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Voluntary Environmental Standards: Furthering Moral Suasion While Preventing Moral Hazard

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We will examine several important examples of voluntary or self-organized attempts by industry to regulate their own behavior to determine (1) why firms choose to form or join such initiatives, (2) how voluntary regulations have influenced behavior in their industries, and (3) how these decisions and behavioral changes differ with the composition and structure of the voluntary regulation and the industries in which they operate. We will analyze both the current functioning of some common examples, and develop and test more general models of voluntary regulations. We will use our empirical findings and validated models to propose heuristics for managers and policy makers.

Approach:
The project has two stages with a major milestone and deliverable at the end of each stage. In both stages, theory development and modeling occur in an iterative process.
Theory Development
Voluntary environmental regulations make for challenging analysis, since the regulation and its impact really represents the outcome of three interdependent theaters of strategic action. In one, firms choose to join or not to join the voluntary agreement. In another, the form of the voluntary agreement itself is negotiated by its members. In the final theater, the participants to the agreement determine how to proceed or behave. Theory development in this project will use economic analysis to model strategic action in these three theaters, but it will also consider the potential for unexpected discoveries and transformations. Decision-making and behavior may be constrained or enlarged by norms within the community of members. Information may flow more easily among participant firms -- thereby changing the nature of strategic interaction.
Empirical Analysis
This analysis will provide information needed by the theory development part of the project, and it will develop methods for use in testing the models. At a minimum this analysis will include investigation of the membership and effect of each voluntary standard. The membership of voluntary regulations can reveal industry expectations for the program, and the relative changes among members and non-members can reveal the effect of the program.
Membership
We will use our database of firm and facility characteristics to evaluate differences between member and non-member firms. Minimal target variables include strategic & operational characteristics, competitive environment, regulatory environment, and history. In past work, we have used discrete dependent variable methods, e.g. probit, to estimate the characteristics associated with membership, and thus to infer why firms join voluntary regulations.
Effect on Performance
We plan to estimate the effect of voluntary standards through the use of several regression techniques. The use of several techniques allows us to test alternative theories and to determine the robustness of our findings. In general, we try to explain changes in firm environmental performance with a set of firm and industry attributes. Since these attributes very over time, we can infer causal relations among them. We can then separate these effects from the influence of the voluntary initiative. (for more information, see http://www.stern.nyu.edu/~aking/working/selfreg.pdf)

Expected Results:
Environmental policy is entering a new stage that will be characterized by a "public-private system of environmental management that is more flexible, performance-based, and cooperative (USEPA,1999)." This research begins to explore one emerging component of this new system, and helps to uncover how the business and its stakeholders can establish "rules of the game" that lead action in a desired direction. We expect that our work will be of direct interest to a variety of groups. Our work will help develop empirical methods and theoretical models for other researchers. Since voluntary standards may be most useful when direct government is difficult, our work will provide useful guidance to international groups such as the international standards organization and the United Nations. Our work will also help business associations design and communicate the nature and functioning of industry sponsored voluntary initiatives. Already, our research is influencing the Chemical Manufacturers Association's management of the Responsible Care program.
Voluntary regulation, along with contractual regulation and information-based regulation, may allow more effective regulation than traditional command and control or even market-based techniques. At the same time, the flexibility that these new forms provide may allow firms to act strategically and thus may cause the disintegration of voluntary regulations themselves. Thus, the central issue in this study is how to allow firms the flexibility to self-govern their actions without allowing them to act with guile. For the environment, this is of vital importance. Many environmental issues involve complex economic and environmental information. Funneling such problems through government is expensive and time consuming. Our study will begin to reveal when the actors themselves can form a self-governing system to regulate their collective behavior. It will provide guidelines to help industry members to design more effective voluntary programs.
Voluntary regulation can shift the cost of governance from the public to the industries, and in so doing reduce the total cost. Because of their unrivaled knowledge about the industry and their unique access to information, companies may be able to more efficiently allocate improvements and police adherence. This could lead to better and cheaper environmental protection.
Environmental stakeholders will need to monitor and watch over such voluntary initiatives. This study will support this in several ways.
This research will further develop techniques for auditing the performance of self-regulatory initiatives. It will also further reveal the role that such auditing will play in ensuring successful environmental regulation.
This research will develop guidelines for how standards organizations and industry associations should design voluntary regulations.
This research will reveal the degree to which self-regulatory approaches should be supported or compensated. Should for example, government provide flexibility on specific regulations if a firm chooses to join a voluntary program, or should an investor expect that investments in such companies bear a lower risk? Our research will help to reveal when and where such compensation is wise.
Finally, since voluntary regulations are emerging in almost every industry, our study may provide an early warning if voluntary regulations are not likely to provide environmental protection.

