumping does not affect the quality of those
products. As a result, the polluting electroplating company could experience
no reputational costs.
This counterargument implies that environmental violations are similar to
such regulatory violations as check kiting and failure to report currency
transactions, which Karpoff and Lott and Alexander find to have negligible
reputation costs.19 Consistent with this view, Julie Doonan, Lanoie, and Laplante report survey evidence that indicates that unfavorable press coverage
and consumer pressure do not affect pollution output by paper pulp mills.20
The debate over the size of any reputational costs has affected the U.S.
Sentencing Commissions deliberations over criminal penalties for environmental violations. The commission issued sentencing guidelines for crimes
by organizations in 1991 but specifically excluded environmental violations
from these guidelines. It since has considered several proposals for environmental guidelines. But the lack of agreement over whether to impose higher
penalties for environmental crimes than for other business crimes has prevented the commission from adopting any of the proposals.21 At the heart
of this disagreement, we propose, is the lack of evidence over whether environmental noncompliance imposes significant reputational costs.22
B.
Related Research
A substantial body of research examines how regulators should set legal

penalties for environmental harms.23 Empirical evidence on the actual sizes
of such penalties, however, is limited. Several papers examine the regulatory
fines imposed for single types of environmental discharges using relatively
19
Karpoff & Lott, supra note 14; Alexander, supra note 14.
Julie Doonan, Paul Lanoie, & Benoit Laplante, Environmental Performance of Canadian
Pulp and Paper Plants: Why Some Do Well and Others Do Not? (unpublished manuscript,
Ecole des Hautes Etudes Commerciales, Montreal 2002).
21
See, for example, the U.S. Sentencing Commission, Report from Advisory Group on
Environmental Sanctions (1993) (http://www.ussc.gov/publicat/environ.pdf). The U.S. Sentencing Guidelines as amended on November 1, 2003, reflect several cumulative amendments
to the environmental provisions. See the U.S. Sentencing Commission, 2003 Federal Sentencing
Guidelines Manual, chap. 2, part Q (http://www.ussc.gov/2003guid/tabcon03_1.htm). But the
Guidelines for Organizations (chap. 8) contain no provisions for environmental violations.
22
See Paul E. Fiorelli & Cynthia J. Rooney, The Environmental Sentencing Guidelines for
Business Organizations: Are There Murky Waters in Their Future? 22 B.C. Envtl. Aff. L. Rev.
481 (1995).
23
See Jean-Philippe Barde, Environmental Policy and Policy Instruments, in Principles of
Environmental and Resource Economics: A Guide for Students and Decision-Makers 157 (Henk
Folmer & H. Landis Gabel eds. 2000); Dennis W. Carlton & Glenn C. Loury, The Limitation
of Pigouvian Taxes as a Long-Run Remedy for Externalities, 95 Q. J. Econ. 559 (1980); and
Dennis W. Carlton & Glenn C. Loury, The Limitation of Pigouvian Taxes as a Long-Run
Remedy for Externalities: An Extension of Results, 101 Q. J. Econ. 631 (1986).
20
658
small samples.24 Our data on legal penalties therefore establish a baseline of

