SCUOLA DI INGEGNERIA INDUSTRIALE E DELL’INFORMAZIONE Corso di Laurea Magistrale in Management Engineering
The Effects of Environmental Disasters and Pollution Alerts on Stock Markets: Evidence from China
Master graduation thesis by: Emilia Tona - 837649
Supervisor: Prof. Giancarlo Giudici
Co-supervisors: Prof. Vikash Ramiah, Dr. Huy Pham
Academic Year 2016 - 2017
The Effects of Environmental Disasters and Pollution Alerts on Stock Markets: Evidence from China
Dedicated to my family,
who always believed in me.
ii The Effects of Environmental Disasters and Pollution Alerts on Stock Markets: Evidence from China
Acknowledgments
I would like to thank Giancarlo Giudici for supporting me in writing this thesis and
for having give me the unique opportunity to spend part of my research period in
Australia, an highly formative experience.
I thank Vikash Ramiah for having welcome me in his research team at University of
South Australia and for the working time spent together. A special thank goes to Huy
Pham for his invaluable support with my research work. I’d like to further thank
Vikash and Huy for having invite me to present my thesis work at the International
Environmental Finance Conference at Ton Duc Thang University.
Moreover, I want to thank Minuha Yang, Xi Yu, Ammar Asbi, Yu He, Christa
Viljoen and Braam Lowies for their special contribute to this amazing experience. I
loved being part of “Vik's Team” and I enjoyed the family environment during our
Friday meetings.
Finally, I’d like to thank my family for their priceless support in every decision of
my life, and especially for always giving me the chance to decide about my future,
without any constrain. Last, but not least, a very special thank to Gianni, the one who
shared with me every tear and every smile, every failure and every success. The one
who has always been by my side, since the beginning, and today more than ever this
goal is also his goal.
iii The Effects of Environmental Disasters and Pollution Alerts on Stock Markets: Evidence from China
Abstract
Environmental disasters cause severe losses in human lives and wellbeing but also
have effects on the economic and industrial activity, impacting on firms’ future
performance and investors’ perception of risk. In 2015, a series of explosions at a
container storage station at the Port of Tianjin involved the detonation of about many
kinds of hazardous and highly toxic chemical, leading to hundreds of deaths and
injuries. Considering that China is one of the largest polluters around the world, it
surely is a key case study to understand the relationship between environmental
disasters and economic activity.
In this thesis we study the effects of 18 chemical disasters, oil spills and pollution
alerts on the Chinese stock market from 2003 to 2015, with the scope to find out how
these catastrophic events affect investors’ behavior. We apply the event study
methodology to analyse how these events affect the stock prices of the different
industries in China. We supplement the methodology with various robustness tests in
order to find out whether these events generate abnormal returns (ARs).
Additionally, we estimate the change in systematic risk, applying GARCH, threshold
ARCH (TARCH), exponential GARCH (EGARCH) and power-ARCH (PARCH).
Our findings show that these events do generate significantly positive and negative
returns for different industries. Surprisingly, there is no clear pattern to state that
polluting industries are the most penalized. On the contrary, there is a clear pattern
showing that environmental disasters create uncertainty on the market and often
change the risk perceived by investors both in the short and long run.
Keywords: Environmental Disasters, Environmental Regulation, Event Study,
Systematic Risk
iv The Effects of Environmental Disasters and Pollution Alerts on Stock Markets: Evidence from China
Abstract – Italiano
I disastri ambientali causano gravi perdite nella vita e nel benessere delle persone,
ma hanno anche effetti sull'attività economica e industriale, incidendo sul rendimento
futuro delle imprese e sulla percezione del rischio da parte degli investitori. Nel
2015, una serie di esplosioni presso una stazione di stoccaggio nel porto di Tianjin ha
comportato la detonazione di molteplici sostanze chimiche pericolose e altamente
tossiche, causando centinaia di morti e feriti. Considerando che la Cina è uno dei
paesi che inquina maggiormente al mondo, questo è sicuramente un caso studio
chiave per comprendere la relazione tra disastri ambientali e attività economica.
In questa tesi studiamo gli effetti di 18 disastri chimici, sversamenti di petrolio e
allarmi sull'inquinamento sul mercato azionario cinese dal 2003 al 2015, con lo
scopo di scoprire come questi eventi catastrofici influenzano il comportamento degli
investitori. Applichiamo la metodologia di studio degli eventi per analizzare come
questi influenzano i prezzi delle azioni delle diverse industrie in Cina. Integriamo la
metodologia con vari test di robustezza per scoprire se questi eventi generano
rendimenti anomali (AR). Inoltre, stimiamo la variazione del rischio sistematico,
applicando GARCH, threshold-ARCH (TARCH), exponential-GARCH (EGARCH)
e power-ARCH (PARCH).
I nostri risultati mostrano questi eventi generano rendimenti significativamente
positivi e negativi per diversi settori. Sorprendentemente, non esiste un modello
chiaro per affermare che le industrie inquinanti sono le più penalizzate. Al contrario,
vi è uno schema chiaro che dimostra che i disastri ambientali creano incertezza sul
mercato e spesso cambiano il rischio percepito dagli investitori sia a breve che a
lungo termine.
v The Effects of Environmental Disasters and Pollution Alerts on Stock Markets: Evidence from China
Table of Contents
Acknowledgments ...... iii
Abstract ...... iv
Abstract – Italiano ...... v
Table of Contents ...... vi
List of Figures ...... viii
List of Tables ...... x
1Introduction ...... 4
2Literature Review ...... 10
2.1 Environmental Regulation Literature ...... 11
2.1.1 Macroeconomic Effects of Environmental Regulations ...... 12 2.1.2 Microeconomic Effects of Environmental Regulations ...... 20 2.1.3 The Financial Effects of Environmental Regulations ...... 25 2.1.4 Social and Environmental Accounting and Reporting ...... 32 2.2 Environmental Regulation in China ...... 36
2.3 Environmental and Natural Disasters Literature ...... 44
2.4History of Event Study Methodology ...... 48
2.4.1 The One-Factor Model ...... 50 2.4.2 The Three-Factor Model ...... 52 2.4.3 The Four-Factor Model ...... 55 2.4.4Event Study Methodology applied to Environmental Finance ...... 60 3Methodology ...... 70
3.1 Abnormal Return ...... 70
3.2 Robustness Tests ...... 74
3.3 Risk Analysis ...... 79
4 Data and Empirical Findings ...... 85
4.1 Data and Background ...... 85
vi The Effects of Environmental Disasters and Pollution Alerts on Stock Markets: Evidence from China
4.2 Empirical Results of Event Study Analysis ...... 91
4.3 Empirical Results of Robustness Tests ...... 102
4.4 Risk Analysis: short- term and long-term change in risk ...... 106
5 Conclusions ...... 118
Bibliography ...... 122
vii The Effects of Environmental Disasters and Pollution Alerts on Stock Markets: Evidence from China
List of Figures
Figure 1: Kuznets curve graph ...... 18
Figure 2: Trends in Infant Mortality Rate. Tanaka, 2010 ...... 37
Figure 3: The impact response curve of Environmental regulation to FDI.Peng at al.
(2011) ...... 42
Figure 4: Impact response curves of FDI to environmental regulation. Peng at al.
(2011) ...... 42
Figure5 : Long-Term Climate Change Risk in China. Ramiah et al. (2015a) ...... 44
Figure 6: China’s map where the provinces that failed in achieving the water quality
target are marked in red and the provinces that achieved the water quality target
are marked in blue ...... 86
Figure 7: Number of statistically significant (95% level) positive reactions of the
106 stock indexes to environmental disasters and pollution alerts...... 97
Figure 8: Number of statistically significant (95% level) negative reactions of the
106 stock indexes to environmental disasters and pollution alerts...... 97
Figure 9: Risk analysis. Short term change in systematic risk following chemical
disasters...... 111
Figure 10: Risk analysis. Short term change in systematic risk following oil spills.
...... 112
Figure 11: Risk analysis. Short term change in systematic risk following pollution
alerts...... 112
Figure 12: Risk analysis. Long term change in systematic risk following pollution
chemical disasters...... 113
Figure 13: Risk analysis. Long term change in systematic risk following oil spills.