Metadata

EPA/NSF ID:
R827918
Principal Investigators:
King, Andrew
Radner, Roy R.
Shaver, James
Technical Liaison:
Research Organization:
New York University
Funding Agency/Program:
EPA/ORD/Valuation
Grant Year:
1999
Project Period:
November, 1999 to October, 2001
Cost to Funding Agency:
$236,390
Project Status Reports:
For the Year 2000

Objective: We will examine several important examples of attempts by industry to regulate their own behavior to determine: (1) why firms choose to form or join such initiatives; (2) how voluntary regulations have influenced behavior in their industries; and (3) how these decisions and behavioral changes differ with the composition and structure of the voluntary regulation and the industries in which they operate. We will analyze both the current functioning of some common examples, and develop and test more general models of voluntary regulations. We will use our empirical findings and validated models to propose heuristics for managers and policymakers.

Progress Summary: At the initiation of the project, the researchers had been granted access to important U.S. Census Bureau data. A dispute between the Census Bureau and the Internal Revenue Service (IRS) caused all pending studies to be voided; thus, the project was hampered by a lack of access to these data. Subsequently, a rewritten census proposal was resubmitted to the Census Bureau and received first round approval. It is now being revised based on the reviewers' comments. We hope to have access to Census data by the end of the summer, but we are going ahead with our research and believe that we can complete all projects with or without Census data.

Progress was achieved in both developing and extending theories of industry self-regulation and empirically exploring the actual effect of important examples of industry self-regulation.

Theory Development

Theory development proceeded on two fronts. Researchers Radner and Dutta developed a model of self-regulation to solve problems of global warming. Their model suggests that under some circumstances, a specific type of industry self-regulation can improve on the non-cooperative business-as-usual case. They show that asymmetric information can impede the creation of viable industry self-regulation and explore how the ability to transfer technology at cost might influence incentive-compatible self-regulation. Their model allows evaluation of the conditions under which industry self-regulation can approach the welfare optimum.

The Radner model investigates only one type of industry self-regulation. King, Lenox, and Barnett developed an informal description of the conditions under which other types of industry self-regulation are likely to form. They consider the issue of missing or asymmetric information in causing the formation of Industry Self-Regulation (ISR). They describe when industry self-regulation is likely to lead to an elite club of member firms and when it is likely to lead to near universal acceptance of an industry standard. They also describe how the strategies of firms may interact, and how ISRs can take different forms and have very different welfare consequences.

Empirical Research

Responsible Care. The team continued to push ahead on research on the chemical industry's Responsible Care (RC) program. A prior study of environmental performance of RC membership was published by the Academy of Management Journal. As an extension to this initial research, in a second paper (submitted) the investigators consider how RC affected the financial performance of participants and nonparticipants. We find that while most of the benefit of industry self-regulation spills over to nonmembers, member firms continue to participate to prevent collapse of the self-regulation effort.

This research suggests that large firms in dirty segments of the chemical industry participate in the RC program to prevent a damaging change in general industry conditions. These firms take this action at considerable financial cost to themselves. Whatever the intentions of these firms, enough poor performing firms take advantage of the shelter provided by RC so that the overall members of the program have lower environmental performance than nonmembers. Clearly, the conflicts within this situation must be resolved. If the environmental performance of the program becomes generally known, the program may no longer forestall regulation or improve stakeholder relations. Alternatively, evidence of the inferior environmental performance of RC may spur a redesign of the program and help it to realize its original promise. Such a redesign may now be taking place.

Other Examples of Industry Self-Regulation. The team also conducted research on other examples of industry self-regulation. We explored adoption patterns for ISO 14000 to understand initial participation in international environmental standards. Using techniques developed during our RC studies, the team conducted a preliminary comparison study of several environmental codes. Preliminary findings suggest that codes with third party certification and explicit sanctions have better success in preventing adverse selection and moral hazard.

