MARKET RISK, ACCOUNTING DATA AND COMPANIES’

POLLUTION CONTROL RECORDS

BARRY H. SPICER”

In recent years, the issues of corporate social performance and the social
responsibilities of business (and businessmen) have become the subjects of a
serious, and at times highly controversial, debate at all levels of society. The
accounting profession has not’been overloaked in this ongoing debate. In the
past few years accountants have been regularly exhorted to measure and report
on various aspects of corporate social performance including such issues as
environmental protection, discrimination in hiring and promotion, product
safety, and consumer policies, etc. - Beams and Fertig (1971), Siedler (1975),
Abt (1972), Linowes (1968, 1973), Colantoni, Cooper and Dietzer (1972),
Brummet (1973). Of particular significance in this regard is the proposal of the
Study Group on the Objectives of Financial Statements (1973, pp.53-55) that:

‘‘An objective of financial statements is to report on those activities of the

enterprise affecting society which can be determined or measured and which
are important to the role of the enterprise in its social environment”.

In response, several serious attempts have been made to take the first steps
towards developing a normative theory of accounting for corporate social
performance - Churchill (1974), Estes (1975), Ramanthan, (1976) - and the
question of whether companies should disclose more information (than they
now typically do) on their social performances is currently confronting
accounting policy-makers.

This paper seeks to provide some empirical evidence that may aid accounting
policy-makers t o form judgements on the social performance disclosure issue. To
accomplish this objective the following question is investigated. Does information
on the pollution control records of companies in pollution-prone industries
convey information to investors about the risk attaching to investment in these
companies’ common stocks? There is some evidence to suggest that this might be
the case. A major survey of institutional investor’s views on the perceived
relationship between corporate social performance and investment policy was
conducted for the Ford Foundation by Longstreth and Rosenbloom (1973). The
responses to this survey (1 15 responses from a possible total of 196) revealed
the existence of a relatively widespread view amongst institutional investors that
a moderate to strong association exists between the risk/return profile of an

*The author is Assistant Professor of Accounting in the College of Business

Administration, University of Oregon. (Paper received March 1977, revised
September 19 77)

Journal of Business Finance & Accounting, 5,1(1978) 67

investment in a company’s securities and its social performance on major issues
such as pollution control. Clearly recognized by institutional investors was the
possibility of increased risk and/or lawer returns on investment in a company
that is prone to environmental problems, which fails to respond to public
pressure, and/or is tardy in its compliance with mandated anti-pollution
requirements. To the extend that the statements of institutional investors (such
as those elicited by the Longstreth and Rosenbloom survey) can be relied upon,
it seems reasonable t o form an a priori expectation that information on
companies’ pollution control records might aid investors in assessing risk.

The paper is structured as follows. The first section provides the context for the
study by outlining the research interest of a number of recent studies that have
investigated the association between market-based measures of risk and. various
other firm-specific variables. The second section discusses the selection of the
sample of companies used in the study and the collection of data. A discussion
of the variables used, the methodology employed, and the results of its
application is contained in the third subdivision.The final section presents a brief
summary and conclusions and makes some recommendations for future research.

THE PREDICTION OF MARKET-BASED MEASURES OF RISK

A number of recent research studies have conducted empirical investigations of

the association between market-based measures of risk and various financial and
other firm-specific variables. Ball and Brown (1969) and Gonedes (1973)
investigated the association between accounting income numbers and market
based estimates of systematic risk; Beaver, Kettler and Scholes (1970), Bildersee
(1975) and Breen and Lerner (1973) investigated the association between a
number of accounting-based variables and market-based estimates of systematic
risk in both bivariate and multivariate contexts. Bildersee (1975), Lev and
Kunitzky (1974) and Rosenberg and McKibben (1973), in addition to the more
traditional accounting based variables, also investigated the association of a
number of other firm-specific variables with market-based estimates of risk in
both a bivariate and multivariate context.