information on the sizes of the legal penalties imposed for environmental
violations.
Our investigation also is related to several papers that examine the share
value impacts of specific types of unfavorable environmental news, such as
oil or chemical spills. Michael Muoghalu, H. David Robison, and John Glascock, James Hamilton, and Robert Klassen and Curtis McLaughlin conclude
that unfavorable environmental news is associated with significant losses in
share values, whereas Lanoie and Laplante, Richard Harper and Stephen
Adams, Laplante, Lanoie, and Roy, Alexander, and Kari Jones and Paul Rubin
find that the share value losses are insignificant.25 We attribute these discrepancies to the relatively small samples examined in most of these studies.
For example, Klassen and McLaughlin examine 22 events, and Lanoie and
Laplante examine 47 events.26 Our sample of 478 violations for 19802000,
in contrast, is sufficiently large to construct a powerful test of the share value
impact.
Several papers examine stock market reactions to news about a firms
environmental sensitivity, such as an investment in pollution prevention or
a positive environmental rating from a nongovernmental environmental organization.27 The authors of these papers interpret a stock market reaction
24
James T. Hamilton, Going by the (Informal) Book: The EPAs Use of Informal Rules in
Enforcing Hazardous Waste Laws, in 7 Advances in the Study of Entrepreneurship, Innovation,
and Economic Growth 109 (Gary D. Libecap ed. 1996), examines hazardous waste violations.
Mark A. Cohen, Optimal Enforcement Strategy to Prevent Oil Spills: An Application of a
Principal-Agent Model with Moral Hazard, 30 J. Law & Econ. 23 (1987), examines oil
spills. Neda Oljaca, Andrew Keeler, & Jeffrey Dorman, Penalty Functions for Environmental
Violations: Evidence from Water Quality Enforcement, 14 J. Reg. Econ. 255 (1998), examines
water pollution infractions in the state of Georgia. Cohen, supra note 16, examines a broader
variety of environmental violations. For an excellent review of research on the monitoring and
enforcement of environmental policy, see Mark A. Cohen, Monitoring and Enforcement of
Environmental Policy, in 3 International Yearbook of Environmental and Resource Economics
44 (Tom Tietenberg & Henk Folmer eds. 1999).
25
See Michael Muoghalu, H. David Robison, & John L. Glascock, Hazardous Waste Lawsuits, Stockholder Returns, and Deterrence, 7 S. Econ. J. 357 (1990); James T. Hamilton,
Pollution as News: Media and Stock Market Reactions to the Toxics Release Inventory Data,
28 J. Envtl. Econ. & Mgmt. 98 (1995); Robert D. Klassen & Curtis P. McLaughlin, The Impact
of Environmental Management on Firm Performance, 42 Mgmt. Sci. 1199 (1996); Paul Lanoie
& Benoit Laplante, The Market Response to Environmental Incidents in Canada: A Theoretical
and Empirical Analysis, 60 S. Econ. J. 657 (1994); Richard K. Harper & Stephen C. Adams,
CERCLA and Deep Pockets: Market Response to the Superfund Program, 14 Contemp. Econ.
Pol. 107 (1996); see Laplante, Lanoie, & Roy, supra note 18; Alexander, supra note 14; and
Kari Jones & Paul H. Rubin, Effects of Harmful Environmental Events on Reputations of
Firms, in 6 Advances in Financial Economics 161 (Mark Hirschey, Kose John, & Anil Makhija
eds. 2001).
26
Klassen & McLaughlin, supra note 25; Lanoie & Laplante, supra note 25.
27
See Seema Arora, Voluntary Abatement and Market Value: An Event Study Approach
(unpublished manuscript, Stanford Inst. Econ. Pol. Res. 2001); Susmita Dasgupta, Benoit
Laplante, & Nlandu Mamingi, Pollution and Capital Markets in Developing Countries, 42 J.
Envtl. Econ. & Mgmt. 310 (2001); and Shreekant Gupta & Bishwanath Goldar, Do Stock
659
to firm-specific environmental news as evidence that capital markets discourage environmental misconduct. Our investigation, however, is very different from these. We use the stock price reaction as a measure of the present
value of the net costs to a firm accused of violating an environmental regulation. We then partition this cost into components that reflect legal penalties
and reputational penalties.
III.
Data
We examine 478 cases in which publicly traded firms were investigated

for, accused of, or settled charges of environmental violations for 19802000.
The sample is obtained from a search of the Wall Street Journal index under
its environment and environmental crime listings. Additional information
on many events is obtained from the Factiva database,28 including followup information on the sizes of penalties imposed that was published after
2000. To be included in the sample, the defendant firm must be listed on the
2002 Center for Research in Security Prices (CRSP) daily returns file on the
day of the earliest Wall Street Journal report of its environmental violation.
Because the Exxon Valdez oil spill resulted in an extremely large penalty,
we exclude it from our sample. The spill occurred in March 1989 and resulted
in a 1994 jury award of $5.3 billion in compensatory and punitive damages.29
Our sample consists of a wide variety of actions involving different types
of environmental harm and initiated by different regulatory agencies or private parties. The following examples illustrate typical cases:
1. In 1980, FMC Corporation was indicted for providing false data to the
Environmental Protection Agency (EPA) about the amount of carbon tetrachloride the firm had released in the Kanawha River in Charleston, West
Virginia.
2. In 1986, a Kerr-McGee Corporation storage tank ruptured and distributed radioactive uranium hexaflouride gas over a part of eastern Oklahoma,
prompting a civil lawsuit from a group of nearby residents.
3. In 1997, Santa Monica, California, city officials charged in a lawsuit
that Mobil allowed methyl tertiary butyl ether to seep in to the citys wells.
4. In 1998, six Rochester, New York, families sued Eastman Kodak alleging that film factory chemicals caused brain cancer in their children.
The wide diversity of events in the sample provides insight into the types
of environmental violations that occur and are reported in major newspapers.
Markets Penalise Environment-Unfriendly Behaviour? Evidence from India (unpublished manuscript, Delhi School Econ., Ctr. Dev. Econ. 2003).
28
Dow Jones & Reuters, Factiva (http://www.factiva.com).
29
Including the Exxon Valdez event would further support our conclusion of no reputational
effect. This is because the legal penalties far exceed the loss in firm share value at the time
of the event. The 2-day abnormal return for Exxon is .67 percent, which represents a loss
in market value of only $398 million.
660