We also conducted research on ISO 9000 that, while not explicitly an environmental code, provides an important opportunity to better understand adoption and performance consequences of industry standards. ISO 9000 has diffused more broadly and more completely than environmental codes, so it provides a better source of empirical evidence. Moreover, in one study conducted under the project, we found that ISO 9000 adoption predicts environmental improvement and adoption of the ISO 14000 standard. This study reinforces the hypothesized relationship between Lean Production practices and environmental performance.

Ann Terlaak of the Bren School of the University of California at Santa Barbara joined the team to conduct Ph.D. thesis research on how the nature of initial members in an industry standard can affect later patterns of adoption and success. She authored a theory paper based on the topic that was accepted by the Academy of Management for its annual conference. A second, empirical, paper will be presented this summer at a prestigious conference in Denmark. This latter paper suggests that in some industries, participating firms have been able to create (or make use of) conditions that bar adverse selection. If so, this paper could provide important evidence about the conditions under which self-regulation is feasible, and could be used to validate some of the assumptions of the Radner/Dutta model.

Causes of Industry Self-Regulation. According to many theories, industry self-regulation occurs when firms must share a common resource. King, Lenox, and Barnett (2001) explain how this resource could be a commonly held industry reputation. In his Ph.D. thesis, Mike Barnett (Stern School of Business, New York University) is investigating how accidents effect the stock price of both the focal firm and other firms in the same industry. He expects to show the conditions under which an Industry Self-Regulation like RC can control the financial spillover of such negative events. This research currently is underway.

Future Activities: Theory development will continue along several fronts. Papers based upon the formal game-theoretic models will be completed and submitted to a journal. Initial work on more informal theories will be modified and improved. One modification will be submitted to the Academy of Management Review. Another version will be directed toward the practitioner audience and will be submitted to Harvard Business Review.

Empirically, the research team will continue to study six industry self-regulation programs, including: (a) the chemical industry's RC program, (b) the petroleum industry's STEP program, (c) the textile industry's E3 program, (d) the pulp and paper industry's Sustainable Forestry Initiative, (e) the International Standards Organization's ISO 14000 environmental management standard, and (f) the International Standards Organization's ISO 9000 quality management standard. These studies will investigate the determinants of membership in these programs and how each effect the performance of member firms and the industry as a whole.

The team also will explore the underlying logic of industry self-regulation by evaluating the degree to which events effect the stock prices of similar firms. We will seek to explore when negative events spill over to other firms in the same industry. We will explore how industry self-regulation effects this spillover.

To help synthesize our theoretical and empirical work on the subject, we plan to organize a conference and compile an edited book. The team also is conducting several internal projects to help synthesize research in the area. Ann Terlaak is conducting a review of the literature on the link between theories of technology diffusion and the diffusion of industry standards. This review will become one of the chapters of her thesis. Mike Barnett also is conducting a review of the empirical literature on reputation and industry self-regulation. Finally, Andrew King, Mike Lenox, and Mike Barnett are creating a more general paper synthesizing several streams of research on collective action and industry self-regulation. This paper will be submitted to the Academy of Management Review.

Book Chapter:

King A, Lenox M, Barnett M. Governing the reputation commons: opportunities and barriers to industry self-regulation. In: Hoffman A, Vantresca M, eds. Organizations, Policy, and the Natural Environment: Institutional and Strategic Perspectives.

Journal Articles:

King A, Lenox M. Industry self-regulation without sanctions: the chemical industry's responsible care program. Academy of Management Journal 2000;43(4):698-716.

King A, Lenox M. Lean and green? An empirical examination of the relationship between lean production and environmental performance. Production and Operations Management.

King A, Lenox M. Does membership have its privileges? Analyzing who benefits from industry self-regulation. Strategic Management Journal.

Papers:

King A, Lenox M, Nash J. Adverse selection, sanctions, and industry self-regulation. 2000.

King A, Lenox M, Barnett M. Governing the reputation commons: opportunities and barriers to industry self-regulation. 2000.

Presentations:

Radner R. A game-theoretic approach to global warming. Presented at INSEAD, May 2001.