...... 113
viii The Effects of Environmental Disasters and Pollution Alerts on Stock Markets: Evidence from China
Figure 14: Risk analysis. Long term change in systematic risk following pollution
alerts...... 114
ix The Effects of Environmental Disasters and Pollution Alerts on Stock Markets: Evidence from China
List of Tables
Table 1: Chemical Disasters ...... 89
Table 2: Oil Spills ...... 90
Table 3: Pollution Alerts ...... 90
Table4 : Reaction of the stock market to environmental disasters and pollution alerts
in China: statistics about the mean abnormal returns (AR) and mean cumulated
abnormal returns in five days (CAR5) and ten days (CAR10) around the event
dates...... 96
Table 5: Reaction of the stock market to environmental disasters and pollution alerts
in China: statistically significant abnormal returns(AR) under three benchmark
models. T-statistics in parentheses ...... 98
Table 6: Reaction of the stock market to environmental disasters and pollution alerts
in China: statistically significant cumulated abnormal returns (CAR) in five and
ten days after the event. T-statistics in parentheses ...... 100
Table 7: Reaction of the stock market to environmental disasters and pollution alerts
in China: robustness tests on abnormal returns (AR). T-statistics in parentheses
...... 103
Table 8: Risk Analysis. Aggregate change in systematic risk ...... 109
Table 9: Risk Analysis. Robustness Tests on Aggregate Risk Model ...... 110
x
The Effects of Environmental Disasters and Pollution Alerts on Stock Markets: Evidence from China
Chapter 1
Introduction
2 The Effects of Environmental Disasters and Pollution Alerts on Stock Markets: Evidence from China
3 The Effects of Environmental Disasters and Pollution Alerts on Stock Markets: Evidence from China
1Introduction
On August 12 th 2015, the blast of about 800 tons of ammonium nitrate and 500 tons
of potassium nitrate, as well as other 40 kinds of hazardous and highly toxic
chemicals, caused a series of explosions killing 173 people from burns and injuring
hundreds of others at a container storage station at the Port of Tianjin (China),with
shock-waves felt many kilometers away. Thousands of people were evacuated from
the area with water, soil and air having been heavily contaminated.
Environmental disasters cause enormous losses of life and wealth every year—a
threat that is recognized as a priority and addressed in public policies. A number of
these accidents occur as a direct consequence of human industrial activity (soil and
water contamination, oil and toxic material leakage, plant explosions) whilst other
events are believed to be indirectly provoked by the release of greenhouse gas
(GHG) emissions and the consequent global warming (droughts, floods and storms).
China is one of the largest polluters around the world, contributing to 19.5% of total
worldwide industrial output and 22.3% of total global of GHG emissions 1 but is also
one the countries who is investing more on renewable energy 2 and sustainability
(Bonzanini et al., 2016; Kutan et al., 2017). Therefore, China is a key case study to
understand the relationship between environmental disasters and economic activity.
This topic is important, because the growth of energy consumption and industrial
activity, as to progress and reduce poverty, generates a trade-off between
1Data are reported from the World Factbook issued by the US Central Intelligence Agency.
2See http://www.businessinsider.com/china-green-energy-plan-2017-5
4 The Effects of Environmental Disasters and Pollution Alerts on Stock Markets: Evidence from China
sustainability and development, that must be addressed by policymakers and
regulators in their agenda.
The main objective of this study is to examine the effect of environmental disasters
and pollution alerts on the Chinese stock markets. Scant research exists that
investigates the relationship between natural disasters and stock market performance
of listed companies in fast-growing countries and therefore China’s pursuit to
balance economic growth and environment pollution remains a challenge (Yuan,
2016; Liu et al., 2017) that can benefit from academic research.
We collected information about chemical disasters and oil spills occurred in China
from 2003 to 2015. In the recent years, the Chinese government showed a high
interest in the minimization of the level pollution, through the introduction of the
Heavy Air Pollution Contingency Plan. With the aim to understand how this plan
impacts on the most polluting industries, we integrated our study with the analysis of
pollution alerts. In sum, our database is made up by 18 events. We analyse the effects
of the events on the Chinese stock markets, identifying 106 industry indexes and
computing the abnormal returns. We find significantly positive and negative returns
for different industries. Surprisingly, there is no clear pattern to state that polluting
industries are the most penalized. On the contrary, there is a clear pattern showing
that environmental industries create uncertainty on the market and often increase the
risk perceived by investors in some industries both in the short and long run.
Our contribution adds to the existing literature in a number of ways. This work is the
first to address the effect on stock markets of chemical disasters, oil spills and
5 The Effects of Environmental Disasters and Pollution Alerts on Stock Markets: Evidence from China
pollution alerts in a country like China which is driving the global economy growth
and where environmental issues are relevant. Second, we show abnormal returns on
stock markets may be interpreted as signals from the market about the expected
commitment from public authorities to leverage on environmental disasters to
introduce more tight regulation and requirements to manufacturing companies. In the
case of China, this signal is very weak. Third, we document environmental alarms
create uncertainty on the exchange, modifying investors’ risk perception; this raises
concerns about the capability of investors to estimate correctly the environmental
risk of polluting industries.
The work proceeds as follows. Chapter 2 firstly reviews the existing literature related
to environmental regulation. Secondly it focuses on the relationship between
environmental regulation and emergencies and stock prices. Thirdly if shows a brief
history the event study methodology. Chapter 3 shows the applied methodology,
while Chapter 4 describes the data, the empirical analysis and main findings. Chapter
5 concludes with our considerations.
6 The Effects of Environmental Disasters and Pollution Alerts on Stock Markets: Evidence from China
7 The Effects of Environmental Disasters and Pollution Alerts on Stock Markets: Evidence from China
Chapter 2
Literature Review
8 The Effects of Environmental Disasters and Pollution Alerts on Stock Markets: Evidence from China
9 The Effects of Environmental Disasters and Pollution Alerts on Stock Markets: Evidence from China
2Literature Review
The use of finance principles to examine environmental issuesis a relatively new
research area and at present, the definition of this area is not in unison. For instance,
it is called “environmental finance” in Australia (Ramiah, Martin and Moosa, 2013)
and “sustainable finance” in Europe (Heinrichs, Martens, Michelsen and Wiek,
2015). Sandor (2012), at Columbia University in the United States, assessed that we
can refer to “environmental finance” as (1) in terms of the use of financial
instruments to protect the environment and (2) when ecological economics
paradigms are applied to finance and investment. Furthermore, Ramiah et al. (2013)
contribute to this discussion by showing that when environmental regulations are
combined with financial markets, it falls under the umbrella of environmental
finance. More recently, Ramiah and Gregoriou (2016) expand this definition by
showing that environmental/sustainable finance covers other areas such as corporate
social responsibility (CSR), public environmental investments, carbon trading, green
bonds, socially responsible investment funds, water markets, corporate
environmental performance and crowd funding of renewable energy projects.
As discussed above, the definition of “environmental finance” is relatively dispersed
and thus this chapter reviews the concept of environmental finance as well as other
closely related fields such as environmental economics and environmental
accounting. Additionally, we show a potential gap in the current literature related to
the effects of environmental disasters.
10 The Effects of Environmental Disasters and Pollution Alerts on Stock Markets: Evidence from China
This chapter is then structured as follows. Section 2.1presents the effects of
environmental regulations on the economy from macroeconomic, microeconomic
and financial point of view, with a further focus on Chinese market. Given that the
main aim of this is to study the effects of environmental disasters on China’s
financial markets, section 2.2 turns its focus to environmental regulation in China.
Section 2.3 reviews the studies related to the impacts of environmental and natural
disasters showing the potential gap and Section 2.4 discusses the event study
literature and its application on environmental finance.
2.1 Environmental Regulation Literature
In this section, we discuss various effects of environmental regulations on the
economy. Firstly, we discuss the literature around the impact of environmental
regulations on macroeconomic indicators such as employment, export, import,
competitiveness and productivity. Within the economics discipline, many scholars
consider environmental regulation as one of the reasons for macroeconomic
disasters, while others claim that environmental degradation is the major cause.
Secondly, we discuss the effects of environmental regulations on microeconomics
factors including plant location, costs of production and productivity. These factors
influence the cost structure of a firm, which plays a fundamental role in the process
of profit maximization. Any new regulations, including environmental regulations,
might alter the production costs, influence a firm’s decision in locating its new plant,
or require the firm to hire more labour to attain the obligatory environmental
standards that in turn affects the productivity.
11 The Effects of Environmental Disasters and Pollution Alerts on Stock Markets: Evidence from China
Finally, we discuss the literature on the effects of environmental regulation in
finance, which cover several areas such as stock prices and returns, corporate
profitability, market value and risk. The overall conclusion is that the effect of
environmental regulations varies across industries and countries. Given that
environmental regulations are designed to achieve various objectives in each
different country, we observed a country effect of environmental regulations.
2.1.1 Macroeconomic Effects of Environmental Regulations
The effects of environmental regulation on employment have been examined
extensively in the literature and three outcomes can be found from the
macroeconomic literature that are negative, positive and no effect. The first outcome
is supported by Crandall (1981) who argues that excessive environmental regulations
and regulations in general cause an increase in inflation, a lag in GDP growth, a
reduction in productivity growth and the depreciation of the currency. Furthermore,
Walsh (2012) affirms that the President Obama’s refusal to tighten ozone standards,
which was suggested by the Environmental Protection Agency in 2011, saved
thousands of jobs. In addition, Greenstone, List, and Syverson (2012) argue that the
introduction and expansion of the U.S. environmental policy are the main reasons for
the decrease in the U.S. manufacturing workforce from 1970 to 2012.