TABLE 1
Environmental Violations Sample
Event Classification
Type of environmental harm:
Air
Surface or drinking water
CERCLA/contaminated site
Miscellaneous or multiple media
Total
Type of action:
Criminal lawsuit
Civil lawsuit
Regulatory fine/action
Consent order
Product recall
Liability assignment
Total
Party bringing the action:
State or local agency
Environmental Protection Agency
Justice Department
Environmental group
Individuals or class-action lawsuits
Total
Number
127
121
167
63
478
28
197
146
31
38
38
478
101
221
86
8
62
478
Note.Distribution of 478 environmental violation events identified from the Wall Street Journal and Factiva database during the
period 19802000. CERCLA p Comprehensive Environmental Response, Compensation, and Liability Act.
Table 1 provides summary information about the sample. It classifies events

according to the type of environmental harm, the type of lawsuit or regulatory
action, and the party bringing the action.
Type of Harm. The breakdown of the sample by the type of environmental harm reveals that, of the 478 events in the total sample, 127 involve
air emissions, including violations of the 1970 Clean Air Act and its 1977
and 1990 amendments. A total of 121 cases involve water contamination.
Of these, 89 involve surface water contamination, including violations of the
1977 Clean Water Act and the Water Quality Act of 1987, and 32 involve
contamination of drinking water supplies and possible violations of the Safe
Drinking Water Act of 1974. An additional 167 events involve contaminated
sites and/or subsurface water contamination, typically involving violations
under the Resource Conservation and Recovery Act of 1976 or the Comprehensive Environmental Response, Compensation, and Liability Act of
1980. The types of environmental harm in the remaining 63 events either
involve two or more of the preceding categories or are classified as miscellaneous. The miscellaneous group includes violations under the Toxic Substances and Control Act of 1976, charges of improper storage of hazardous
661
materials, and several cases in which the specific violation is not discernible
from the available press articles.
Type of Action. Table 1 shows that only 28 events involve criminal
lawsuits. Many more (197) involve civil lawsuits filed by either private parties
or such agencies as the EPA. State and federal regulatory fines or actions
compose 146 events, and in 31 events the initial announcement indicates
that the firm and regulatory agency agreed to a court-sanctioned consent
order. In 38 events, a firm recalled a product to avoid environmental sanctions.
As an example, in May 1986 General Motors recalled more than 86,000
automobiles that violated emission standards. A final 38 events are classified
as liability assignments. These involve situations in which the initial Wall
Street Journal press announcement reveals that the defendant firm had been
assigned liability for a previously reported environmental violation. For example, in January 1993, a California appellate court upheld most of a jury
verdict requiring Shell Oil, rather than its insurers, to pay the companys
estimated $1 billion cost of a toxic-waste cleanup near Denver.
Party Bringing the Action. Forty-six percent (221) of the events involve
lawsuits or regulatory actions brought by the EPA. An additional 86 events
involve civil or criminal lawsuits filed by the Department of Justice. In many
of these 86 events, the Justice Department acted in cooperation with or relied
in part upon EPA investigations. In 101 events, the action was brought by
a state or local environmental agency. Environmental groups, such as the
Sierra Club Legal Defense Fund, were directly involved at the beginning of
only eight of the events (typically as plaintiffs in lawsuits), and 62 other
events were initiated by individuals. This last category includes several classaction lawsuits.
IV.
Market Value Effects of Environmental

Violation Announcements
In this section we investigate the effects on firm values when news about
a violation is first announced. In 108 of the 478 events, the initial press
report indicates that an environmental violation may have occurred. We label
these allegation announcements. For example, in January 1995 a WCI Steel
plant discharged contaminated water into a nearby stream. The firm eventually settled with the EPA by paying an undisclosed fine, but the initial
announcement revealed only that a violation might have occurred. In 136
events, the initial press report indicates that charges were filed against the
defendant company by a government agency or private party. In the remaining
234 cases, the initial press report indicates settlement of the case. Settlements
include agreements between the defendant firm and the initiating party, consent orders, trial outcomes, and announcements of fines by regulators. Note
that the events classified as settlement announcements are still the first recorded public record of the violation. While these news events report that
662
TABLE 2
Abnormal Stock Returns Associated with the Initial Press Announcements of
Environmental Violations, by Type of Environmental Harm
Announcement Type
Allegation:
Mean
Median
t-statistic
Observations
Charges filed:
Mean
Median
t-statistic
Observations
Settlement:
Mean
Median
t-statistic
Observations
All:
Mean
Median
t-statistic
Observations
Air
Surface or
Drinking
Water
CERCLA/
Contaminated
Site
Miscellaneous
or Multiple
Media
Total
1.56
.81
2.08*
30
1.75
.01
1.55
28
2.33
.78
1.99
34
.49
.42
.68
16
1.69
.66
3.25**
108
.32
.51
.39
20
2.48
1.09
3.29**
41
1.16
.88
2.87**
51
1.97
.68
1.12
24
1.58
.72
3.80**
136
.17
.26
.48
77
.57
.20
1.09
52
.43
.20
1.30
82
.20
.03
.49
23
.35
.11
1.72
234
1.49
.41
3.45**
121
1.04
.43
3.30**
167
.95
.16
1.42
63
1.00
.43
5.12**
478
.52
.48
1.69
127
Note.Average 2-day cumulative abnormal returns for environmental violations reported in the Wall
Street Journal or Factiva database during the period 19802000, categorized by the type of environmental
harm and the announcement type. Allegation announcements contain information that a violation may have
occurred. Announcements of charges filed contain information that formal charges were filed against the
defendant company. Settlement announcements are events in which information about a settlement is
included in the initial press report about the violation. Returns are expressed as percentages. CERCLA p
Comprehensive Environmental Response, Compensation, and Liability Act.
Indicates statistical significance using a two-tailed test at the .10 level.