Dutta PK, Radner R. A strategic analysis of global warming. Presented at the Stern School of Business, New York University, February 2001.
Radner R. A strategic analysis of global warming. Presented at the Environmental Economics Seminar, Columbia University, October 2000.
Radner R. A strategic analysis of global warming. Presented at the National Science Foundation/CEME Decentralization Conference, Northwestern University, April 27-29, 2001.
Dutta PK, Radner R. Choosing cleaner technologies. Presented at the Stern School of Business, New York University, April 2001.
Terlaak A, King A. Do firms get run over by bandwagons? Exploring the effect of early adopters on the diffusion of the ISO 9000 management standard. Presented at the Nelson and Winter Conference, Aarlborg, Denmark, June 2001.
King A, Lenox M, Barnett M. Governing the reputation commons: opportunities and barriers to industry self-regulation. Presented at the 2000 Kellogg Conference on Organizations, Policy and the Natural Environment, Northwestern University, Evanston, IL, May 2000.
Terlaak A. Governmental solutions to problems of transferring environmental best practices. Presented at the 2001 Academy of Management Conference, Washington, DC, August 2001.
Barnett M. Industry self-regulation and stock price movements. Presented at the Consortium on Competitiveness and Cooperation (CCC) Colloquium, Duke University, Raleigh, NC, April 2001.
King A, Lenox M. Industry self-regulation without sanctions: the chemical industry's responsible care program. Presented at the Institute for Environmental Studies, University of Pennsylvania, January 27, 2000.
King A. Opportunities for industry self-regulation. Presented at the Greening of Industry Conference, Chapel Hill, NC, November 14, 1999.
King A. Voluntary environmental standards: furthering moral suasion while preventing more hazard. Presented at the EPA/National Science Foundation Conference: Beyond Compliance: What Motivates Environmental Behavior? Washington, DC, June 4, 2001.
Barnett M. Waves of collectivizing: a dynamic model of competition and cooperation over the life of an industry. Presented at the 2001 Academy of Management Conference, Washington, DC, August 2001.
King A, Lenox M. Who adopts management standards early? An examination of ISO 14001 certifications. Presented at the 2001 Academy of Management Conference, Washington, DC, August 2001.
King A, Lenox M. Who adopts management standards early? An examination of ISO 14001 certifications. In: Best Paper Proceedings of the Academy of Management Annual Conference.


For the Year 2001

Objective:
The objective of this research project is to examine attempts by industry to regulate their own behavior, and to determine: (1) why firms choose to form or join such initiatives; (2) how voluntary regulations have influenced behavior in their industries; and (3) how these decisions and behavioral changes differ among the various types of voluntary regulation and industry structure. As part of this project, the effectiveness of common voluntary regulations are being analyzed, and more general models of voluntary regulations are being developed. Our empirical findings and validated models are being used to propose heuristics for managers and policymakers.

Progress Summary:

We have made progress in developing theories of industry self-regulation and empirically exploring the effect of important examples of industry self-regulation on environmental and financial performance. As highlighted below, our progress includes publications, presentations/outreach, thesis progress, awards, and the addition of a new team member.

Publications
Nine working papers were completed.
Three papers were submitted to research journals.
Four papers were accepted for publication in peer-reviewed journals.

Presentations/Outreach
Andrew King facilitated a discussion at the World Bank on sustainability and industry standards.
Andrew King also organized a seminar at World Resources Institute's Bell conference on sustainability and industry standards.
Ann Terlaak's research was selected and presented at two prestigious conferences, one at the Wharton School, and the other at the Danish Research Unit on Industrial Development.

Thesis Progress
Ann Terlaak and Mike Barnett advanced to degree candidacy. Ann expects to defend her dissertation on September 5, 2002. Mike will defend his dissertation in the summer of 2003.

Awards
Andrew King received the prestigious Pioneer Award from the World Resources Institute.
Ann Terlaak received the most prestigious award in her field for research leading to a thesis, the INFORMS Dissertation Proposal Award.

Team Members
Susan Perkins-Rodriguez (NYU) was added as a new team member and quickly became a productive member.

During the reporting period, we initiated three new research directions; each of these are championed by a Ph.D. student, and supervised by a project team member.

Ann Terlaak's research received a tremendous amount of attention during the year. Her research uses a signaling model to predict when firms will join and benefit from International Standards Organization (ISO) 9000. She tests this model using her own data and data developed by the team. She has developed theories and evidence for when ISO 9000 improves financial performance, operational efficiency, and environmental performance. For her work, Ann received the INFORMS Dissertation Proposal Prize. She will join the faculty at the University of Wisconsin. Andrew King is her principal advisor.