The attention now being given to this topic stems from the central role that an
individual security’s systematic risk Pi (defied as the contribution an individual
security makes to portfolio risk) plays in the theory of portfolio mipagement
and the probability that conventional estimates of systematic risk (Bi based
exclusively on historical price series) will contain significant measurement errors.
This latter possibility arises because the process generating a security’s returns
may change over time (i.e., Pi may vary) as investors react to the receipt of
information on events they perceive to have firm-specific impacts. Changes in
management, financial policy or product lines, or exogeneous events such as the
passage of legislation or the promulgation of government regulations that may

68 Barry H . Spicer
have significant economic impacts on certain classes of companies, are examples.
In these circumstances, pi may not provide an unbiased and consistent estimate
of the “true” underlying pi and, hence, may not alone provide a sound basis for
the prediction of future levels of systematic risk. Moreover, evidence on the
stability (stationarity) of systematic risk indicates that while relatively stable at
the portfolio level (where the interest is in the behaviour of averages of pi’s over
time), at the level of the individual security, pi tends to change over time.

Under these conditions relying on conventional estimates of pi alone to predict

the future level of systematic risk is a hazardous undertaking. Attempts to
improve these predictions, first by isolating those events that are perceived by
investors to affect the riskiness of common stocks and then by developing
alternative methods of estimating future levels Of pi, take on added importance.
As a first step towards isolating some of the events that are perceived by
investors to affect the riskiness of common stocks, a number of researchers,
including Beaver, Kettler and Scholes (1970, p.679) and Bildersee (1975, pp.
82-83) have suggested an investigation of the association between market
measures of risk and variables - other than those based on accounting data -
that might affect risk. Along these lines, this study empirically investigates the
association between market measures of risk and companies’ pollution control
records in both a bivariate and multi-variate context.

One criticism that has been leveled at association studies of this type is that they
are basically “fishing expeditions” which have failed to identify the basic
characteristics that determine risk because they are based on inadequate
theoretical investigations of the operational and financial processes affecting a
firm’s risk. However, this criticism seems overly harsh. The fact of the matter is
that the process by which investors judge the riskiness of common stocks is not
well understood. In the absence of a complete underlying theory, some searching
for significant associations by researchers can be expected as an initial step in an
attempt to explain the risk levels assigned by the market to common stocks and
to improve the prediction of future levels of risk.

SAMPLE SELECTION AND DATA COLLECTION

The sampte selected for the investigation consists of 18 firms in the pulp and
paper industry. This particular sample was chosen for two reasons. First, a major
issue of social concern arising out of the operation of firms in the pulp and paper
industry is the resulting pollution of air and water resources and is a major
problem for companies in this industry. This conclusion is supportable in that
the pulp and paper industry is included amongst those industries that spend
substantial proportions of their capital and operating and maintenance budgets
on pollution abatement. In 1973 the pulp and paper industry spent 18.8 per cent
of its capital budget on pollution abatement (McCraw-Hill(l970)) and was

Market risk, accounting data and companies’ pollution control records 69

expected to spend 20.1 per cent in 1974 (Council on Environmental Quality
(1974, pp.233-236). Operating and maintenance expenditures are expected to
make up 60 per cent of total expenditures on pollution abatement. Furthermore,
a review of Standard and Poor’s Surveys of the Paper Industry since 1970 shows
that industry analysts believe that the pressure on the industry to abate its
pollution is of major economic significance. The 1972 survey (p.18) contains this
statement:

“Of the clouds that overhang the industry the question of costs of pollution
control and preservation of the environment is perhaps the darkest ... Overall,
it may be said that the question of pollution control is going to be exerting
considerable pressure on management of paper companies for some time. On
the immediate horizon is the threat of a zero pollution bill that would
prohibit any pollution by 1985. Versions of the bill have been passed by both
the House and Senate. It is estimated that such zero-discharge would require
an expenditure of $5 billion to $8 billion by 1985. Considering that the
industry’s total net worth is only $10.7 billion, this is not a good prospect”.