On the other hand, Repetto (1995) claims that higher investments in more
environmentally-friendly equipment could limit the growth of employment but they
are not causing any job loss and, in fact, environmental protection creates more jobs.
In addition, Bezdek, Wendling, and Di Perna (2008) show the evidence of the
12 The Effects of Environmental Disasters and Pollution Alerts on Stock Markets: Evidence from China
positive aggregate effect of investments in environmental regulations on
employment.
Other studies have shown that the relationship between employment and
environmental policies does not exist. Eberly (2011) and Sinclair and Vesey (2012),
for instance, claim that no empirical evidence demonstrates that a decline in
employment is caused by changes in regulation. Moosa and Ramiah (2014) support
this argument by showing cross-sectional scatter diagrams between unemployment
and environmental burden. Moreover, Morgenstern, Pizer and Shih (2000) argue that
the relationship between employment and environmental policies is insignificant.
Regarding international trade, many studies have examined the relationship between
trading activities and environmental risk. The literature we will discuss afterwards
shows that environmental regulations have no negative impact on international trade
apart from manufacturing industries. According to Tobey (1990), Walter (1982),
Pearson (1987) and Leonard (1988), there is no statistically significant effect of strict
environmental regulations on net exports.
By examining the relationship between importing activities and environmental costs,
Grossman and Krueger (1993) find no relationship between pollution control costs in
the U.S. and imports from Mexico and no cross-industry difference in environmental
costs. Furthermore, Jaffe, Peterson, Portney and Stavins (1995) contribute to this
debate by showing the small international difference of environmental costs
compared to differences in labour costs and productivity.
13 The Effects of Environmental Disasters and Pollution Alerts on Stock Markets: Evidence from China
Kalt (1988) demonstrates that changes in environmental compliance costs do not
explain the change in net exports for the entire economy with an exception for
manufacturing industries where a negative effect is observed. Maitra (2003)
examines 78 industrial categories for the period between 1967 and 1977 and, similar
to Kalt (1988), fails to establish a relationship with the overall market but observes a
relationship within the manufacturing industry.
Moreover, the effects of environmental regulations on international trade have been
examined via comparative advantages in export amongst countries. For instance,
Low and Yeats (1992) analyse the export activities of “dirty” industries, which have
the highest pollution control costs, in multiple countries. They demonstrate that
developed countries reduce the proportion of “dirty” product exports, whereas
developing countries increase the proportion of “dirty” product exports during the
period between 1965 and 1988. Furthermore, Low and Yeats’s (1992) study shows
that there is an increase in comparative advantage for developing countries that
export pollution-intensive products. In a more recent study, Levy and Dinopoulos
(2016) find that environmentally-friendly (polluting) firms earn more profits and
engage in more exporting activities if the consumers have strong (weak) preferences
for environmental quality.
When we examine the relationship between environmental regulation and
competitiveness, we find that the direction between the two factors at country level is
uncertain. The adverse effect of environmental regulation on competitiveness in
international markets has been documented in the literature by Moosa and Ramiah
(2014) where the authors show that environmental regulations have three main
14 The Effects of Environmental Disasters and Pollution Alerts on Stock Markets: Evidence from China
effects: rise in imports, decrease in exports and the tendency of regulated companies
to move overseas. Stewart (1993), however, suggests that the reduction in
international competitiveness due to stringent environmental policies is just one of
the possible outcomes but he argues that the contribution of a cleaner environment
and resource conservation should be considered.
On the other hand, according to Porter (1991), the international competitiveness may
be improved by environmental regulation. The Environmental Protection Agency
(1992) argues that the introduction of environmental regulations lead to a reduction
in emission and overall costs of businesses are achieved through more cost-effective
processes. Esty and Porter (2002) support this finding by showing that countries with
a more stringent and aggressive environmental regime tend to be more competitive.
Other studies argue that environmental regulations can boost competitiveness via
innovation. For instance, Gardiner (1994) affirms that it is beneficial for domestic
economy if more stringent policies are also imposed in other countries. Barbera and
McConnell (1990) indicates that environmental regulation can encourage companies
to invest more in research activities to invent new, less polluting and more efficient
production techniques that will subsequently improve competitiveness.
The relationship between environmental regulations and international
competitiveness can be expressed in an indirect way if we analyse the real effective
exchange rate, whose determinant factors are: the nominal exchange rate, the
domestic inflation, and the foreign inflation (Moosa and Ramiah, 2014). The
environmental regulations might cause an increase in the real exchange rate, due to
15 The Effects of Environmental Disasters and Pollution Alerts on Stock Markets: Evidence from China
an appreciation of the nominal currency or an increase in domestic inflation relative
to foreign inflation, with a consequent decrease in the competitiveness level. By
applying the flexible-price monetary model, Moosa et al. (2014) suggest that the
general currency will depreciate if the environmental regulation unfavorably affects
the economic growth. However, the authors argue that there is no clear evidence that
the environmental regulation would increase inflation and shrink competitiveness.
This result is consistent with a study by Haveman and Christainsen (1981) in which
the authors shows how environmental regulation might cause a one-time rise in the
price of particular goods and services but it does not result in a continuous growth in
the price level or inflation rate.
The debate around the true effect of environmental regulations on economic growth
is still unsettled. Some authors sustain that there is a trade-off between economic
growth and environmental degradation. For instance, Moosa et al. (2014),argue that
the increase in economic activity requires more inputs that causes a larger amount of
environmental waste, and therefore environmental degradation. Daly (1991) sustains
that an increase in environmental waste and concentration of pollutants lead to the
degradation of environmental quality that will subsequently cause a greater decrease
in human welfare in comparison to surges in income.
The Jorgenson and Wilcoxen’s (1990) study shows that average growth rate of the
real Gross National Product (GNP) of the U.S. drops by approximately 0.2% per
year, over the period from 1974 to 1985, due to the effects of operating costs
associated to pollution control, pollution control investment, and compliance with
motor vehicle emission standards. The authors also find that GNP may have been
16 The Effects of Environmental Disasters and Pollution Alerts on Stock Markets: Evidence from China
1.7% higher than the actual historical value in the absence of environmental
regulations.
On the other hand, Beckerman (1992) illustrates that, in the long run, becoming
wealthy certainly improves the environment, showing a positive correlation between
environmental improvement and economic growth. Meyer (1992) finds that the effort
to improve environmental quality doesn’t deter economic growth and development.
Munasinghe (1999) contributes to this discussion by showing that the adoption of
more environmentally sustainable regulations fosters higher development levels at a
lower environmental cost. Moreover, Esty and Porter (2002) argue that promoting
economic growth is one of the most important aspects to enhance environmental
results.
Selden and Song (1994), referring to the environmental Kuznets or inverted-U curve,
argue “while industrialization and agricultural modernization may initially lead to
increased pollution, other factors may cause the eventual downturn, at least for some
pollutants”. Xepapadeas (2005) suggests to include environmental factor in the
economic growth models in order to analyse a number of issues in environmental
economics. The author concludes that environmental pollution negatively affects the
utility of individuals.
17 The Effects of Environmental Disasters and Pollution Alerts on Stock Markets: Evidence from China
Figure 1: Kuznets curve graph
Nevertheless, Zhang (2012) argues that is not cautious to use the environmental
Kuznets curve hypothesis to solve environmental problems in economic growth
because the true relationship can be N-shaped or more flexible shape. Moreover, the
author claims that environmental quality can be a produ ctive input for economic
growth.
Regarding the impact of environmental regulation on productivity, the literature give
us evidence of the existence of two main lines of thoughts, one is supporter of the
negative relationship, the other one is against this theory. However, we can notice
how the first line of thoughts has been mostly supported by studies conducted before
the Kyoto Protocol (2005). Instead, after the Kyoto Protocol a positive impact of
environmental regulation on productivity has been reported. Moreover, productivity
levels always vary across industries because they adopt different technologies in their
production processes, and the productivity level of sectors/firms is also affected
differently by different categories of environmental regulations.
18 The Effects of Environmental Disasters and Pollution Alerts on Stock Markets: Evidence from China
The measure of the impact of environmental regulation on productivity can be
conducted using three main approaches: growth accounting, macroeconomic general
equilibrium models, and single-equation models. The first approach has been applied
by Denison (1979) who finds a loss between 13% and 20% in productivity due to
environmental regulations. However, Denison (1979) has been criticized by
Haveman and Christainsen (1981) because of his failure in explaining the large
residual factor and because his methodology ignores the effects of energy crisis.
Another critique comes from Moosa et al. (2014) regarding the lack in considering
how the change in labour and capital requirement for product redesign can shift to
more energy efficient products.