* Indicates statistical significance using a two-tailed test at the .05 level.
** Indicates statistical significance using a two-tailed test at the .01 level.
the firm settled an environmental charge, they also contain the first press
mention indicating that there was an environmental violation in the first place.
Table 2 reports on the average 2-day abnormal stock returns for the initial
press announcements of environmental violations for all 478 cases and for
each announcement type. The 2-day event window consists of the day before
and the day of the initial press report. Abnormal returns are calculated as
the actual 2-day return minus a forecast return from a one-factor market
model. We estimate the market model using trading days 230 through 31
relative to the initial press date, and we measure market returns using the
CRSP equal-weighted index with dividends. Test statistics are calculated
using the mean and standard error of the cross section of abnormal returns.
Different procedures to calculate the test statisticsfor example, the procedure discussed by Wayne Mikkelson and M. Megan Partchyield quali-
663
tatively identical results.30 The empirical results also are similar when we
use size-adjusted abnormal returns using the method described by Elroy
Dimson and Paul Marsh.31
For all 478 initial press announcements, the average 2-day abnormal stock
return is 1.00 percent, with a t-statistic of 5.12. The share price effect
depends on the type of information contained in the initial announcement.
Announcements of allegations and charges filed result in mean abnormal
stock returns of 1.69 percent and 1.58 percent, respectively, and are
statistically significant at the 1 percent level. The mean abnormal stock return
for settlement announcements, in contrast, is smaller in magnitude (.35
percent) and insignificant at the 5 percent level.32
Nonparametric test statistics (not reported in the table) yield the same
inferences as those in Table 2. For example, the Wilcoxon signed-rank statistic
for all 478 events is 4.77, which indicates that the average abnormal return
is negative. Furthermore, the average abnormal return is negative for each
category of environmental harm. Differences in the average abnormal return
across types of harm are not statistically significant (the F-statistic equals
1.06, with a p-value of .37).
For 55 of the 478 cases, other potentially confounding news about the
defendant company was announced in the Wall Street Journal the day before,
the day of, or the day after the initial press announcement about the environmental violation. Many of these are routine announcements regarding
dividends or earnings reports. Others involve nonroutine announcements regarding asset sales or potential takeover rumors. Omitting these 55 events
from the sample does not materially affect the results. The average abnormal
return for the remaining 423 events, for example, is 1.15 percent (t p
5.36).
We believe that this is the first large-sample study to examine different
types of events to document that news about an environmental violation is
indeed costly for firms. Furthermore, the stock value losses are similar for
different types of environmental harm, including air emissions, water discharges, and site contamination.
30
Wayne H. Mikkelson & M. Megan Partch, Withdrawn Security Offerings, 23 J. Fin. &
Quantitative Analysis 119 (1988).
31
Elroy Dimson & Paul Marsh, Event Study Methodologies and the Size Effect: The Case
of UK Press Recommendations, 17 J. Fin. Econ. 113 (1986).
32
Settlement announcements can result in relatively small share value losses for three reasons.
First, violations that settle quickly may result in smaller penalties than those that do not settle
quickly. Second, settlement announcements may not be the first news of the violation to reach
financial markets. By construction, all announcements in our sample represent the first press
mention of the violation. But it is possible that information about some of our events leaked
before the initial press announcement, particularly when the first press announcement is of a
settlement. And third, settlement announcements contain information that severely reduces
investors uncertainty about the size of the penalty. Such information is not released when the
initial press announcement is about allegations or charges filed.
664
Only the initial press report of a violation causes a significant stock price
reaction. For 102 of the 478 events in our sample, we identified a subsequent
article in the Wall Street Journal or Factiva database that contained substantially new information about the matter. The average abnormal 2-day
stock return for these 102 subsequent announcements is 1.20 percent, with
a t-statistic of 1.00. For 34 of these 102 events, the Wall Street Journal
reports a third news story with significant new developments. The 2-day
abnormal return for the 34 third announcements is .39 percent, with a tstatistic of .58. In collecting the data, we also found 21 announcements that
indicated that pending environmental charges against a defendant company
had been dropped. The mean 2-day abnormal return for these 21 events is
positive but not significantly different from zero.
V.
Legal Penalties for Environmental Violations
Firms violating environmental rules face several forms of legal penalties,

