The Role of Corporate Headquarters in DfE Adoption

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Sustaining Industry Self-Regulation in the Face
of Free-Riding
Michael Lenox
Andy King
Associate Professor Fuqua School of Business Duke
University
Associate Professor Tuck School of
Business Dartmouth University
March 27th, 2004
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Industry Self-Regulation
Collective attempts by firms to regulate their
own behavior

• Some examples
• Movie ratings by the MPAA
• Accounting standards by FASB
• Environmental standards by trade associations
• When is industry self-regulation (ISR) feasible?
• What are the major impediments to
  self-regulation?
• What institutional structures are needed to make
  viable?

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Responsible Care

• Established in October 1989
• Sponsored by the American Chemistry Council
  (formerly CMA)
• Members pledge to adopt 10 principles, 6 codes,
  gt100 practices
• Participation required for ACC membership
• A leading example of environmental
  self-regulation
• Widely cited program
• ACC is a strong association with many leading
  firms
• Chemical industry accounts for majority of toxic
  emissions in U.S.

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Why self-regulate?

• Tangible benefits to self-regulation
• Avoid or preempt costly government regulation
• Limit cross-industry substitution (e.g. boycotts)
• Minimize stakeholder ire (e.g. NIMBY problems)
• Poor behavior often impacts others within
  industry
• Exxon Valdez spill impacted entire oil shipping
  industry
• UC Bhopal accident had negative impact on all
  chemical stocks
• Rampant information asymmetries with stakeholders

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The Reputation Commons
Differentiated
High
Ability of Stakeholders to Differentiate Between
Firms
Common Reputation Problem
Mollified Stakeholders
Low
Low
High
Threat of Sanctions by Stakeholders Against Firms
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Challenges to ISR

• Adverse Selection Moral Hazard
• Do worse performing firms choose to participate?
• Do participating firms perform worse?
• (King Lenox. 2000. Industry Self-Regulation
  Without Sanctions. AMJ.)
• (Lenox Nash. 2002. Industry Self-Regulation
  and Adverse Selection.)
• Spillovers Free Riding
• Do spillovers and free-riding occur?
• Why do firms participate?
• (King Lenox. 2003. Sustaining ISR in the Face
  of Free-Riding.)

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Spillovers and Free-riding

• Reputation may suffer from the tragedy of the
  commons
• Benefits of improving reputation may spillover
  to others
• Commons will be subject to free-riding by firms
  in industry
• Solutions involve structures to sanction
  non-compliance
• Participation is typically voluntary
• Anti-trust laws limit sanctions firms may use
  against competitors
• Any fines or similar punishments must be accepted
  voluntarily
• Expulsion from association is only true sanction
• Can ISR be sustained in the face of
• spillovers and free-riding?

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Some Possibilities

• Participation in self-regulatory efforts provides
  an excludable private good
• Practices embodied in the standard create value
  for the firm, i.e., the win-win hypothesis (why
  collective?)
• Membership allows firms to credibly communicate
  that they are of a superior type, i.e.,
  differentiate
• Participants in self-regulatory efforts
  internalize more of the public (collective) good
  created

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Some Possibilities

• Unilateral benefits exceed private costs of
  self-regulation (Olson)
• Greater cost borne if program collapses (Segerson
  Dawson)
• Firms benefit from the presence of
  self-regulation
• Firms would be better off free-riding (if the
  program continues)
• A critical number of firms may band together to
  prevent the program from collapsing
• A knifes edge equilibrium exists where if one
  exits, all exit

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Our Approach

• Empirically examine the U.S. chemical industry
  and the Responsible Care Program
• Analyze Tobins Q pre and post the advent of
  Responsible Care across all chemical firms
• Consider and empirically address the fact that
  firms self-select into the Responsible Care
  program

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Our Data

• Sample
• Public U.S. chemical manufacturing firms
• Unbalanced panel from 1987-1996
• 198 firms constituting 1473 firm-year
  observations
• 48 participants in Responsible Care (in 1990)
• Sources
• American Chemistry Council membership lists
• Financial data from Standard Poors Compustat
  Dataset
• Environmental data from U.S. EPAs Toxic Release
  Inventory (aggregated from facility level)

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Our Measures
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Estimates of Q (1987-1996)
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Our Findings I

• Pre-post test of Responsible Care impact on firm
  performance
• Advent of RC corresponded with a simultaneous
  rise in Tobins q (10)
• Impact on non-RC firms was greater than for
  members (14 vs. 5)
• Member firms benefited from ACC but less so after
  RC (16 vs. 7.5)
• Thus, the benefits of RC appear to spillover to
  non-participants at an expense to participants

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Additional Measures
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Estimates of RC Membership
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Our Findings II

• Selection model with participation decision
• On average, non-RC firms would have been worse
  off participating
• On average, RC firms would have been better off
  not participating!
• 23 out of 48 RC firms were better off by
  participating
• Tended to be the dirty firms in dirty segments
• Likely seeking the insurance benefit
• 25 out of 48 RC firms would have been better off
  by not participating
• Tended to be the large, visible firms (e.g.
  Dupont, Dow)
• Taking one for the team, a la Segerson Dawson
  model?

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A Speculative Typology
Loners (visible, diversified)
Leaders (large, visible)
Self-regulate
Leeches (dirty, low cost)
Laggards (small, niche)
Do not self-regulate
Do not participate
Participate in program
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Leeches?

• Participation may serve as a smoke screen
• Membership may reduce insurance premiums and
  liability by demonstrating due diligence
• Poor performing forms join to gain insurance
  benefits
• Compliance is weakly enforced
• Compliance is self-reported, sanctioning is
  informal
• Members are rarely kicked out
• Velvet glove (vs. iron fist) approach

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Previous Findings

• Probit model of RC participation decision
• Larger, focused, visible firms tended to join RC
• Dirty firms in dirty segments tended to join RC
• FE model of changes in relative factory emissions
• In general, chemical firms reduced emissions
  since 1990
• On average, RC firms improved their environmental
  performance less quickly than non-members
• Poor performers tended to be the dirty firms in
  dirty segments

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Previous Findings

• Comparative analysis across four environmental
  codes
• Responsible Care (Chemical Manufacturers)
• Sustainable Forestry Initiative (Pulp Paper)
• Encouraging Environmental Excellence (Textiles)
• Responsible Distribution (Chemical Distributors)
• Probit model of ISR participation decision
• Those with third-party verification and who
  kicked out non-complying members did not suffer
  from adverse selection.

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Summary

• Benefits of self-regulation spillover to the
  industry as a whole
• Small firms free-ride off the efforts of
  participants
• Large, visible firms tend to join the
  self-regulatory program and comply to prevent its
  collapse
• Poor performing firms tend to join the
  self-regulatory program to gain insurance but
  fail to comply
• Monitoring and sanctioning appear to solve the
  adverse selection and moral hazard problems
• Speculation -- solving the above problems may
  address the free-riding problem by
  differentiating firms

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Policy Implications

• Suggests both opportunities limits to industry
  self-regulation
• Public policy may facilitate self-regulation by
• Raising the costs of failure to self-regulate
  (though is this really self-regulation?)
• Rewarding self-regulatory participants (when they
  get the governance structures right)
• Reducing stakeholder information asymmetries
  (providing unilateral incentives to
  differentiate)
• Perhaps easier to implement the latter in a
  global context than traditional regulation