The macroeconomic general equilibrium model, that includes a long-term growth
component, has been applied by Jorgenson and Wilcoxen (1990) who find an
increase of 3.79% in capital stock and a raise of 2.5% in the GNP in the absence of
environmental regulations. Data Resources Incorporated (1979) discovers that the
pollution control investment leaves no room for alternative capital investments in
plant and equipment with a consequent decrease in labour productivity (more
employees are required to maintain the production at that level).
Thirdly, Haveman and Christainsen (1981) introduce the single-equation models to
show an adverse effect of environmental policies on productivity. Siegel (1979)
explains the structural breaks in productivity between 1967 and 1973 finding that the
reduction of pollution expenditure was a significant negative factor. According to
Gollop and Roberts (1983) and later to Gray (1987), the slowdown in productivity is
caused by regulations, especially environmental regulations, in the 1970s. In addition
19 The Effects of Environmental Disasters and Pollution Alerts on Stock Markets: Evidence from China
to this discussion, Barbera and McConnel (1986, 1990) argue that the average
productivity of polluting industries is negatively affected by environmental
regulations However Berman and Bui (1999) sustain that the effects of
environmental regulations on productivity are not necessarily negative and can
instead be positive under certain conditions. Moosa and Ramiah’s (2014) study also
illustrate a positive relationship between environmental regulation and labour
productivity.
2.1.2 Microeconomic Effects of Environmental Regulations
According to Moosa and Ramiah (2014) the effect of environmental regulations on
the costs of production can be measured through various approaches, including the
survey approach and analytical cost function approach. Although the estimation
process is not perfect, the literature suggests us that compliance costs of
environmental regulations affect business activities with a possible reduction in
firms’ profits and shareholders’ benefits. Moreover, given that firms do not have
identical cost structures, the effect of environmental regulations on cost structure
may differ at a firm level.
In the U.S., the Census Bureau has been using the Pollution Abatement Cost and
Expenditure (PACE) survey to estimate the cost of environment protection to private
industry since 1973. However, Berman and Bui (1999) and later Becker and
Henderson (2001) provide clear indication that the survey approach is not ideal for
measuring costs of environmental regulations on production showing a clear concern
about possible mistakes the estimation of costs.
20 The Effects of Environmental Disasters and Pollution Alerts on Stock Markets: Evidence from China
Through the application of analytical cost function approach, Becker et al. (2001)
study the costs of environmental regulations on firms in different industries and find
that production in heavily-regulated firms results in higher costs in comparison to
less-regulated firms. The authors also suggest that there is an higher vulnerability to
environmental regulation in young firms. Moreover, Becker et al. (2001) argue that
PACE underestimated the environmental expenditures.
From the literature, it’s evident that the debate about the difference between ex-ante
and ex-post costs of environmental regulations is still unsettled. For instance,
Oosterhuis (2006) illustrates how the ex-post realised costs of environmental
regulations are doubled up by the ex-ante estimation of costs. Crain and Crain (2010)
further highlight that the report commissioned by the Small Business Administration
uses different sources of data to deliver the total costs of federal regulations on firms.
Additionally, Sinclair and Vesey (2012) contribute to this debate arguing that the
limitation in the estimation of the Office of Management and Budget for major
federal regulations in the U.S. is partly due to the dependence on agencies’ ex-ante
estimates.
Apart from the cost of production, the choice on plant location plays a significant
role in the cost structure of a firm. According to the pollution haven hypothesis by
Levinson and Taylor(2008), firms tend to relocate to countries where environmental
policies are less stringent and in particular firms from developed countries tend to
move their polluting businesses to developing countries in order to avoid stringent
environmental regulations. This process, known as carbon shifting process, allows
the firms to reduce compliance costs and benefit from cheap labour with a
21 The Effects of Environmental Disasters and Pollution Alerts on Stock Markets: Evidence from China
consequent reduction of production costs. Moosa et al. (2014) argue that the
maximisation of expected net present value plays one of the main roles in making a
decision on plant location and timing.
The effect of environmental regulations on plant location can be measured through
the use of the survey approach and the econometric approach. For instance, Stafford
(1985) and Lyne (1990) use the survey approach to interview business executives
who are involved in the decision-makingprocess of plant location and find that
environmental regulation is not one of the main determinants of plant location.
Moreover, Levinson (1996) shows some concern about the interpretation of survey
results and about the accurate measurement of the real effect of environmental
regulation on plant location.
The econometric approach to measure the effect of environmental regulations on
plant location has been applied for instance by Bartik (1988) who shows that the
effects of environmental variables on business locations are small within Fortune 500
companies during the period from 1972 to 1978. Furthermore, McConnell and
Schwab (1990) use the same econometric approach on the data from vehicle
assembly plants in the 1970sdemonstrating that environmental regulations appear not
to affect firm-location decisions. Additionally, Levinson (1996) in his study about
the effects of the stringency of state environmental regulations on plant location,
finds a weak relationship between differences in environmental regulations amongst
the states of the U.S. and location choices.
22 The Effects of Environmental Disasters and Pollution Alerts on Stock Markets: Evidence from China
However, Becker and Henderson (2000) criticize the studies by McConnel and
Schwab (1990) and Levinson (1996) from many aspects. The authors argue that the
previous studies ignore differences within states’ regulations and group both
polluting and non-polluting industries together. Furthermore, they observe that no
specific regulatory process is used as a proxy for environmental regulation in those
studies. In their study of investigation of the effects of air quality regulation on plant
location, births, sizes and investment pattern decisions in polluting industries in the
U.S., Becker and Henderson (2000) show that the reason why polluting industries
relocate to less polluted regions is to evade stringent environmental regulations
which significantly affect timing of plant investments.
The foreign direct investment (FDI) is another factor that could be used to study the
effect of environmental regulations on firm-location decisions. For instance, Jaffe et
al. (1995) show that the effects of environmental regulations on firms’ investment
decisions can be examined via either change in FDI or decisions for domestic plants.
The authors conclude that the motivating factors for environmental regulations and
taxes are similar. However, Moosa et al. (2014) sustain that most literature on FDI
does not consider environmental regulation as a factor that determines changes in
FDI. Wheeler and Mody (1992) and Moosa and Cardak (2006), for instance, when
studying the determinants of FDI do not include the environmental factor.
Other studies have investigated the effects of environmental regulations on
investment decisions of businesses. Marcus and Kaufman’s (1986) study, for
instance, shows that firms are hesitant and cautious in response to new energy policy.
Yang, Burns and Backhouse (2004) contribute to this discussion arguing that
23 The Effects of Environmental Disasters and Pollution Alerts on Stock Markets: Evidence from China
environmental uncertainty leads to the postponement of investment decisions. On the
other hand, Hoffman (2007)argue that the EU ETS results caused an increase in
investment in technology of German electricity industry, but that the technological
changes are moderate in comparison to the carbon emission targets of the EU ETS.
Furthermore, Hoffmann, Trautmann and Hamprecht (2009) sustain that investment
decisions in the German power industry are not deferred by regulatory uncertainty
caused by EU ETS.
The literature on the relationship between environmental regulations and productivity
at the firm and sectoral levels is relatively sparse. According to Moosa et al. (2014),
the effect of environmental regulations on productivity at thefirm and sectoral level
can be estimated through labour productivity (LP) or total factor productivity (TFP).
Labour productivity is calculated as an amount of unit produced by a unit of labour,
ignoring the contribution of capital, energy, and materials. The total factor
productivity is estimated as an amount of output produced by a unit of aggregate
inputs. Gray (1987) observes that the two techniques can lead to an incorrect
measurement of the effect of environmental regulations on productivity because of
their lack in differentiating the contribution of regulatory compliance costs from
other input costs. Additionally, Gray and Shadbegian (1993) argue that measurement
errors are caused by the use of observed productivity figures that lead to biased
results.
Berman and Bui (1999) apply micro-regulatory changes to provide variation between
regions and assess effects of regulatory changes on PACE directly to overcome
selection bias and measurement errors. The authors also show that environmental
24 The Effects of Environmental Disasters and Pollution Alerts on Stock Markets: Evidence from China
regulations cause an increase in environmental operating costs which only affects
productivity in the short-term. Moreover, Greenstone et al. (2012) measure a
decrease of 2.6% in TFP due to stricter air quality regulations, in particular oriented
to manage the ozone levels.
Nevertheless, Graff and Neidel (2011) evaluate a negative correlation between the
productivity of farm workers and ozone levels and in particular they measure an
average labour productivity increases by 4.2% when the ozone level declines by 10
parts-per-billion. The authors further postulate the possibility to have additional
benefits if the government promulgates more stringent regulations on ozone
pollution.