The second reason for choosing this particular sample is that the firms that make
up the sample were included among the 24 firms in the pulp and paper industry
whose pollution control records were the subject of a major study by the Council
on Economic Priorities CEP (1970). In this study the CEP, on the basis of
extensive data, rated each of the 13 1 pulp mills owned by study firms on the
efficacy of their air and water pollution control systems. This data is essential to
the empirical investigation because it provides the basis for the construction of a
pollution control index that provides a measure of a firm’s relative pollution
control record at a point in time. The CEP rating system and the derivation of a
pollution control index are discussed in the following section.

All financial data on the various companies were taken from the annual
COMPUSTAT tape. Monthly stock price data were obtained from the quarterly
COMPUSTAT tape supplemented where necessary by other sources.

Of the 24 companies studied by the CEP, four were excluded because each had
less than 25 per cent of their sales in the paper industry. While the 25 per cent
sales requirement is admittedly arbitrary, the rationale of using some such cutoff
is to include in the sample only those companies whose record in pollution control
in the paper industry is likely to be considered by investors in making investment
decisions. Two companies were excluded because their financial data were not
available on the annual COMPUSTAT tapes. The remaining 18 firms making up
the sample are listed on the New York Exchange and appear to be generally
representative of the larger firms in the pulp and paper industry. These firms are
listed below:

70 Barry H.Spicer
 NAME OF COMPANY

Boise Cascade International Paper

Champion International Kimberly Clark
Crown Zellerbach Mead
Diamond Potlatch
Fibreboard St. Regis Paper
Georgia-Pacific Scott Paper
Great Northern Nekoosa Union Camp
Hammermill Westvaco
Hoerner-Waldorf Weyerhauser

QUANTIFICATION OF VARIABLES, METHODOLOGY AND RESULTS

The question under investigation is - Does information on the pollution control

records of companies in pollution-prone industries convey information to investors
about the risk attaching to investment in these companies’ common stocks? The
method employed to address this question is an empirical examination of the
cross-sectional relationship between two market measures of risk and a measure
of the pollution control records of sample companies in both a bivariate’and
multivariate context. The methodology draws on a number of recent studies
that have focussed on the association between market measures of risk and
various non-price corporate variables. These studies were referenced in a preceding
section. The objective is to evaluate the contribution that knowledge of
companies’ pollution control records makes towards explaining the observed
variation in market measures of the riskiness of companies’ common stocks.

The following subsecson discusses how the pollution control records and market
measures of risk were quantified for each of the sample companies. Also discussed
is the choice of the time period over which market measures of risk were
quantified. The manner in which other non-price corporate variables used in the
empirical investigation were quantified is explained as necessary in the discussion
of methods and results.

QUANTIFICATION OF POLLUTION CONTROL RECORDS AND MARKET

MEASURES OF RISK

Pollution control record - The measurement of each company’s pollution control

record was achieved by deriving a pollution control index from the basic data
published by the CEP (1970) study of the pollution control systems employed by
each company in their pulping facilities. The CEP study focussed on virgin
pulping facilities of each company because it concluded that these. operations
generate the most severe pollutants of all paper production processes. Because of
this conclusion the CEP (1970, p.43) maintains that pollution control

Market risk, accounting data and companies ’pollution control records 71

performarice of each company in this area’should provide a rough measure of the
seriousness of its abatement activities. In their study the CEP rated each mill on
the efficacy of its air and water pollution control systems. Water pollution control
systems were rated on the “adequacy” of primary, secondary and tertiary
tr-atment facilities installed; air pollution control systems were rated on the
“adequacy” of controls over particulate emissions (from both power and
production equipment) and gas and odour emissions. An “adequate” rating was’
assigned on the basis of an overall evaluation of installed equipment’s ability to
meet “state of the art” criteria which are essentially the highest level of control
technologically and economically achievable. This is a flexible concept which
changes over time as new and more efficient pollution control methods become
available. While there may be disagreement over the method used by the CEP to
make its evaluation, it does have two important virtues. First, it is literally the
only extensive evaluation available and second, the criteria correspond fairly
closely to recent legislative requirements, i.?., those promulgated under the
Federal Water Pollution Control Act Amendments of 1972.

The ratings provided by the CEP were used in this study to develop a pollution
index for each company in the sample. This pollution index was based on the
percentage of a company’s pulp and paper productive capacity (tons/day) with
“adequate” pollution controls and was determined by taking a simple average of
the percentages of productive capacity with: (a) adequate primary water pollution
controls; (b) adequate secondary water ,pollution controls; (c) adequate controls
over particulate emissions; and (d) adequate controls over gas and odour
emissions. For example, if a company had a productive capacity rated at 5,000
tons/day of which: (a) eighty per cent has adequate primary water pollution
controls; (b) forty per cent has adequate secondary water pollution controls;
(c) fifty per cent has adequate controls over particulate emissions; and (d) thirty
per cent has adequate controls over gas and odour emissions, a pollution index
of fifty was assigned to that company. A company with adequate controls in all
categories would be assigned an index of one hundred whereas a company with
inadequate controls in all categories would be assigned a zero index.

Deriving a company’s pollution index in this fashion clearly is open to criticism.

First, the pollution index weighs water and air pollution systems equally whereas
it can be argued that the adequacy of water pollution systems is most important
since greater e,xpenditures are typically required to mitigate water pollution.
Secondly, it would be desirable to utilize water usage rather than productive
capacity to assess the adequacy of water pollution controls due to differences in
mill efficiencies in this respect. Unfortunately, information on water usage was
incomplete in the CEP study. However, within limits, it is felt that the pollution
index as derived provides a reasonable and useful assessment of the relative
pollution control records of the sample companies.

72 Barry H. Spicer
Market measures ofrisk - Two market measures of risk are used in this study.
The first provides a measure of rota1 risk of an individual security and was
computed as the standard deviation of periodic stock returns for each company
in the sample over the 1968-1973 time period. The reasons for choosing this
particular time period are discussed below. The second measure of risk employed
is a measure of security’s systematic or non-diversifiublerisk. It was estimated
from the market or diagonal model as developed by Sharpe (1963), which asserts
a linear relationship between the return on a security and a market factor common
to all assets:

where Rit !i the return on security i in period t; a i and pi are constants for each
security i; Rmt is the aggregate return on all securities in the market in period t
and is referred to as the market factor; and Eit is a random disturbance term
which reflects that portion of a security’s return in time period t that is not a
linear function of Rmt.It is assumed that E(Eit) = 0; 4 R m t , Zit) = 0 for all i; and
cr(Pit, Ejt) = 0 for all i # j. The tildes on Rit, Rmt and Zit denote random variables.
The contribution of the individual security to portfolio risk, i.e., the security’s
systematic risk, is given by pi and is the relevant parameter of interest to investors
concerned with the selection of an optimal portfolio. Estimates of pis for the
time period under study were obtained in the usual manner by running a time-
series least squares regression on monthly price data for the period 1968-1973.
The measure of general market conditions (the market factor) utilized was
Standard and Poor’s Composite Price Index.

The assumption underlying the use of a series of historical returns to measure

both total and systematic risk is that ex ante uncertainty will manifest itself ex
post in the distribution of returns. Therefore, to the extent that the degree of
variability of returns for any stock can be assumed to be a relatively stable
quantity, the ex post measure of risk can be taken as an estimate of ex ante
uncertainty or risk. The higher the observed variation, the higher the risk
involved in holding the stock.