including fines, payments to damaged parties, compliance costs, and cleanup
expenses. The amount paid in settlement of a violation frequently is not
disclosed. But by searching the Factiva electronic database and hard copies
of the Wall Street Journal, we found data on the legal penalties for 148 of
the 478 events in the sample. We base our examination of legal penalties on
these 148 events. In 107 of these events, the offending firm was fined or
ordered to pay monetary damages to an injured party. In 70 events, the firm
paid the costs to comply with regulations or remediate prior damage. In 29
events, the firm paid both a fine and a cleanup cost.
The top section of Table 3 reports data from the 107 events in which fines
were imposed or monetary damages awarded to victims. Although we use
current dollar amounts in citing specific examples, the summary statistics in
Table 3 are in constant year 2000 dollars. The mean amount awarded is $13.2
million, although most amounts are substantially smaller. The median, for
example, is $1.52 million. Although the mean payment levels vary by the
type of environmental harm, a one-way analysis of variance indicates that
the differences are not statistically significant. The F-statistic from the analysis of variance is 1.24, with a p-value of .30.33
Defendant companies frequently pay large amounts in fines and damage
claims. A typical air emission case, for example, is a $990,000 fine paid by
International Paper in 1989 for violations of the Clean Air Act at a Maine
paper pulp mill. Examples of fines for water violations include a 1982 Mobil
33
Clean-air violations are associated with the largest mean penalty, $31.7 million. This mean,
however, is affected by two settlements that are not typical among the air emission cases and
do not reflect actions taken under the Clean Air Acts. The first is Union Carbides $350 million
settlement of claims stemming from the December 3, 1984, leak of poison gas from the firms
Bhopal, India, pesticide plant, and the second is Monsantos $81.9 million settlement of claims
arising from the use of Agent Orange during the Vietnam War. When these unusual cases are
omitted, the mean assessed penalty for air emission cases is $4.5 million.
665
TABLE 3
Sizes of the Legal Penalties Levied for Environmental Violations,
by Type of Environmental Harm
Penalty
Actual fines and
damage awards:
Mean
Median
Observations
Actual compliance
and cleanup costs:
Mean
Median
Observations
Air
Surface or
Drinking
Water
CERCLA/
Miscellaneous
Contaminated or Multiple
Site
Media
31.7
1.2
26
4.0
.8
32
11.0
3.0
32
6.1
1.5
17
13.2
1.5
107
123.0
27.9
12
36.7
5.7
16
108.0
18.8
33
102.0
17.8
9
93.6
13.5
70
Total
Note.Data on the legal penalties imposed for 148 events in our sample for which penalty data are
available in the Wall Street Journal or Factiva database, 19802000. Twenty-nine cases appear in the top
and bottom sections because they have both fine and cleanup cost data. Amounts are in millions of constant
year 2000 dollars. CERCLA p Comprehensive Environmental Response, Compensation, and Liability Act.
Oil agreement to pay the state of Alabama $2 million for illegally discharging
drilling fluids into state waters and a 1998 agreement by Shell Oil to pay
$1,500,000 to settle Justice Department civil charges arising from the companys chemical discharges into the Mississippi River.
The bottom section of Table 3 reports on the 70 events for which we have
information on firms estimated costs to comply with regulatory or courtimposed mandates or to clean up environmental damage. In general, compliance and cleanup costs are substantially higher than fines and damage
awards. In the 1989 International Paper case, for example, in addition to its
$990,000 fine, the firm also agreed to spend $4.2 million to install air pollution
control equipment at its Maine plant. In the 1998 Shell Oil case, the company
also agreed to perform environmental projects valued at over $10 million
along the Mississippi River. As another example, in 1981 Ohio Edison was
fined $1.55 million for sulphur dioxide and other emissions at its coal-burning
power plants. At the same time, the firm agreed to spend an estimated $367
million to comply with Clean Air Act requirements.
Overall, the mean compliance or cleanup cost is $93.6 million, with a
median of $13.5 million. Once again, although the mean values differ according to the type of harm, the differences jointly are not statistically significant (the F-statistic is .40, with a p-value of .75).
VI.
Reputational Costs for Environmental Violations
In this section, we combine data on market value losses with data on the
legal penalties to derive a measure of the reputational cost imposed on environmental violators. To compute the reputational cost, we assume that the
666
initial change in market value is investors unbiased estimate of the total loss
to the firm from its environmental violation. This is consistent with our
finding, reported in Section IV, that the stock price reaction to the initial
announcement captures most of the firms total loss in market value. Some
of this loss is attributable to investors expectations that legal penalties will
be imposed on the firm. Using a rational expectations assumption, we use
the legal penalty eventually imposed as an unbiased estimate of the size of
the legal penalty expected at the time of the initial press announcement. If
the initial market value loss is no greater than the legal penalty, we infer
that the market value loss reflects investors expectations of the legal penalty.
If the market value loss exceeds the legal penalty, then we attribute the
difference to lost reputation.
The null hypothesis in these tests is that there is no reputational effect.
The alternative is that the reputational effect is negative. We thus conduct
one-tailed t-tests to test the null.
We have data on legal penalties for 148 of the 478 violations in our sample.
The top section of Table 4 reports on the reputation effects in these 148
events and for subsets of these events partitioned by the type of environmental
harm. The mean 2-day abnormal stock return for all 148 events is .62
percent. The mean legal penalty for these 148 events is 2.26 percent of the
firms market value of equity. That is, the legal penalties by themselves imply
a loss of 2.26 percent in market value. The difference between the observed
loss and the implied loss from the legal penalties is 1.64 percent. This is our
point estimate of the mean reputational effect. The point estimate is positive
because the legal penalty, on average, more than explains the market value
loss.
The point estimate of the reputational effect also is positive for three of
the four types of environmental harm. Only for water-related violations is
the mean reputational effect negative. Even here, however, the low t-statistic
of .18 indicates that we cannot reject the null hypothesis that the reputational
loss is zero.
The data in the top section of Table 4 include many events in which the
initial press report of the environmental violation is of a settlement. As
reported in Section IV, the mean stock price reaction to settlement announcements is smaller in magnitude than when the initial press announcement is of an allegation or charges filed. It is possible that, for some settlement
announcements, information about the violation was previously available to
investors. Including these events could bias downward our estimates of the
stock price effect of the violation and the reputational loss.
In the bottom section of Table 4, we therefore exclude events in which
the initial press announcement is of a settlement. For the remaining 50 cases,
the mean 2-day abnormal stock return is 1.95 percent. The mean legal
penalty for these 50 cases is 1.55 percent of the market value of equity. The
difference, .4 percent, is the point estimate of the reputational effect. Using
TABLE 4
Reputational Costs for Environmental Violations, by Type of Environmental Harm
Air
All 148 observations with data on both stock returns and legal penalties:
Mean % change in market value
Mean implied % change from the legal penalty imposed
Mean reputational effect (as % of market value) (row 1 row 2)
Reputational effect t-statistic
Number of observations
Excluding initial announcements that include settlement information:
Mean % change in market value
Mean implied % change from the legal penalty imposed
Mean reputational effect (as % of market value) (row 1 row 2)
Reputational effect t-statistic
Number of observations
Surface or
CERCLA/
Miscellaneous or
Drinking Water Contaminated Site Multiple Media
Total
.69
3.9
3.21
1.76
32
.52
.43
.09
.18
41
1.01
1.8
.79
.85
54
.29
4.48
4.78
1.66
21
.62
2.26
1.64
2.39
148
2.79
1.46
1.32
1.10
9
1.57
.77
.80
.86
17
3.26
3.46
.20
.06
14
.00
.26
.26
.27
10
1.95
1.55
.4
.4
50
Note.This table compares firms market value losses to their legal penalties. The t-statistics test the null of no reputational effect against the alternative that the
effect is negative (that is, that there exists a reputational loss). CERCLA p Comprehensive Environmental Response, Compensation, and Liability Act.
668
this estimate, we would conclude that, on average, the reputational penalty