Mike Barnett's research is perhaps the most far reaching of any team member. One part of his thesis uses data from the Internal Revenue Service (IRS) to investigate when firms form (and contribute to) cooperative industry associations, and he investigates whether and when these associations influence the performance of the industry. Another part of his thesis investigates a basic driver for industry self-regulation and collective action. Using accident data from the Environmental Protection Agency (EPA) and public newspapers, he explores when a chemical accident at one firm causes negative abnormal returns among related firms. Mike is testing whether participation in industry self-regulation initiatives moderates the financial effect of such accidents. By measuring when reputation is a "commons," Mike hopes to better understand when industry self-regulations will form. Andrew King and Michael Lenox are his advisors.

Susan Perkins-Rodriguez is the newest team member. In her research, she investigates firm location and processing decisions. She hypothesizes that different underlying geographic conditions give rise to different agglomerations of firms. These agglomerations act as a kind of self-regulation that affects environmental performance, knowledge spillovers, and financial performance. Andrew King and Michael Lenox are her team contacts and advisors.

The team also continued to synthesize research in the area. Ann Terlaak completed a review of the literature on the link between theories of technology diffusion and the diffusion of industry standards. Mike Barnett conducted a review of the empirical literature on reputation and industry self-regulation. Finally, Andrew King, Mike Lenox, and Mike Barnett continued to work on a general synthesis of several streams of research on collective action and industry self-regulation.

The team began organizing a conference and special issue on industry collective action. The conference is tentatively scheduled to take place at Dartmouth College in Hanover, NH, in July 2003. The team has proposed to The Strategic Management Journal that it publish a special issue of the papers presented at the conference.

Future Activities:
The research team will continue to study six industry self-regulation programs, including: (1) the chemical industry's Responsible Care Program; (2) the petroleum industry's STEP program; (3) the textile industry's E3 program; (4) the pulp and paper industry's Sustainable Forestry Initiative; (5) the International Standards Organization's ISO 14000 environmental management standard; and (6) the International Standards Organization's ISO 9000 quality management standard. These studies will investigate the determinants of membership in these programs and how each affects the performance of member firms and the industry as a whole.

The team also will explore the underlying logic of industry self-regulation by evaluating the degree to which events affect the stock prices of similar firms. Further exploration will be conducted to determine when negative events spill over to other firms in the same industry. In addition, further study will explore how industry self-regulation affects this spillover.

Book Chapter:

King A, Lenox M, Barnett M. Strategic responses to the reputation commons problem. In: Hoffman A, Ventresca M, eds. Organizations, Policy, and the Natural Environment: Institutional and Strategic Perspectives. Stanford, CA: Stanford University Press, 2002, pp. 393-406.

Journal Articles:

Barnett ML. A dynamic model of competition and cooperation. Academy of Management Review.

Barnett ML. All for one? Examination of changes in trade association activity. Strategic Management Journal.

King A, Shaver M. Are aliens green? Assessing foreign establishments? environmental conduct in the U.S. Strategic Management Journal 2001;22(11):244-256.

King A, Lenox M. Does it really pay to be green? The Journal of Industrial Ecology 2001;5(1):105-116.

King A, Lenox M. Exploring the locus of profitable pollution reduction. Management Science 2002;48(2):289-299.

Barnett ML. Industry self-regulation as collective strategy: institutional buffer or binder? Academy of Management Journal.

Terlaak A, King A. Information asymmetries, imitation, and strategic foresight: a signaling framework to analyze the adoption process of an industry management standard. Administrative Science Quarterly.

King A, Lenox M. Lean and green? An empirical examination of the relationship between lean production and environmental performance. Production and Operations Management.

Lenox M, King A. Prospects for building absorptive capacity through information provision. Strategic Management Journal.

Terlaak A, King A. The role of industry management standards in solving problems of asymmetric information. Academy of Management Journal.

Papers:

King A, Michael L, Nash J. Adverse selection, sanctions, and industry self-regulation. Working Paper, 2000.

King A, Lenox M, Barnett M. Governing the reputation commons: opportunities and barriers to industry self-regulation. Working Paper, 2000.

Terlaak A, King A. Information asymmetries, imitation, and strategic foresight: a signaling framework to analyze the adoption process of an industry management standard. University of California?Santa Barbara, Working Paper, 2002.

King A, