Investigating Environmental Disclosure And The Potential Links With Company Financial Performance Accounting Essay
This report is aimed at discussing environmental disclosure. Environmental disclosure is a method of responding to the changing perceptions of a corporation’s relevant publics on how organizational processes or production procedures may have impact on the natural environment. This report is aimed at providing information on environmental disclosure and the potential links with company financial performance. The report is divided in seven sections. After reviewing relevant literature to the topic, no significant evidences was found to correlate environmental disclosure and the potential links with Company Financial Performance. Therefore, a link was not identified.
Over the three decades, the topic of environmental problem has been of significant interest to scholars and businesmans. However, few studies have been made to measure the impact of transforming the business into an eco-friendly firm. The financial aim of all firms is to enhance the wealth of the shareholders (Atril, P., Mc Laney E., 2008). Thus, all investment projects should produce profit. However, in the case of environmental projects the results still seem to be inconclusive. Some authors claim that environmental regulation imposes additional costs for firms (Palmer, et al, 1995). This view is based on the premise that pollution abatement and environmental improvements have decreasing marginal net earnings (Walley, N., Whitehead, B., 1994). In contrast, some other researchers states that environmental regulation can incentive win-win scenarios in which both social welfare and private benefits of firms grow (Porter, M.E. , 1991). A third group argues that economical outcomes present an inverse U-shaped relationship between environmental performance and financial performance. This view predicts a positive both dimensions up to the level of environmental performance is maximized (Horvathova, E., 2010). Another current of thought debates that there is a neutral relationship between environmental and financial performance because firms that do not invest in environmental programs will have lower costs and lower prices, while firms that invest in social responsibility will have higher costs but will have customers happy to pay higher prices (McWilliams, A., Siegel, D., 2001).
Generally speaking, there is no consensus in the financial effects of environmental investments. The aim of this report is to identify the financial benefits that firms may obtain by disclosing information in their annual reports or adjoining environmental reports about environmental issues regarding their operations. The US electric utility industry will be analyzed in order to determine whether disclosing environmental practice improved its financial performance or not. This industry represents a good starting point for the research since investment in environmental projects are easily traceable and the firms in this sector are the most experienced in the application of ambient regulation and practices. The article to be used as a guide is: "Can environmental investment and expenditure enhance financial performance of US electric utility firms under the clean air act amendment of 1990?" by Toshiyuki Sueyoshi and Mika Goto (Sueyoshi, T., Goto, M., 2009). This article presents a comprehensive view of the financial results of this industry after almost two decades of ambient legislation.
The issue raised from this previous analysis is, then, "Is there any correlation between environmental investment and disclosure, and company’s financial performance?" The aim of the research, therefore, will be focused on finding the tangible benefits that both ambient projects and the disclosure of this information produce in firm’s annual results. So far, environmental disclosure is voluntary. Its content and extent are entirely defined by the company.
This report is aimed at providing deep information on the raised issue. The first section provides background information on environmental disclosure. The second piece explains the rationale behind ambient disclosure. The third portion comments about impact and benefits of environmental disclosure in firm’s financial performance. The forth segment presents information from different countries and how this issue is tackled worldwide. The fifth parcel presents the perception of different actors about the topic and concludes.
It is a common thought that the objectives of business and the environment seemed irremediably irreconcilable. In other words, what helped one would almost certainly harm the other. Almost two decades of ambient initiatives in the international corporations has given room to a more optimistic mind-set which promises reconciliation of environmental and economic concerns. Environmental improvements is often the best way to increase a company’s efficiency and, as a consequence, profitability (Zhang, B., et al, 2008). Environmentalists present projects that benefit the environment and create financial value. However, environmental expenditures are significant and hide the benefits of win-win opportunities. That does not imply that managers should return to their old ways of fighting, ignoring, and hamstringing any and all environmental regulatory efforts. The challenge is, then, to identify the projects that will have the greatest impact. In this manner, managers must concentrate on finding smarter and finer trade-offs between business and environmental concerns. At this point, the environmental challenges become more complex and costs continue to shoot up, therefore, win-win solutions will become increasingly scarce (Lopez-Gamero, M.D., et al, 2010).
Firm’s management has a growing array of choices to respond to environmental pressures. However, managers lack of frameworks that allow them to turn their good intentions into reality. A feasible option is the free trade. In this fashion, market prices would be able to reflect the comprehensive societal impact of products and processes, more flexible regulations, and investors who pay greater regard to environmental considerations. In this train of thought, instead of focusing on win-win solutions, managers should be better focusing on trade-off zones where environmental benefit is weighed against value destruction. Shareholder value, rather than compliance, emissions, or costs, is the critical metric (Mohai, P., et al, 2009).
In order to assist firm’s management to measure the financial effects of the environmental and social liabilities pertaining to business’ operations and products, environmental evaluation and accounting techniques have been developed. Environmental accounting systems now form part of industrial decision making process in developed countries (Goodstein, E.S., 2002). Environmental accounting can be defined, then, as the identification, allocation and analysis of material streams and their related money flows by using accounting systems to provide insight in environmental impacts and associated financial effects (Steele, A.P., Powell, J.R., 2002). Environmental accounting can be used to demonstrate the potential for environmentally beneficial investments to yield significant financial pay-offs. As any other accounting system, environmental accounting should produce information to underpin the decision making process at different organizational levels (Atril, P., Mc Laney E., 2008).
Environmental accounting is responsible for identifying and considering environmental costs. An environmental cost is a charge that have a direct financial impact on a company (internal costs), and costs to individuals, society and the environment for which the company is not accountable (external costs). Conventional management accounting systems attribute environmental costs to general overhead accounts with the consequence that product and production managers have no stimulus to reduce environmental costs and executives are often unaware of the range of these costs. Hence, identifying, assessing and correctly allocating environmental costs permits management to identify opportunities for cost savings. Environmental costs should be allocated directly to the relevant cost drivers. Identifying cost drivers and allocating costs accordingly is the conceptual cornerstone of Activity Based Costing (ABC). Activity-based costing improves internal cost calculation by allocating costs typically found in overhead accounts to the polluting activities and products that are determined by quantitative life cycle assessment procedures. Quantitative life cycle assessment for environmental accounting systems consists in coupling a quantitative value to environmental impacts associated with a project by compiling an inventory of relevant energy, material inputs and environmental releases, evaluating the potential environmental, social impacts, and interpreting the results (Little, A.D., 2000).
Environmental accounting, then, should produce information for firm’s customers, competitors, employees, government, community representatives, investment analyst, suppliers, lenders, managers, and owners. Therefore, environmental disclosure is a particular outcome of environmental accounting (de Beer, P.P., Friend, F.F., 2006).
It can be inferred that as any other accounting standard, environmental accounting is sensible to definitions and accounting practices, therefore, their results may be biased by accounting practices. In this manner, one report may present different results. Hence, the benefits of an environmental project may be hidden by accounting policies (Elliot, B., Elliot, J., 2009). This is new component add more complexity to the value calculation process for environmental endeavours.
Finally, environmental project viability depends upon how the cost are identified and allocated within the firm’s accounting. This dependency inherits the weaknesses of the accounting methods and standards a business employs. Errors or misinterpretations of cost identification and allocation may diminish project credibility and support. Shareholders are eager to support any new strategy that ensures an increment in their capital. Reporting tangible results for environmental initiatives is the best way to ensure their prevalence in the current economy. Clear measurement systems in resource consumption will ease the identification of cost drivers. Hence cost will be fairly allocated to business outcomes. Better cost allocation means better results. Gray information jeopardizes not only environmental project continuity, but also environment per se. Accounting standards should also include descriptions and definitions for investments and assets associated to environmental plans. The objective is to have a clear accounting standard framework. Environmental project results can be easily perceived by the community, the challenge is, then, to explain shareholders how their wealth is also positively affected by these sorts of initiatives with tangible outcomes and trustable reports.
Environmental disclosure can be described as the information which relates the environmental outcomes that corporate actions have on stakeholders in a manner that is meaningful, fair, and useful. In other words, environmental disclosure is a method of responding to the changing perceptions of a corporation’s relevant publics on how organizational processes or production procedures may have impact on the natural environment (Walden, W.D., Schwartz, B.N., 1997).
Norway was the first country requiring all firms included by the Accounts Act to publish a clarification of whether they polluted the environment and to report executed and planned operations for appropriate environmental protection as from 1989 (Fallan, E., Fallan, L., 2009). According to some authors, US formally started its legislative works on environment disclosure until 1990 (Porter, M.E., 1991). However, there were no requirements for a uniform report. How much to report and what type of content to make were almost entirely up to the company. The most usual statement in annual reports from companies, having no serious environmental impact fulfilling the statutory requirements, was: The firm does not pollute the external environment. Even though the annual report was under auditing control, the environmental part of it was not. These limited regulations for environmental information should make it fairly easy and inexpensive for companies to fulfil the legal obligations. These mandatory requirements were modest. Actually, most environmental disclosure of information in annual reports should still be provided on a voluntary basis (O’Donovan, G., 2002).
Some theories, like Legitimacy one, predict that companies respond to pressure from society by providing voluntarily environmental information to legitimate their existence and to demonstrate society’s need for their services. Voluntary disclosure makes the likelihood of opportunistic behaviour greater than under regulated information requirements. However, even mandatory environmental disclosures cannot stop strategic use of voluntary environmental disclosure. Companies may disclose environmental information according to their own self-interest, when future earnings and potential cash flows are negatively affected (Palmer, K., et al, 1995). The reports are more likely to appear as a specific event and the content will vary more widely when regulations are lacking. Environmental disclosure is mostly a legitimacy device and not an accountability mechanism, and according to some authors more legislation is not necessarily required to improve accountability, but rather better review and enforcement are needed. The bottom-line is: regulation of environmental reporting would not lead companies to report on bad news (Perego, P., Hartmann, F., 2009). Pro-voluntary reporting sectors claim that firms in countries with regulations face considerable costs and therefore diminished competitiveness (Porter, M.E., 1991). However, empirical experience has shown that an information strategy of environmental disclosure motivates polluters to reduce emissions, even in the absence of statutory requirements (O’Donovan, G., 2002).
The motivation for statutory requirements is that such regulations will limit adverse environmental impacts. However, there is no consensus as to how regulations affect business. Some authors claim that markets work most efficiently and effectively when there is adequate information. As a consequence, the volume and content of environmental disclosure are important to secure the supply of such information (O’Donovan, G., 2002). The extent of the environmental disclosure and its consequences in business performance will be discussed in the next sections.
Why Environmental Disclosure?
It is commonly acknowledged that the main aim of for profit corporations is to generate acceptable returns for their shareholders. Some authors state that large corporations have to satisfy a broader group of interested stakeholders, whose interests are more than just financial. Corporations are social creations and it has been argued that their existence depends on the willingness of society to continue to allow them to operate. The idea of a social contract between business and individual members of society suggests that, while the main aim of a business is to make profits, it also has a moral obligation to act in a socially responsible manner. Management disclosure decisions are linked to a broad range of interconnected political, social and economic influences. Legitimating tactics and public disclosures an organisation makes will differ depending on whether it is trying to gain, maintain or repair legitimacy. The extent to which relationships between these variables exist has not been tested. In this context it is argued that studies about whether voluntary social and environmental annual report disclosures are related to legitimacy motives have, to some extent, stagnated.
Reduce in Cost of Capital
There is not a homogenous opinion about benefits of environmental investment and, therefore, environmental disclosure. The former US Vice President Al Gore presents the 3M’s pollution case study as one win-win example (Yang, M.G., et al, 2010). Pollution Prevention strategy consisted of a group of over 3,000 mainly employee-generated projects, which have reduced 3M’s emissions by over 1 billion pounds since 1975 while saving the company approximately 500 million. Other companies like General Motors reduced its disposal costs by USD $12 million by establishing a reusable container program with its suppliers, the Commonwealth Edison, a major US electric utility company, realised USD $25 million in financial benefits through more effective resource utilisation, Andersen Corporation implemented several programs that reduced waste at its source and had internal rates of return exceeding 50%, and Public Service Electric and Gas Company saved more than $2 million in 1997 by streamlining its inventory process (Porter, M.E., 1991).
However, some others argue that environmental cost are high and may hurt a firm. Chemical industry committed to programs to reduce emissions of hazardous wastes. This industry sector soon found that it was starving other important projects, like plant upgrades, and that roughly two-thirds of its capital budget went to environmental spending. Perhaps even more alarming, nearly 80% of plant engineers’ time was being consumed by environmental projects. Environmental costs have continued to distance both inflation and economic growth for the past two decades. Some environmental issues are strategic because their impact on value is high enough either to put core elements of the business at risk or to fundamentally alter a company’s cost structure, and because managers have considerable discretion about how to respond (Carroll, A. B., Shabana, K. M., 2010). A good example is the issue of chlorine-free paper production facing the pulp and paper industry in the US. Opinion is sharply divided on when, and even whether, government regulation will prohibit the use of chlorine in the paper manufacturing process. The value implications for pulp and paper companies are enormous, not only because of the absolute cost of chlorine-free production but also because some companies are likely, by virtue of their plant configuration or other reasons, to enjoy a relative competitive advantage in this form of manufacture (Porter, M.E., 1991).
Even though, some other researchers claim that the success of an environmental projects depends upon the accounting systems. Some accounting models like the EEGECOST (Environmental Engineering Group environmental costing model) have being developed to promote environmental accounting (de Beer, P.P., Friend, F.F., 2006). EEGECOST is based on the principles of the total cost assessment environmental accounting system. The objective of the model is to fully understand the cost significance of environmental and human health related decisions, activities and consequences over the whole life cycle of a product or process; at present and especially for the future. This model is different from traditional environmental accounting systems available in the world market. For EEGECOST, the set of cost and benefit items included are broader than in traditional systems, risk and uncertainty are dealt with in a systematic fashion, the model assists in quantifying items that are usually left un-quantified (intangibles and externalities), and traditional overhead items are assessed and allocated to specific cost drivers (a cost driver is the actual activity or reason for a cost to occur) of a project or process. The EEGECOST model was used to evaluate the cigarette production process. The analysis was conducted at the Heidelberg factory of British American Tobacco. The case study proved the importance of accounting for all environmental costs, both internal as well as external, and allocating these costs to cost types and cost drivers in a structured environmental accounting model. The model provides the framework for corporate evaluation of alternative projects and processes and for estimating economic and environmental performance. The model can assist industries in identifying, recording and allocating environmental costs within environmental media groups, using cost types and cost drivers, to enhance their corporate decision making processes (de Beer, P.P., Friend, F.F., 2006).
As a conclusion, firm’s Managers must have the necessary information to make informed trade-offs between cost and environmental control. Business unit managers rarely have adequate information about even current environmental costs let alone possible future liabilities or pressures (Porter, M.E., 1991). The best way to provide that information is to create systems to track and disseminate emissions data on a cross-functional basis, provide environmental cost accounting, and perform thorough, opportunity-oriented (rather than compliance-oriented) third-party audits (Bouslah, K., et al, 2010). The ultimate goal is to show share holders the benefits of environmental investment in order to incentive long term and sustainable strategies.
Enhance Company Reputation
Company reputation is conferred by outsiders to the corporation, but may be controlled by the corporation itself. This indicates that changes in social norms and values are one motivation for organisational change and also one source of pressure for organisational legitimation. By establishing its legitimacy, firms both lessen the regulatory burden that would otherwise constrain the execution of corporate strategy, and keep from the market the potential stigma associated with a reputation for environmental recklessness (Carroll, A. B., Shabana, K. M., 2010).
Reputation and legitimacy arguments maintain that firms may strengthen their legitimacy and enhance their reputation by engaging in Corporate Social Responsible activities such as environmental projects. Legitimacy is defined as a generalized perception or assumption that the actions of an entity are desirable, proper, or appropriate within some socially constructed system of norms, values, beliefs, and definitions. Perceptions of a firm’s concern for society illustrates that the firm is able to build joint relationships, which indicate that the firm is able to operate whilst adhering to social norms and meeting expectations of different stakeholder groups. Firms focus on value creation by leveraging gains in reputation and legitimacy made through aligning stakeholder interests. Reputation and legitimacy sanction the firm to operate in society (Brammer, S., Pavelin, S., 2006).
Some studies have found that consumers report that many claim to be influenced in their purchasing decisions by the environmental and Corporate Social Responsible reputation of firms. According to the Social Investment Forum, USD $2.32 trillion (one in eight dollars) under professional management in the United States was involved in environmental and socially responsible investing in 2001. It has also found that the majority of collaborators comment an inclination for working in socially responsible companies. Alongside, strong vendor standards and independent monitoring helps build company’s reputation and the value of its brand, which are among its most valuable assets (Carroll, A. B., Shabana, K. M., 2010).
Environmental investments pay. Some firms that have negative social performance in the areas of environmental issues and product safety use charitable contributions as a means for building their legitimacy. Corporations are also reasoned to enhance their legitimacy and reputation through disclosure of information regarding their performance on different social and environmental issues (Kamens, D.H., 1985). Researches propose that policy-makers empower consumers by providing consumers with more information through mandatory reporting on social and environmental performance and the development of a comprehensive environmental awareness. As an example, Novo Group has registered some benefits because customer perceives the firm as an organization deeply involved in genetic modification and yet maintains highly interactive and constructive relationships with stakeholders and publishes a highly rated environmental and social report each year. Whereas, Monsanto’s has a bad perception in European consumer markets as a result of perceived imposition of unlabelled, genetically modified food, ingredients and its opacity in environmental information (Carroll, A. B., Shabana, K. M., 2010). Comprehensive campaigns should be design within businesses in order to satisfy stakeholders’ demands while, at the same time, allow the firm to pursue its operations. By engaging its stakeholders and satisfying their demands, the firm finds opportunities and solutions which enable it to pursue its profitability interest with the consent and support of its stakeholders.
Each country has developed environmental disclosure policies at different pace. In the US, environmental regulation was mainly developed on two periods. The first period lasted from easily 1970s to 1985. Firms faced with new regulations of high technical specificity. They did little more than comply with the regulations and often fought or present obstacles to them. Companies were generally unwilling to internalize environmental issues, a reluctance that was reflected in the delegation of environmental protection to local facilities, a widespread failure to create environmental performance-measurement systems, disclosure, and a refusal to view environmental issues as realities that needed to be incorporated into business strategy. During the mid to late 1980s, a shift in the regulatory context and the maturing of the environmental movement created an incentive for companies. With regulations focused more on ultimate environmental results and less on the mechanics of compliance, firms began to exercise greater discretion in their environmental response. During the second era, from mid 1980s to mid 1990s, the emergence of the win-win mind-set was a direct result of the extraordinary success companies achieved in reducing pollution. Many of the reduction programs made good financial sense, while few required truly fundamental changes in production processes or product designs. In order to demonstrate their commitment to environmental progress, companies were quick to publicize their successes. Even researchers easily came to the conclusion that continued environmental action could more than pay for itself. However, no specific regulation was made for environmental disclosure. The American Accounting Association has suggested a basic framework for environmental disclosure. However, there is no legislation which underpins the release of these reports in annual basis. In this fashion, environmental disclosure structure cannot be improved (Walden, W.D., Schwartz, B.N., 1997).
Norway was the first country which made compulsory the inclusion of the environmental disclosure in late 1980s. However, there were no requirements for a uniform report. In 1999, a new accounting legislation was implemented. The requirements for environmental disclosure became more comprehensive in the new Accounts Act. If the environmental impact was considered to be of significance, all firms had to disclose how the business affected the natural environment. The information should nevertheless be included in the annual report. However, in addition to the modest regulations from earlier the regulations in the new Accounts Act were extended to report environmental information on the entire product or service life cycle. The exact scope was not clear, therefore the Norwegian Accounting Standards Board made a preliminary standard, describing eight different conditions that are central to the external environment and, consequently, of importance to report. The purpose of the change in statutory regulation of environmental reporting is to affect positively the environmental performance and to meet with the information needs of shareholders, investors, lenders, employees, authorities, and the general public. Even though, the annual report is an object for auditing, but the environmental disclosure is still not (Fallan, E., Fallan, L ., 2009).