A measure of total as well as systematic risk was included for two reasons. First,
most non-market indicators or measures of risk (such as those based on accounting
data) are seen as measures of total rather than systematic risk - Beaver, Kettler
and Scholes (1970, p.659), Bildcrsee (1975, p.82). If this is so, then an improved
understanding of the determinants of total risk may lead also to an improved
understanding of the determinants of each of the systematic and individualistic
components of total risk. Along these lines, Beaver, Kettler and Scholes (1970,
pp.659-660) argue that it is reasonable to view accounting measures not only as
surrogates for total risk of a company’s common stock but as surrogates for
systematic risk as well. They base this argument on evidence that indicates a

Market risk, accounting duta and companies’pollution control records 73

strong positive correlation between the systematic and indiFdualistic components
of total risk. The second reason for including a measure of total risk is based on
the contention that has been raised in the literature that total risk may be the
relevant measure of risk for some investors. While it may be true that an investor
can avoid the effects of unsystematic or individualistic risk by the simple expedient
of diversifying his portfolio, it has been argued that a diversified portfolio may not
be available to all investors because of limited resources (Bierman 1974). For these
investors, as well as those who, for one reason or another, have a substantial stake
in one corporation (e.g., controlling shareholders) the means to assess the total
risk attaching to a company’s shares is clearly relevant.

The choice of the 1968-1973time period - This specific time period was chosen
for several reasons. First, it spans a period of significant growth in public pressure
for environmental protection and pollution control (c.f., Coppock et al. 1972)
in which a number of major and far reaching pieces of environmental legislation
were enacted.’ Second, the time at which the CEP released its 1970 report on
the pollution control records of sample companies is centered at the midpoint of
the 1968-1973 time period. If information on companies’ pollution control
records is relevant to investors’ risk assessments, then it seems reasonable to
expect the impact of this information to be reflected in measures of market risk
over the 1968-1973 time period. Furthermore, as it is likely that at least part of
the information compiled by the CEP 1970 report was previously available to the
market via press reports, company news releases, etc., the assumption made in
this study is that market risk, if impacted, would be impacted over the entire
1968-1973 time period. No attempt was made to ascertain whether changes in
risk lagged the public availability of information on companies’ pollution control
records or vice versa. Rather the assumption is that the impact on market risk
occurred over the entire 1968-1973 time period.* In this context, a reasonable
interpretation of a company’s pollutipn control index based on the data
contained in the CEP’s 1970 report, is that it provides a measure of the
responsiveness of sample companies to public pressure for pollution abatement
over the study period.

METHOD AND RESULTS

Some preliminary evidence on the contemporaneous association between the

riskiness of companies’ common stocks and their pollution control records was
obtained by computing Spearman’s Rank Order Correlations between the variables
of interest. Table 1 presents correlation coefficients (rs) which indicate the degree
of association between the total and systematic risk of sample companies’
common stocks and their pollution control records. In each case the signs on the
correlation coefficients indicate an inverse association between companies’
pollution control records and the riskiness of their common stocks. While the rs
and their associated levels of significance for a one-tailed test (given in brackets)

74 Barry H. Spicer
do not allow rejection of a null hypothesis of no association at a .05level of
significance for a one-tailed test, they are, in each case, reasonably close to the
margin of significance.

TABLE 1
SPEARMAN RANK ORDER CORRELATIONS

Variable of Interest I Pollution Index Based on the Percentage of

Productive Capacity Adequately Controlled

Total Risk -.2918

(.121)
Systematic Risk - .3890
(.056)

To extend the correlational analysis, two sets of partial correlations also were
calculated between each measure of risk and the measure of companies’
pollution control records, i.e., the pollution index based on productive capacity.
In each case, a different set of control variables was used. These control variables
were drawn from previous studies that had shown them to be associated
significantly with market measures of risk. Removal of the effects of variation in
these variables from the measure of association between the variables of interest
here, should provide at least a preliminary indication of the potential contribution
the pollution control variable can make towards the explanation of the observed
variation in market measures of risk.

The first set of partial correlation coefficients reported in Table 2 control for
those accounting-based measures of risk used by Beaver, Kettler and Scholes
(1970) as instrumental variables in the prediction of future systematic risk on
the basis of past estimated systematic risk. These included earnings variability,
average asset growth and average payout. Computation of these variables for
the sample period 1968-1973 followed the definitions given by Beaver, Kettler
and Scholes (1 970, p.666). While seven accounting variables originally were
included in the regression equation by the researchers, due to multi-collinearity
problems the final instrumental equation contained only the three accounting
measures mentioned above. The seven accounting variables originally included
were payout, leverage, liquidity, size, earnings variability and an accounting beta
which measured the covariability of each firm’searnings with that of an overall
market average of earnings.