2.1.3 The Financial Effects of Environmental Regulations
In the literature a number of studies confirm the presence of a relationship between
environmental issues and the stock market. According to Moosa and Ramiah (2014),
stock prices and returns will be determined by the investors’ opinions on whether the
information is good news or bad news for underlying companies. Ramiah, Moosa
and Martin (2013) argue that environmental regulations can produce three possible
stock market reactions: positive, negative and mixed. Feldman Soyka and Ameer
(1996) sustain that an increase in returns by approximately 5% tend to be
experienced by firms with environmental management and environmental
performance, since they have lower perceived risks. Klassen and McLaughlin (1996)
find a positive relationship between environmental news and abnormal returns when
firms win environmental awards. By studying 748 U.S. environmentally-friendly
25 The Effects of Environmental Disasters and Pollution Alerts on Stock Markets: Evidence from China
firms through the Carhart 4-factor Model, Chan and Walter (2014) find that high
environmental performing firms create wealth for shareholders in the long run. In
their study of analysis of the relationship between environmental regulations and the
stock market, Ramiah Morris, Moosa, Gangemi and Puican (2016) find that the U.K.
stock market mostly reacts positively to announcements of environmental regulation.
“Green effect” is a new term emerging in this field by Pham, Ramiah and Moosa’s
(2015) study, which refers to abnormal return associated with environmental
regulations.
However, Moosa et al. (2014) argue that a negative reaction with a consequent
negative abnormal return is detected when environmental regulations are regarded as
bad news by investors. Moreover Muoghalu, Robinson and Glascock (1990) find that
hazardous waste lawsuits in the U.S. cause a statistically significant loss of 1.2% on
the stock market value corresponding to a loss of $33.3 million in equity value.
Hamilton (1995) finds that investors are likely to experience a statistically significant
negative abnormal returns if firms release higher pollution figures in Toxics Release
Inventory reports, with an average loss of $4.1 million in stock value when the
information arrives. Additionally, White (1995) detects a strong negative risk-
adjusted returns by environmentally-oriented mutual funds when firms have poor
environmental performance. Klassen and McLaughlin (1996) conclude that news
about an environmental crises leads to significantly negative abnormal returns.
Mixed reactions to environmental regulations can be detected in the stock market.
For instance, Flammer (2012) studies the relationship between announcements of
environmental CSR and stock market reaction using event study methodology and
26 The Effects of Environmental Disasters and Pollution Alerts on Stock Markets: Evidence from China
finds firms that behave responsibly towards the environment experience an increases
in stock prices while firms that behave irresponsibly towards the environment have a
decrease in stock prices. The author concludes both positive stock market reaction to
eco-friendly events and negative stock market reaction to eco-harmful events of
firms that have higher levels of environmental CSR. In their study, Ramiah et al.
(2013) hypothesise that investors in polluting industries have to experience negative
abnormal returns whilst environmentally-friendly industries have to experience
positive abnormal returns, assuming that the environmental authority has the
objective to penalise polluters and encourage environmentally-friendly businesses.
Ramiah et al. (2013) detect no changes in the wealth of shareholders of industries
considered as heavy polluters, such as the electricity industry, in Australia after the
implementation of stringent environmental regulation. The authors explain this
results by the ability of electricity providers to pass the costs of environmental
regulations onto consumers. On the other hand, a value destruction is experienced by
shareholders of other industries that are not considered as the biggest polluters, such
as the beverage sector, as they experience an increase in the cost of production
originating from the rise of electricity cost. Due to these findings, Ramiah et al.
(2013) argue that green policies are not effective in their current forms.
By studying the relationship between EU ETS and stock markets Veith, Werner and
Zimmermann (2009),suggest that firms in European electricity industries
successfully pass environmental costs onto consumers and overcompensate for all
the costs originated by a rise in the price of emission allowances. The authors remark
the existence of a positive correlation between share prices of electricity providers
and rising prices for emission allowances. Furthermore, Oberndorfer (2009) finds
27 The Effects of Environmental Disasters and Pollution Alerts on Stock Markets: Evidence from China
results that are consistent with Veith et al. (2009), by studying electricity
corporations in Italy, UK, Denmark, Finland, Portugal, Germany and Spain. The
author also shows a negative reaction of electricity providers’ stock prices to a
decrease in European Union Allowance (EUA) prices and these results vary across
countries. Additionally, Oestreich and Tsiakas (2015) show that German firms that
receive free EUA experience higher stock returns in comparison to firms that do not.
The authors also suggest that a higher carbon risk is associated with polluting firms,
hence they are likely to have higher expected returns.
The effects of the costs to be compliant with environmental regulations on firms’
financial performance have been largely studied in the literature. The literature we
analyse shows that environmental regulations tend to cause three possible effects on
corporate profitability: negative, positive and neutral. For instance, Spicer
(1978)shows that when U.S. firms in the pulp and paper industry have better
pollution-control records, they tend to have higher profitability and lower systematic
risk in comparison to firms that have poorer performance. Porter and Van Der Linde
(1995) further suggest that environmental regulations promote business innovations
which in turn reduces costs of compliance with a consequent increase in profitability.
Hart and Ahuja (1996) conduce a study on S&P500 firms and show that putting
some effort into reducing emissions through pollution prevention increases firms’
profitability within the two-year period after initiating the procedure. Waddock and
Graves (1997) find a positive relationship between corporate social performance
(CSP) and profitability. Additionally, Hart (1997) states that “in the industrialized
nations, more and more companies are ‘going green’ as the firms realize that they
28 The Effects of Environmental Disasters and Pollution Alerts on Stock Markets: Evidence from China
can reduce pollution and increase profits simultaneously”. Analyzing the relationship
between environmental regulations and profitability in Egypt, Wahba (2008)finds a
statistically significant positive relationship between corporate environmental
responsibility and market value as measured by Tobin’s q ratio. The author further
concludes that if firms have a better corporate environmental responsibility
performance, it is likely that Tobin’s q ratio is higher than one and the firms will be
more profitable.
On the other hand, Chen and Metcalf (1980) sustain that firm management hesitates
to increase pollution abatement costs because it leads to lower reported earnings. The
authors also state that there is not enough evidence to claim a positive relationship
between the pollution control records and profitability due to the fact that high-
earning firms have higher pollution abatement costs, whereas low-earning firms have
lower abatement costs. Moreover, Wagner, Vanphu, Azomahou and Wehrmeyer’s
(2002) study uses dummy variables to spot the effects of sub-sectoral influences for
various sub-sectors of industrial sectors and find a significant negative relationship
between environmental performance and economic performance within the paper
industry in the UK, Italy, the Netherlands, and Germany.
Other studies show that the relationship between environmental compliance and
financial performance is not significant. Mahapatra (1984), for instance, concludes
that a relationship between the pollution abatement costs and profitability does not
exist due to the fact that pollution control costs do not produce income. Mill (2006)
fails to observe a relationship even after looking at mean risk-adjusted returns of
firms. Murray, Sinclair, Power and Gray (2006) further fail to link share prices with
29 The Effects of Environmental Disasters and Pollution Alerts on Stock Markets: Evidence from China
environmental disclosures in a time series analysis after studying the relationship
between share prices and environmental and social disclosures by examining 100
largest firms in the U.K.. In a more recent study, Naila (2013) fails to establish this
relationship with manufacturing firms in Tanzania and has been criticised for having
a small sample bias. McWilliams and Siegel (2000) sustain that the reason for not
establishing a relationship is due to the failure to consider R&D costs.
Considering that the market value of a firm can be defined as the value of the
outstanding shares, which is calculated by either multiplying the number of shares by
stock prices, orby summing the value of debt and equity where required rate of return
or cost of funding is an important element, Moosa et al. (2014) suggest that the
environmental performance of firms can affect both stock prices and cost of funding
implying the effect of environmental performance on the market value of firms.
Among the studies that analyse the relationship between environmental regulations
and market value, Cohen, Fenn, and Naimon (1995), explain that the market returns
of S&P500 is generally met or exceeded by the return of well-balanced portfolios
that track S&P500 and include environmental leaders in the portfolios. Dowell, Hart,
and Yeung (2000) conduct a study on market value of U.S. multinational
corporations whose results show corporations with higher environmental standards
can have much higher market values. The authors further sustain that environmental
regulations create and not destroy the value of the firm and propose three factors to
support the statement. Firstly, there is no evidence of cost savings when firms
commit to lower environmental standards. Secondly, if firms do not adopt higher
environmental standards, new investment can be more costly. Finally, adhering to
30 The Effects of Environmental Disasters and Pollution Alerts on Stock Markets: Evidence from China
higher environmental standards leads to several benefits for firms, including
heightening employee morale, that as a consequnce, increases productivity. Cahan,
Chen, Chen and Nguyen (2015) show that when firms have good CSR performance
and favourable media coverage, they experience an increase in firms’ value or lower
cost of capital. A new valuation model has been developed by Fatemi, Fooladi and
Tehranian (2015) with the purpose to evaluate the effects of CSR performance on the
value of firms and the results indicate a value creation for firms if they spend their
resources on the community, society or environment. However, Vernon (1992) and
Korten (1995) argue that it can be more costly for firms when recapitalising old
equipment that is not environmentally friendly, with a consequent decrease in
earnings which negatively affect the market value of firms.
The literature about the impact that environmental regulations have on risk is wide
spread. The fact that regulations including environmental regulations create
uncertainties on the market can lead to changes in stock prices and market volatility.
According to Ramiah et al. (2013), the Australian stock market can have mixed
reactions to environmental regulations and polluting (environmentally-friendly)
industries can become riskier (less risky). By studying 300 large public U.S. firms,
Feldman et al. (1996) examine the relationship between environmental management
and risk in order to understand how corporate environmental activities affect the firm
market value. Their results indicate that when firms invest in their environmental
management, they experience a significant reduction in perceived risk and an
increase in stock price of approximately 5%. Halkos and Sepetis (2007) further
analyse the stock prices of Greek firms and find that improvements in the
31 The Effects of Environmental Disasters and Pollution Alerts on Stock Markets: Evidence from China
environmental management system and environmental performance cause a
reduction in firms’ beta.
Ramiah et al. (2013) observe that green policies affect both the short-term and long-
term systematic risk. The authors’ results show that, in case of stringent
environmental control, systematic risks of polluters increase and systematic risks of
environmentally-friendly industries decrease, and the reverse happens when the
policies are rejected. Ramiah et al. (2013) sustain that political uncertainties
surrounding a particular regulation cause changes in risks and the authors label it as
the diamond risk structure of environmental regulations.
Furthermore, Ramiah, Pichelli and Moosa (2015b) study the risk shifting pattern in
the U.S. and find an increase in short-term systematic risk of one of the leading
polluters (oil and gas refining industry). From their study it results that 47% of
industries are not affected by the announcements of environmental regulation, while
36% of industries experience an increase in short-term systematic risks, and 17% of
industries encounter a decrease in short-term systematic risks. In addition, Ramiah et
al. (2015b) claim that U.S. industries tend to be more responsive to environmental
regulations with respect to Chinese industries.
2.1.4 Social and Environmental Accounting and Reporting
The commitment of countries to reduce their carbon emission forces companies to
adopt a more socially responsible behavior. In the literature many researchers study
the relationship between environmental performance and environmental disclosures
32 The Effects of Environmental Disasters and Pollution Alerts on Stock Markets: Evidence from China
and the results are quite heterogeneous. Numerous studies show poor environmental
performers tend to release more environmental disclosures while other studies find
firms tend to provide more disclosure if they have a high environmental performance
index. On the other hand, many articles argue that there is no relationship between
environmental performance and environmental disclosures.
Feldman, Soyka and Ameer (1996) focus their study on the importance of an
organization to be socially responsible. The authors find that when firms adopt better
environmental management and achieve higher environmental performance, they
have the tendency to experience lower risk and higher return. A study conduct by
Michelon, Pilonato, Ricceri and Roberts (2016) suggests that some firms may try to
cover up their environmental disasters, and corporate and financial frauds by
publishing their social and environmental reports.
Patten (2002) studies the relationship between environmental disclosures and
environmental performance of 131 U.S. companies by using the data obtained from
the Environmental Protection Agency’s Toxics Release Inventory (TRI) The author
finds that “higher levels of toxic releases (adjusted for firm size) are associated with
higher levels of environmental disclosure (measured using both content analysis and
financial report line counts)”. In other words, Patten (2002) highlights that firms tend
to release environmental disclosures if they are polluting more. Bewley and Li
(2000) arrived to similar conclusions studying the annual reports of 188 Canadian
manufacturing firms. The authors suggest a negative association between
environmental performance and environmental disclosures. Hughes, Anderson and
Golden (2001) analyse 51 U.S. manufacturing firms and they also find that
33 The Effects of Environmental Disasters and Pollution Alerts on Stock Markets: Evidence from China
environmental disclosures are mostly released by poor environmental performers. In
their study, Freedman and Jaggi (2005) argue that the polluting firms in countries
that are committed to the Kyoto Protocol have relatively greater environmental
disclosures. The results are consistent also with Cho and Patten’s (2007) findings.
They conclude that “poorer environmental performance leads to higher levels of
disclosure”. Similarly, Farag, Meng and Mallin (2015) investigate the social
performance of Chinese listed non-financial companies in the Shanghai Stock
Exchange. They find that the high social disclosure is associated more with
environmentally sensitive industries and that little attention has been paid to ethical
issues. Interestingly, their findings show that the better the financial performance, the
worse the corporate social performance disclosure.
On the other hand, a positive correlation between environmental performance and
environmental disclosures has been spotted by a number of studies. Among them,
Al-Tuwaijri, Christensen and Hughes (2004) argue that there is a positive
relationship between environmental disclosures and environmental performance.
Similarly, in their study about environmental disclosures of 191 firms in 2003 from
pulp and paper, chemicals, oil and gas, metals and mining and utilities industries,
Clarkson, Li, Richardson and Vasvari (2008) find a positive relationship between
environmental performance and level of discretionary disclosures in environmental
and social reports.
Moreover, in the literature there are studies which find that the relationship between
environmental performance and environmental disclosures is not significant. For
instance, Ingram and Frazier (1980)study 40 firms supervised by the Council on
34 The Effects of Environmental Disasters and Pollution Alerts on Stock Markets: Evidence from China
Economic Priorities (CEP) and their results do not show could any link between
environmental performance and environmental disclosures. Similar results are found
by Wiseman (1982), who analyses 26 of the largest U.S. firms that are monitored by
CEP. The author introduced an environmental index which covered economics
factors, environmental litigation, pollution abatement activities and other
environmental disclosures and classifies environmental disclosures based on the
nature of the disclosures (qualitative or quantitative). His finding show that the
relationship between CEP environmental performance rankings and the Wiseman
environmental disclosure index rankings is not statistically significant.
Similar results are obtained also by Freedman and Wasley (1990) who examine the
relationship between pollution disclosures and corporate pollution performance of
firms in steel, oil, pulp and paper, and electric utilities industries. The authors’
conclusion is that the relationship between pollution disclosures and firms’
environmental performance is not supported by any empirical evidence. Freedman
and Jaggi (2010) examine environmental performance of EU, Japanese and Canadian
firms and their environmental disclosures using GHG emission as a benchmark, and
indicate that firms with better environmental performance do not necessarily have
better environmental disclosures. More recently, Alrazi, De Villiers and Van Staden
(2016) study 205 firms from 35 countries and use CO2 emission intensity as a
benchmark for environmental performance, and claim that the level of overall
environmental disclosure is not influenced by environmental performance.
35 The Effects of Environmental Disasters and Pollution Alerts on Stock Markets: Evidence from China
2.2 Environmental Regulation in China
“China is the world’s second largest economy, but the enormous costs of its growth
are becoming apparent. Residents of its boom cities and a growing number of rural
regions question the safety of the air they breathe, the water they drink and the food
they eat. It is as if they were living in the Chinese equivalent of the Chernobyl or
Fukushima nuclear disaster areas” . These are Wong’s words in his article Life in a
Toxic Country at The New York Times in 2013 3
Recent years have seen in the literature a growing number of studies related to
environmental regulations and their effects on economy in China. Moreover, the
mass media has been showing more and more attention on the environmental
situation in China and the effects on its citizens’ health. Given that this thesis is
focused on the analysis of China’s financial markets, in this section we review a
selection of papers and articles related to this topic.
Tanaka (2010) conducts a study to quantify the impacts of air pollution and related
regulations on infant mortality in China. The author exploits plausibly exogenous
variations in air quality generated by environmental regulations since 1995. These
legislations imposed stringent regulations on pollutant emissions from power plants.
The results of his study suggest that the regulations led to significant reductions in air
pollution and infant mortality rate (IMR). His estimations show that 25,400 fewer
infants died per year than would have died in the absence of the regulations,
3http://www.nytimes.com/2013/08/04/sunday-review/life-in-a-toxic-
country.html?pagewanted=all&_r=1&
36 The Effects of Environmental Disasters and Pollution Alerts on Stock Markets: Evidence from China
corresponding to about a 21 percent decline in IMR. Moreover, his findings
highlights that the maternal exposure to pollution on fetal development plays a
crucial role. Tanaka’s (2010) study indicates that a one percent reduction in total
suspended particulates (TSP) results in a 0.95 percent reduction in IMR, whereas a
one percent reduction insulphur dioxide results in a 0.82 percent reduction in IMR.
The author also argues that the estimated impact of a unit change in TSP is of similar
magnitude to that found in the U.S., but the elasticity is substantially higher in China.
This further finding highlights the greater benefits associated with regulations when
pollution is already quite high.
Figure 2: Trends in Infant Mortality Rate. Tanaka, 2010 In this plot the author shows the general trend of infant mortality per 1,000 live births between the Two Control Zone (TCZ) and the non-Two Control Zone (non-TCZ) localities. The annual mean is calculated using the total population as the weight. The dotted vertical line indicates the timing of 1995 Pollution Prevention and Control Law (APPCL) amendment, and the solid vertical line indicates the timing of TCZ policy implementation in January 1998. Note that the 1995 APPCL was amended in August. Because each observation presents the annual average value, the dotted vertical line is
37 The Effects of Environmental Disasters and Pollution Alerts on Stock Markets: Evidence from China
located at 1995, while the solid vertical line is located between 1997 and 1998. This is to clarify the timing of the TCZ policy implementation.
Hills and Man (1998) study the relationship between environmental regulators and
industrial enterprises in China. With the aim to explain the ‘implementation gaps’,
they present a model of the implementation process and use case studies from the
industrial city of Foshan in Guangdong Province. The authors argue that a decisive
role is played by the ‘informal relationships’ between individuals and organizations.
They claim that given the ‘cultural predisposition to harmony and consensus-
building among key actors’ and the importance of decentralized implementation
responsibilities in China, the achievement of national environmental policy
objectives can be constrained by weaknesses in the system at the local level.
Shi and Zhang (2006) adopt a multi-actor environmental governance model to
examine and understand the reason why a China's state-dominated system of
industrial pollution control has fallen in mitigating the environmental impacts of
rapid industrialization. According to the author, the initial failure of China’s
environmental regulation can be attributed to several factors. Firstly, China
developed its environmental regulation in the 1970s, with low experience and
essentially no institutional capacity. Secondly, China didn’t have a strong
environmental state, with large and effective monitoring and enforcement capacity.
Furthermore, the regime was mainly designed to target large state-owned enterprises
within a centrally planned economy via direct command-and-control interventions.
Finally, industry experienced constant and rapid change in the 1990s, both in in
terms of quantity and in terms of structure (quality).
38 The Effects of Environmental Disasters and Pollution Alerts on Stock Markets: Evidence from China
According to Shi and Zhang (2006), in recent years the Chinese environmental state
has been changing along three parallel strategies:
• modernizing the existing environmental regulatory networks, in order to
enable the central regulatory agencies and institutions to adapt better to the
new circumstances of a globally integrated market economy;
• decentralizing environmental policy and strengthening local governments to
fulfill their environmental responsibilities;
• adopting a proactive approach to involve non-state actors, institutions and
mechanisms in environmental governance in pollution control.
Shi and Zhang (2006) conclude that in the long term, greater openness and
integration will be beneficial to the modernization of China’s industrial
environmental governance. However, they state that the question remains whether it
will be enough to protect China’s (and the global) environment; but there seems to be
little alternative.
Qi’s (2008):study aims at describing the environmental governance system in China;
at formulating a theoretical framework to explain the institutional constraints that
lead to environmental degradation; and finally at evaluating the effectiveness of
China’s environmental governance. The author compares common features of the
China and U.S. environmental governance systems that shape both each country’s
choice of environmental governance concepts and tools, and the way and
effectiveness which they are applied. The paper concludes by suggesting areas in
which further comparative understanding may be of value, including: (1) focusing on
better understanding of the role of plan and law in China’s governance system; (2)
39 The Effects of Environmental Disasters and Pollution Alerts on Stock Markets: Evidence from China
comparing American Federal-state agreement system for implementation of
environmental law with China central-local system of target responsibility
agreements for implementation of the plan; (3) improving understanding of the
nongovernmental, as well as civil service, resources needed to assure compliance
with environmental laws and plans; (4) finding and adopting legal and institutional
means to resolve current difficulties in central-local and cross-border environmental
governance.
According to Mol (2009), China's system of environmental governance is changing
rapidly, resulting in new environmental institutions and practices. State authorities
rule increasingly via laws and decentralize environmental policymaking and
implementation. The author states that non-state actors – both private companies and
(organized) citizens – are given and taking more responsibilities and tasks in
environmental governance and this results in new relations between state, market and
civil society in environmental governance, with more emphasis on efficiency,
accountability and legitimacy.
One of the most contentious debates today is whether pollution-intensive industries
from rich countries relocate to poor countries with weaker environmental standards,
turning them into “pollution havens.”. Dean, Lovely and Wang (2009) estimate the
strength of pollution-haven behavior by examining the location choices of equity
joint venture (EJV) projects in China. A location choice model is derived from a
theoretical framework that incorporates the firm’s production and abatement
decision, agglomeration and factor abundance.
40 The Effects of Environmental Disasters and Pollution Alerts on Stock Markets: Evidence from China
Dean at al. (2009) analyse a sample of 2,886 manufacturing joint venture projects
during 1993-96 and show that EJVs from all source countries go into provinces with
high concentrations of foreign investment, relatively abundant stocks of skilled
workers, concentrations of potential local suppliers, special incentives, and less state
ownership. Their findings show that environmental stringency does affect location
choice, but not as expected. In particular the authors argue that low environmental
levies are a significant attraction only for joint ventures in highly-polluting industries
with partners from Hong Kong, Macao, and Taiwan. In contrast, joint ventures with
partners from OECD sources are not attracted by low environmental levies,
regardless of the pollution intensity of the industry.
Peng, Tian, Tian and Xiang (2011) apply the impulse response function of VAR
model and the estimation variance decomposition method to investigate the two-way
dynamic relationship between environmental regulation and FDI during 1985 to
2009. Their findings show that the generalized impulse response of the impact effects
of environmental regulation on FDI become less and less in long-term, verifying
“hypothesis of pollution haven”. Furthermore, Peng at al. (2011) argue that the
inverse U-shape curve of “environmental regulation - FDI” depends on the choice of
regulation indicators. Through the analysis of the positive impulse response, the
authors illustrate that the inflows of FDI would cause the deterioration of ecology
and the intervene of governments, which gives pressure to the transformation of
environmental regulation standard.
41 The Effects of Environmental Disasters and Pollution Alerts on Stock Markets: Evidence from China
Figure 3: The impact response curve of Environmental regulation to FDI. Peng at al.
(2011)
Figure 4: Impact response curves of FDI to environmental regulation. Peng at al. (2011)
Zheng and Shi (2016) conduct a study to investigate pollution haven hypothesis at
domestic level in China. Using panel data of 30 provincial level regions for the
period 2004 to 2013, this paper empirically examines to what extent multiple
42 The Effects of Environmental Disasters and Pollution Alerts on Stock Markets: Evidence from China
environmental policies affect intra-country relocation of polluting industries in
China. The authors found that the implementation of both economic policy
instrument like pollution discharge fee and public participation like letter complaints
on environmental problems encourages industrial relocation, whereas the
implementation of environmental legal policy instrument like laws, regulations and
rules prevents polluting industries from relocating to other regions. Moreover, their
study demonstrate that the relocation effect of environmental policies varies with
industrial characteristics. In particular the authors argue that, compared with water
pollution-intensive industry, air pollution-intensive industry dominated by stated-
owned capitals are insensitive to legal policy instruments. Zheng and Shi (2016)
finally suggest that the validity of pollution haven hypothesis is jointly associated
with the type of environmental policy as well as industrial characteristics.
Ramiah, Pichelli and Moosa (2015a) study the effects of environmental regulation
announcements on corporate performance in China and their results show that
several polluting industries experience an increase in short-term systematic risk due
to the announcements of environmental regulations. However, from their study there
is no evidence of firms experiencing a decrease in short-term systematic risk due to
environmental regulations. Moreover, Ramiah et al. (2015a) observe no changes in
short-term systematic risk for the 81% of industries in China and they suggest three
possible outcomes for long-term systematic risk including increase, decrease and no
change in risk.
43 The Effects of Environmental Disasters and Pollution Alerts on Stock Markets: Evidence from China
Figure5: Long-Term Climate Change Risk in China. Ramiah et al. (2015a)
2.3 Environmental and Natural Disasters Literature
Environmental disasters cause enormous losses of life and property every year, a
threat that is recognized and addressed in both the Sendai Framework for Disaster
Risk Reduction 4 and the 2015 Sustainable Development Goals 5. Organizations from
both the risk reduction and development fields are working to design programs that
build risk understanding and risk perception to encourage protective action in
communities that are often at risk from multiple, overlapping threats.
The empirical evidence shows natural disasters may have significant impact on stock
exchanges. Wang and Kutan (2013) analyse the impact of 84 Japanese natural
disasters on the domestic stock market for the period 1982 to 2011 and concluded
4http://www.unisdr.org/we/coordinate/sendai-framework 5http://www.un.org/sustainabledevelopment/sustainable-development-goals/
44 The Effects of Environmental Disasters and Pollution Alerts on Stock Markets: Evidence from China
that natural disasters have an indirect impact on changing the volatility of stock
returns. The authors also show that an inefficient market response might be caused
by the delayed information due to the death and loss of the disasters.