In the case of South Africa, some researchers are promoting the practice of the environmental accounting. In this fashion, firms would have available accounting information to produce environmental disclosures. However, there is no legal obligation to produce these reports (de Beer, P.P., Friend, F.F., 2006).
These three examples show that there is no consensus on both information structure and the legal obligation to issue environmental disclosures. The limited scope of the regulation approach has a significant effect on mandatory environmental disclosure volume and content in annual reports. Another common factor is the low number of firms which accomplish environmental information laws. Regulations without close review, auditing control and enforcement will not motivate full compliance. The statutory regulations requiring mandatory reporting in annual reports probably trigger a process, where companies on a voluntary basis, are adapting to the legal requirements by substituting environmental disclosure in annual reports for separate reports and special sections. The growth in environmental information content variety is mostly due to the development of voluntary reporting. However, there is no universal notion of accomplishment and, therefore, different countries and societies have different political cultures regarding attainment.
Variations in Environmental Disclosure
Each country has its own specific regulatory framework. In this manner, environmental obligations are also different among regions. As an example, Malaysian and Australian environmental disclosure are aimed at presenting the same information to similar audiences, but differ in content and timing. Australian companies disclosed more and extensive environmental information compared to Malaysian companies. The factors that have some level of impact on environmental disclosure practices among Australian companies are financial performance and ISO 14001 certification, while ISO certification is the sole factor for Malaysian environmental disclosure practice (KPMG, 2002).
The voluntary criteria of ISO 14001: Environmental Management Standards represents an international consensus on what constitutes best practice about environmental management systems. ISO 14001 assists organizations to improve their performance and make a positive impact on business results. ISO 14001 accredited companies are obliged to develop their mission, targets, policies and procedures that continuously monitor the effects of their operations against the natural environment. However, the only common denominator in all countries appears to be the influence that market factors have over the adoption of environmental policies.
Pressure from media
Media pressure has positive effects on environmental disclosure. Media coverage given to environmental fines from regulators is associated with increased levels of environmental disclosure (Nau, D., 1998). This finding indicates that, although annual reports communications are directed primarily to the financial stakeholder grouping, the concerns of the general public also influence disclosure levels. Organisations with a higher degree of media exposure tend to be more prone to pressure from social and political stakeholders. Evidence suggests that organisational visibility prompts firms to take leading roles in managing environmental impacts (Brammer, S., Pavelin, S., 2006).
Electronically vs. hard copy reporting
Nowadays, 28.7% of the world population has access to internet (IWS, 2010). Even this number is increasing in a yearly basis, not all customers have access to firms’ web sites which are the official communication channel of the businesses. The implication is, therefore, those electronic versions of environmental disclosure are only available for those users who have access to the Internet. Thus, information on environmental matter may only be obtainable. However, hardcopy reporting does not fix the problem either. Hard copies would be available for a broader range of users, but the distribution becomes harder and expensive. Additionally, hard copies have a bigger environmental impact than electronic versions. Thus, a balanced mix should be the optimal strategy to communicate the environmental progress of firms. Legislations do not specify whether the environmental disclosure should be prepared electronically. Even though, electronic version is getting more presence across industries.
Demand of assurance
Assurance in environmental disclosure depends upon several factors. One of them, and probably the most influent, is the accounting standards. Accounting standards delimit the manner in which costs and, therefore, benefits are going to be allocated. Different accounting standards may produce different results. Additionally, there is not a standard to compare data processed by firms. With no reference, data certainty is not measurable, thus, no qualification can be produced. The first step to attend this issue is to establish a common framework to report environmental results. In this manner, data evaluation would become an objective task. So far, environmental disclosure depends upon regulators and business ethics.