Market risk, accounting data and companies ’pollution control records 75

The second set of partial correlation coefiicients reported in Table 2 coritrol .for
those smoothing measures and accounting ratios that Lev and Kunitzky (1974)
found to exhibit significant associations with market measures of risk. Based on
a review of arguments on the subject of smoothing, Lev and Kunitzky hypothesized
that the ability of a firm to smooth its various input and output series (such as
sales and capital expenditures) in order to decrease environmental uncertainty
should be associated with market-determined risk measures. They found the
smoothing indices for sales, dividends, capital expenditures and earnings, together
with an average dividend payout ratio, to be associated significantly with market
measures of risk in a multivariate context. These variables are controlled for in
the second set of partial correlations reported in Table 2 . Computation of these
variables for the sample period 1968-1973 followed the definitions given by Lev
and Kunitzky (1974, p.263). The extent of smoothness of a series was measured
by the mean absolute deviation of the actual changes in the variable from the
trend over the sample period.

TABLE 2
PARTIAL CORRELATIONS BETWEEN COMPANIES’ POLLUTION
CONTROL RECORDS AND MARKET MEASURES OF RISK

Partial correlations controlling for Partial correlations controlling for

earnings variability, growth and sales, dividend, capital expenditure
payout ratioa and earning smoothing indices and
Variable of payoutb
I
Interest
Pollution index based on the percent Pollution index based on the percent
of productive capacity adequately of productive capacity adequately
controlled (1970 data) controlled (1970 data)
I I
I I
Total risk -.3437 -.4825
(.114) (.047)
Systematic -.5411 -.5112
risk (.023) (.037)

aAccounting based variables used by Beaver, Kettler and Scholes (1970) as instrumental
variables in the prediction of future systematic risk on the basis of past estimates of
systematic risk.
hariables found by I,ev and Kunitzky (1974) to be significantly associated with the risk of
common stocks.

The partial correlations and their associated levels of significance (given in

brackets) reported in Table 2 suggest that, at least for this sample and for the
time period studied, market measures of risk and companies’ pollution control
records tended to be associated significantly even when the effects of other
nonmarket measures of risk utilized in previous studies have had their effects
removed. These results provide additional support for the contention that
76 Barry H. Spicer
knowledge of a company’s pollution control may convey information to investors
that is useful for assessing the riskiness of common stocks. However, this
conclusion should be tempered by an understanding that in partial correlation
the effect of the control variable(s) is assumed to be linear throughout its range.
The extent to which this assumption may be assumed to hold for this data has
not been investigated.

Multiple regression analysis also was employed to evaluate the potential

contribution of the pollution control variable to the explanation of observed
variation in market measures of risk. The following method was employed:

(1) For each measure of market risk,a stepwise multiple regression was run to
select from among a list of nine accountingbased variables those three variables
which explain the greatest proportion of’the observed variation in the dependent
variable (total risk or systematic risk) over the sample period.

The stepwise regression program used was that contained in Nie, Hull, Jenkins,
Steinbrenner and Bent (1975, Ch.20). In this program, the independent variable
chosen for entry at each step is the variable not yet in the regression equation
which has the largest square partial correlation with the dependent variable.
That is, the variable chosen to enter is the one which explains the greatest amount
of the variance in the dependent variable which is unexplained by variables
already in the equation. The nine accounting variables from which this selection
was made were:

(a) Profitability - average of the annual ratios of income available for

common stockholders to ending common stockholders equity.

(b) Size - average of the natural logarithms of the yearly total asset size.

(c) Leverage - average of the annual ratios of senior securities to total assets.

(d) Growth - natural logarithm of the ratio of total closing asset size in year
1 to the total closing asset size in year t.

(e) Coverage - average of the annual ratios of net income plus fmed charges
to fmed charges.

(f) Turnover - average of the annual ratios of net sales to total assets.

(g) Liquidity - average of the annual current ratios.

(h) Payout - sum of cash dividends paid to common stockholders to the

sum of income available for common stockholders for the sample period.
Market risk, accounting data and companies ’pollutioncontrol records 77
 (i) Earning variability - standard deviation of the earnings/market price ratio.
The stepwise regression was cut off after only three variables entered the regressior
equation beoause it was found that inclusion of all, or most, of the nine variables
in the regression equation was potentially harmful and caused the adjusted
coefficient of multiple correlation (corrected RZ)to fall. This is consistent with
the findings of Beaver, Kettler and Scholes (1970, p.672) who found that
inclusion of more than a few instrumental variables in the regression equation
caused the standard error of the estimate to increase.

( 2 ) The contribution of the pollution control variable to the explanation of

observed variation in market measures of risk was then evaluated in two ways.
The first method employed was to add the pollution control variable to the
regression equation containing the best three accountingyariable predictors and
then calculate the increment in explained variation expressed as a proportion of
the variation unexplained by the three accounting variables already in the
equation. The second method employed was to add the next best accounting
variable to the regression equation containing the best three accounting variable
predictors. The proportional increment in explained variation so obtained was
then compared with that obtained from the addition of the pollution control
variable. The purpose of this comparison was to provide some indication as to

TABLE 3
MULTIPLE REGRESSION ANALYSIS: TOTAL RISK ON ACCOUNTING
DATA AND A MEASURE OF POLLUTION CONTROL
Stepwise Regression iddition of Pollution Addition of Pollution
to Find Best Three :ndex to the Accounting Ratio to
Accounting Ratios iegression the Regression
Independent
Variable Zoefficient t-value "efficient t-value
-
Constant .0584 1.94 ,0875 2.91
Earning variability .3846 4.01 .4123 3.81
Size -.0069 - ,0002 .05 -.0058 1.88
Leverage .0382 .0811 2.65 .0379 1.67
Pollution index - ,0004 1.86
(productive capacity)
Current ratio .0031 .61
Summary statistics
Coefficient of multiple
correlation ~2 ,677 .749 ,688
Corrected R2 ,631 .692 .6 17
F-rat io 9.08 8.98 6.63
Proportionate increase .225 ,035
in explained variation
due to addition of
independent variable

78 Barry H. Spicer
which of the two variables - the pollution index or the next best accounting
ratio - explained the greatest proportion of the variation in total and systematic
risk not explained by the regression containing the best three accounting variable
predictors.

The results of these various regressions are set out in Table 3 and Table 4. The
results in Table 3 are for the dependent variable total risk.

As can be seen from Table 3, the initial stepwise regression selected three variables:
earning variability, size and leverage. The addition of the pollution control
variable (which enters the re ression with the correct sign) results in an
improvement in corrected The squared partial correlation coefficient
between total risk and pollution control variable when earnings variability, size
and leverage are controlled for is .225. This indicates that the increase in
explained variation expressed as a proportion of unexplained variation is 22.5
per cent. This is significantly higher than the proportional increase in explained
variation of 3.5 per cent that results from the addition of the next best account-
ing variable (the current ratio), to the regression equation. It is interesting to
note that an unrestricted stepwise regression to find the best four predictors of
total risk from all nine accounting variables and the pollution control index based
on productive capacity, resulted in the same regression equation as in column 2
of Table 3.
TABLE 4
MULTIPLE REGRESSION ANALYSIS: SYSTEMATIC RISK ON
ACCOUNTING DATA AND A MEASURE OF POLLUTION CONTROL
Stepwise Regression 9ddition of Pollution Addition of Next Best
to Find Best Three Lndex to the Accounting Ratio to
Independent
Variable
Accounting Ratios
Coefficient
h e Regression
- -
h e Regression