Barton (2005) examined the US stock market performance after the Hurricane
Katrina and reported that stock markets reacted positively after the storm. The same
result was found after hurricanes Andrew, Hugo and Camille. Nevertheless,
Weiderman and Bacon (2008)test efficient market theory by examining the effect of
Hurricane Katrina on oil companies' stock prices. They conduct an event study
analysis on 15 firms with interests in the Gulf of Mexico and examines the effect of
Hurricane Katrina on stock price's risk adjusted rate of return before and after August
30, 2005. Their results show stock returns dropping significantly prior to Hurricane
Katrina reaching land. Weiderman and Bacon (2008) support semi-strong market
efficiency, reflecting that the market rapidly anticipated the devastation of Hurricane
Katrina. The authors conduct proper statistical tests for significance and the results
show that oil company stock price returns started a significant downturn up to 25
days prior to the hurricane event on August 30, 2005.
Worthington and Valadkhani (2004) investigated the impact of 42 natural disasters
(severe storms, floods, cyclones, earthquakes and bushfires) on the Australian stock
market. They used the daily price and accumulation returns from 1982 to 2002 for
the All Ordinaries Index (AOI).Applying autoregressive moving average (ARMA)
models, the authors’ findings indicate that different kinds of natural disasters lead to
mixed impacts on market returns and in particular bushfires, cyclones and
earthquakes have a major effect on market returns, unlike severe storms and floods.
45 The Effects of Environmental Disasters and Pollution Alerts on Stock Markets: Evidence from China
Worthington et al. (2004) argue that net effects can be positive and/or negative with
most effects being felt on the day of the event and with some adjustment in the
following days.
The literature proposes several possible explanations to the correlation between
natural disasters and stock prices on exchanges. Fama (1970) sustains that markets
are semi-strong-form efficient and therefore prices react to public information
including the announcement of a firm, changes in economic policy, breaking through
of a new technology, regime change, and natural disasters.
Focusing on disasters caused by industrial activity, whenever a company is found to
be responsible and liable for environmental damages, injured parties and public
authorities are deemed to be compensated, according to the court decisions. Cash
costs and reputation damages will severely affect the company. Yet, the effects of
environmental pollution are not limited to fathomless and enduring damages at the
local level, but they spread to the whole economy, with effects on expectations about
growth, productivity, firm profitability and business risk (Jorgenson and Wilcoxen,
1990; Barbera and McConnell, 1986; Esty and Porter, 2002; Moosa and Ramiah,
2014). Changes in expectations are fatally going to induce stock price adjustments on
stock exchanges, and this will regard both companies directly involved in the
accident, and companies that might be indirectly affected.
Sullivan-Wiley and Short Gianotti (2017) address environmental hazard risk
perception in a multi-hazard context in eastern Uganda, with particular attention paid
to the role that risk reduction and development organizations (RDOs) play in shaping
46 The Effects of Environmental Disasters and Pollution Alerts on Stock Markets: Evidence from China
risk perceptions, as well as their potential to influence protective action. To better
understand risk prioritization, the authors used survey data from farming households
to generate four indices reflecting several components of risk perception and to
predict holistic risk perception through multivariate regression analysis.
Sullivan-Wiley et al. (2017) find out that the factors shaping smallholder risk
perception vary among hazards within the study population and that characteristics of
both hazards and individuals are important. Furthermore, their results reveal a
relationship between risk perception, self-efficacy, and protective action, which
suggest that risk reduction and development programs can play an important role in
affecting both risk perception and the capacity of smallholders to respond to
environmental threats.
According to a great number of studies (Muoghalu et al., 1990; White, 1995;
Feldman et al., 1996; Klassen and McLaughlin, 1996; Oberndorfer, 2009; Flammer,
2012; Chan and Walter, 2014; Oestreich and Tsiakas, 2015; Pham et al., 2015;
Ramiah et al., 2013; Ramiah et al., 2015a; Ramiah et al., 2015b; Ramiah et al.,
2016), disasters’ outcry might lead policymakers to introduce more severe
regulations and binding requirements for manufacturing companies, causing a
reduction in profit margins and an increase in idiosyncratic risk
On the other hand, Neto, Da Silva Gomes, Bruni and Filho, (2017) investigate the
impact that environmental disasters have on the volume of socio-environmental
disclosure and investments of Brazilian companies from 1997 to 2012. They set the
level of socio-environmental disclosure and investment before the occurrence of the
47 The Effects of Environmental Disasters and Pollution Alerts on Stock Markets: Evidence from China
accident and then compare it to the level of disclosure and investment after the
accident. Their results show that the companies reported a higher volume of socio-
environmental disclosure in the two years after the occurrence of the accidents – with
statistical significance of 2.9%. Statistically significant variations of 8.2% and 0.7%
were found in the totals of contributions to society and in environmental investments,
respectively. On the other hand, there was no statistically significant variation in the
internal social indicators
2.4History of Event Study Methodology
Recent years have seen a growing body of literature related to event study
methodology and its development Myers and Bakay (1948), Barker (1956, 1957,
1958), Ashley (1962), Ball and Brown (1968), Fama et al. (1969), Brown and
Warner (1980, 1985), Fama and French (1993, 2015), Carhart (1997), Ramiah, Cam,
Calabro, Maher and Ghafouri (2010), Ramiah (2012, 2013), Ramiah and Graham
(2013), Ramiah, Martina and Moosa (2013), Ramiah, Moosa, Pham, Scundi and
Teoh (2015), Ramiah, Regan-Beasley and Moosa (2016), Pham, Ramiah, Moosa and
Nguyen (2016) and Ramiah, Pham and Moosa (2016). However event study
methodology was first introduced in finance by Dolley (1933) who studied 95 stock
splits from 1921 to 1931.
Event study methodology is used not only to examine the effects of firm-specific
events, but also to analyse non-firm-specific announcements, such as earthquakes,
tsunamis, terrorist attacks, regulatory announcements, and many others. For instance,
Binder (1983, 1985) uses monthly and daily data to study 20 regulatory changes
48 The Effects of Environmental Disasters and Pollution Alerts on Stock Markets: Evidence from China
between 1887 and 1978 and finds weak evidence that announcements of the
regulations affect the wealth of shareholders.
Binder (1998) observes that anticipation of the market to regulations and
uncertainties about event dates are the two major difficulties of event study of
regulation. However, the author argues event study remains a powerful tool to
inspect the effects of regulations when event dates around a policy are known.
Binder (1998) further introduces five methods to calculate abnormal return (AR) in
event study methodology: (1) mean adjusted returns, (2) market adjusted returns, (3)
market model (Fama, Fisher, Jensen and Roll, 1969), (4) the CAPM and (5) the
multifactor model—Arbitrage Pricing Theory (Ross, 1976). Brown and Warner
(1980) apply the event study methodology to monthly stock data and conclude that
multifactor models do not work better than the market model. According to Cam and
Ramiah (2014), event studies can have a wide range of results, depending on the
estimation techniques used. The authors observe fewer and smaller abnormal returns
than an evaluation based on Brown and Warner (1985), after controlling for
systematic risk factors.
In this chapter we review the development of event study methodology, analysing the
One-factor Model (Brown and Warner, 1985), the Three-Factor Model (Fama and
French, 1992) and the Four-Factor Model (Carhart, 1997). Secondly, we discuss how
event study methodology has been applied to environmental finance.
49 The Effects of Environmental Disasters and Pollution Alerts on Stock Markets: Evidence from China
2.4.1 The One-Factor Model
Brown and Warner’s (1985) study is focused on the analysis of the characteristics of
daily stock returns with the aim to find out the effects they can have on event study
methodology. The authors first use various models to measure excess returns and
examine the statistical properties of both daily stock returns and excess returns. They
then build the samples by randomly selecting securities and event dates. After
postulating that no abnormal returns should be detected if they are measured
correctly, they estimate the probability of discovering a given level of abnormal
performance.
Brown and Warner (1985) highlight that one of the potential issues with using daily
data instead of monthly data is the risk of having a significant departure from
normality. Fama (1976) suggests that distributions of daily returns are fat-tailed
relative to a normal distribution. Similar finding for the distribution of daily excess
returns are shown by Brown and Warner (1985). Moreover, using the OLS method to
estimate market model parameters can create severe bias and inconsistency due to
non-synchronous trading between the security and the market (Dimson, 1979 and
Scholes and Williams, 1977).
A number of issues related to variance estimation has been also detected. For
instance, non-synchronous trading can lead to serial dependence on daily excess
returns (Ruback, 1982), cross-sectional dependence of the security-specific excess
returns (Brown and Warner, 1980; Beaver, 1981 and Dent and Collins, 1981), and
the stationarity of daily variances in which the variance of stock returns rises around
50 The Effects of Environmental Disasters and Pollution Alerts on Stock Markets: Evidence from China
announcement dates such as earnings announcements (Beaver, 1968 and Patell and
Wolfson, 1979).
Abnormal returns are estimated by the authors using various measurements, whose
procedures are described here below.
Mean adjusted return
(1) , = , −