accounts for .4/1.95 percent, or 20.5 percent, of the losses experienced
by firms investigated or charged with environmental violations.
The t-statistic for the mean reputational effect, however, is only .40. So
even for the subsample of events included in the bottom section of the table,
the data cannot reject the null hypothesis that the reputational effect is zero.
Furthermore, none of the estimates of reputational effect are statistically
significant for any of the four types of environmental harm.
The lack of evidence of a reputational penalty is even more notable considering that our measure of the legal penalty ignores some of the explicit
costs many firms face. Such costs typically include attorneys fees, court
costs, managers time, and any lost profits from forgoing the activity that
triggered the environmental charges in the first place. If we were to include
such costs, the portion of the market value loss that we could attribute to
lost reputation would be smaller than reported in Table 4. The fact that our
estimates of the reputational effect are not significantly different from zero
even excluding these other explicit costsserves further to support the conclusion that firms do not on average experience reputational losses when
they violate environmental regulations.
These results are notable also because they differ from the estimates of
large reputational losses reported for product recalls, false advertising, unsafe
services, frauds, punitive damages lawsuits, defense procurement frauds, and
financial misrepresentation (see the footnotes in Section IIA). The fact that
reputational penalties are found for other types of corporate wrongdoing
indicates that our results are not due to low-powered tests. Rather, the results
indicate that environmental violations differ from other types of wrongdoing
in one important respect: firms that violate environmental regulations typically do not impose direct harms on their customers, employees, suppliers,
or other stakeholders. Reputational penalties are negligible in such cases
because there are no repeat market transactions through which the violations
costs are internalized by the firm.
VII.
A.
Extensions
The Cross-Sectional Relation between Abnormal Returns

and the Legal Penalty
In this section, we investigate whether cross-sectional differences in the

stock price reactions are related to the legal penalty. Table 5 reports the
results of robust least squares regressions using White-corrected standard
errors to correct for the presence of heteroskedasticity. The dependent variable
is the firms 2-day abnormal stock return. The independent variables include
dummy variables for allegation and charges filed announcements (leaving
settlement announcements to be reflected in the intercept term), plus (1) a
669
dummy variable set equal to one if we have information that a fine was
imposed on the company, (2) the amount of the fine when a fine is imposed
(this variable is zero for firms for which we do not have fine data), (3) a
dummy variable set equal to one if we have information that compliance or
remediation costs were imposed on the company, and (4) the amount of the
compliance or remediation cost (this variable is zero for firms for which we
do not have cleanup cost data).
The results using data on all 478 events in the sample are reported in
model 1 of Table 5. The coefficients for allegation and charges filed announcements are negative and statistically significant, consistent with our
previous findings that abnormal returns are most negative for these types of
announcements. The negative coefficient for the fine amount (t-statistic p
2.81) indicates that the abnormal stock return is significantly and negatively
related to the size of the fine. The abnormal stock return is not significantly
related to the size of the cleanup cost imposed on the firm.
Model 2 reports the results using data from only the 148 events for which
we have data on the legal penalties. The results are similar to those in model
1. Thus, firms losses in share values are related to the size of the fine or
damage award eventually imposed by regulators or the courts. This is consistent with our finding that legal penalties are important in disciplining
environmental violations. Not only is the average share value loss explained
by the average legal penalty, but in the cross section, the share value loss is
related to the legal penalty at the firm level. Furthermore, it is the fine amount,
not the cleanup cost, that seems to matter in explaining the share value loss.
In results not reported, we find that the abnormal stock return is not
significantly related to other characteristics of the violation, including the
type of environmental harm, the type of action, or the identity of the party
bringing the action. In all of these tests, the abnormal stock return is significantly related to the size of the fine or damage award eventually imposed
on the company. This is consistent with the conclusion that firms share value
losses reflect primarily their expected future legal penalties.
B.
Potential Legal Penalties
Information on the legal penalties is available for only 148 of the 478
events in the sample. For many additional events, however, press reports
provide information on the sizes of penalties that could be imposed. For
example, in 1987 the U.S. Justice Department filed a civil lawsuit seeking
damages from Browning-Ferris Industries for hazardous waste violations at
a Louisiana facility. Press reports at the time speculated that Browning-Ferris
could pay $70 million in damages. We found speculation on such potential
penalties for 212 events in our sample. As might be expected, the potential
penalties are much higher than the actual penalties reported in Table 3. The
670
TABLE 5
Cross-Sectional Relations between Share Value Losses
and Legal Penalties
Independent Variable
Allegation announcements (#102)
Charges filed announcements (#102)
Type and cost of legal penalty imposed:
Dummy variable equal to 1 when fine or
damage award information is available
Dollar amount of the fine or damage award
divided by the market value of firm equity
Dummy variable equal to 1 when compliance
or cleanup cost information is available
Dollar amount of the cleanup cost divided
by the market value of firm equity
Intercept
F-value
p-value
R2
Model 1
Model 2
1.33
(2.19)*
1.19
(2.50)*
2.29
(1.53)
1.70
(2.22)*
.00353
(.76)
.00207
(.17)
.2660
(2.81)**
.0275
(3.01)**
.00118
(.19)
.00541
(.44)
.0217
(1.06)
.0041
(1.28)
3.69
.001
.028
.0179
(.93)
.0053
(.37)
2.84
.012
.079
Note.Least-squares estimates in which the dependent variable is the 2-day announcement period
abnormal stock return. Model 1 data consist of all 478 events in the sample. Model 2 data consist
of 148 events for which we have information on legal penalties. Values in parentheses are t-statistics,
calculated using Whites robust estimator to correct for heteroskedasticity.
* Indicates statistical significance using a two-tailed test at the .05 level.
** Indicates statistical significance using a two-tailed test at the .01 level.
mean potential fine or damage award is $122 million, and the mean potential
cleanup cost is $120 million.
The effect of using these data on potential penalties is to further undermine
any empirical basis for a reputational cost. This is because the potential
penalties are much larger than the firms losses in share values.
Hardly ever, however, is the actual penalty as large as the potential penalty.
In the Browning-Ferris case cited above, the firm eventually paid $2.5 million,
not $70 million. For 28 events in our sample, we have data on both the size
of the potential penalty, as it was discussed in press accounts, and the size
of the actual penalty when it subsequently was reported. The mean reported
potential fine for these 28 cases, in constant year 2000 dollars, is $3.14 billion,
whereas the mean actual fine eventually imposed is only $33.7 million. The
median potential fine is $9.5 million, and the median actual fine is $4.0
million. These data suggest that it is inappropriate to use potential penalties
as proxies for investors expectations of the actual penalties imposed.
C.
671
Sample Selection Bias
Our sample is selected from environmental violations reported in the Wall

Street Journal, with follow-up information collected from the Factiva database. This biases our sample toward violations that the Wall Street Journal
editors deem newsworthy. Anecdotal evidencefor example, the tendency
to include the stock price change in the storysuggests that events with
large valuation consequences are likely to be deemed newsworthy. Thus, the
sample is likely to be slanted toward events with large stock price reactions.
These are precisely the events for which we would expect to measure larger
reputational costs. The fact that we do not find evidence of large reputational
costs further supports the inference that such costs are not significant for
environmental violations.
VIII.
Conclusions
Debate over environmental policy frequently occurs amidst a vacuum of

empirical evidence. Little is known about the sizes of the penalties imposed
on firms that violate environmental regulations and whether such penalties
are imposed by regulators or market forces. If significant penalties are imposed by the marketfor example, through customers or suppliersthen
legal penalties can be redundant and more easily lead to overdeterrence.
In this paper we address these issues by providing empirical evidence on
the market and legal penalties imposed on companies that violate environmental regulations. Our data cover a total of 478 events for 19802000 in
which firms were investigated, convicted, or cited for environmental violations. We find that firms investigated or charged with violating environmental
rules experience statistically significant and economically meaningful decreases in common share values. For announcements of alleged environmental violations, the average abnormal stock return is 1.69 percent, with
a t-statistic of 3.25. For announcements that charges have been filed against
the firm, the average abnormal stock return is 1.58, with a t-statistic of
3.80. This constitutes the first large-sample evidence that news of an environmental violation corresponds to a loss in share value.
The loss in share value, while significant, is not on average larger than
the legal penalties imposed on the violating firm. This implies that the share
value losses are due to prospective legal penalties rather than to any reputational costs. Thus, unlike such other types of corporate wrongdoing as
criminal fraud and product safety problems, reputational concerns are not a
sizeable deterrent to environmental violations. Rather, the primary deterrence
occurs through regulatory and legal penalties. Consistent with this interpretation, we also find that the size of the initial stock price reaction is related
to the regulatory fine that eventually is imposed.
672

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The Booth School of Business, University of Chicago

The Reputational Penalties for Environmental Violations: Empirical Evidence

THE REPUTATIONAL PENALTIES FOR

JOHN R. LOTT, JR.,

the journal of law and economics

these firms share values, on average. Thus, while environmental violators

The Reputational Cost Controversy

Details of the Controversy

As Benjamin Klein and Keith Leffler argue, reputation disciplines certain

the journal of law and economics

on firms committing private frauds reflects lost reputation.14 Only a small

A substantial body of research examines how regulators should set legal

the journal of law and economics

small samples.24 Our data on legal penalties therefore establish a baseline of

We examine 478 cases in which publicly traded firms were investigated

the journal of law and economics

Table 1 provides summary information about the sample. It classifies events

Market Value Effects of Environmental

the journal of law and economics

Indicates statistical significance using a two-tailed test at the .10 level.

the journal of law and economics

Legal Penalties for Environmental Violations

Firms violating environmental rules face several forms of legal penalties,

Reputational Costs for Environmental Violations

the journal of law and economics

the journal of law and economics

this estimate, we would conclude that, on average, the reputational penalty

The Cross-Sectional Relation between Abnormal Returns

In this section, we investigate whether cross-sectional differences in the

Potential Legal Penalties

the journal of law and economics

Sample Selection Bias

Our sample is selected from environmental violations reported in the Wall

Debate over environmental policy frequently occurs amidst a vacuum of

the journal of law and economics

Afsah, Shakeb, Laplante, Benoit; and Wheeler, David. Controlling Industrial

the journal of law and economics

portance of Punitive Damages Awards. Journal of Law and Economics

Peltzman, Sam. The Effects of FTC Advertising Regulation. Journal of

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