Constant 1.3841
t-value
2.13
Zoefficient
1.2640
-
t-value 3efficient
1.91 1.412
-
t-value
2.13
Earning variability 4.SO41 1.97 4.869 1.99 3.519 1.18
Size -.lo28 1.44 -.0153 .5 8 -.0914 1.24
Current ratio .1568 1.34 ,1323 1.1 1 .2128 1.53
Pollution index -.0039 .98
(productive capacity)
Payout -.4317 .78
Summary statistics
Coet'ficient of multiple
correlation ~2 .433 .475 .461
Corrected R2 .352 .354 .336
F-rat io 3.3 1 2.12 2.56
Proportionate increase .075 .048
in explained variation
due to addition of
independent variable
- -
Market risk, accounting data and companies 'pollution control records '9
The results in Table 4 are for the dependent variable systematic risk.
In this case the initial stepwise selected three accounting variables: earning
variability, size and the current ratio. The addition of the pollution control
variable (which once again enters the regression with the correct sign), results in
only a marginal improvement in corrected R” The squared partial correlation
coefficient between systematic risk and the pollution control variable when
earning variability, size and the current ratio are controlled for, is .075,indicating
that the proportional increase in explained variation is 7.5 per cent. This may be
compared to the 4.8 .per cent increase which results when the next best account-
ing variable, the payout ratio, is added to the regression.

To summarize, the results of the multiple regression analyses, like the results of
the preceding partial correlation analysis, also provide some support for the
contention that information on companies’ pollution control records may be
relevant to investors for assessing both the total and systematic risk of common
stocks. However, one interesting aspect of the regression analysis should be
noted. As can be seen from both Tables 3 and 4 when the pollution control
variable is forced into the regression there is a sharp decline in the coefficient
and significance of the size variable in the regression equation. Statistically, this
is due to the fact that t h e e two variables are highly correlated. (Pearson’s
product moment correlation is .64). One plausible explanation of this result may
be that risk is closely related to size which in turn affects the availability of
resources to the company and hence its ability to finance the purchase and
installation of pollution control equipment.

SUMMARY AND CONCLUSIONS

The question of whether investors would find information on corporate social

performance relevant for investment decision-making purposes is being given
increased attention by the accounting profession and accounting policy-makers
at the SEC and elsewhere. The contribution of this study has been t o demonstrate
that knowledge of companies’ relative pollution control records does appear to
have the potential to convey some relevant information (over and above that
which is contained in published accounting data) to investors for judging the
riskiness of the common stocks of companies in pollution-prone industries.
However, the results of the partial correlation and multiple regression analyses
on which this finding is based are only a first step. Additional research is
necessary before it can be stated (with a reasonable level of confidence) that
information on companies’ pollution control record’s is actually useful to
investors for estimating risk.

One avenue for future research would be to determine whether the passage of
major environmental control legislation (which establishes a basis for judging

80 Barry H. Spicer
companies’ pollution control records) has an observable impact on the market’s
perception of the level of risk (total and systematic) attaching to the shares of
companies in pollution-prone industries. If it can be established that investors
(in aggregate) do react to information about events pertinent to the determination
of companies’ pollution control records (to the extent such information is
publicly available) then a stronger case can be made for increasing the content of
this information by (1) experimenting with alternative specifications, measures
and reporting formats for companies’ pollution control records and/or (2)
increasing the accessibility of this information by reducing its cost to investors.

NOTES
At the federal level major enactments include: The Clean Air Act of 1970, the Federal
Water Pollution Control Act Amendments of 1972, the Resource Recovery Act of 1970
and the National Environmental Policy Act of 1969.

It may be noted at this point that &s for sample companies were subjected to a relatively
simple test for stationarity. This was accomplished by an F test of the null hypothesis of
no difference for each company’s &s computed for equal time periods before and after
1970. It was possible to reject the null hypothesis for only one of the 18 sample
companies.
’ However, the F test for the contribution of the pollution control variable to the
regression equation was not significant at 01 = .05 for either the regression on total risk or
the regression on systematic risk.

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Market risk, accounting data and companies’ pollution control records 83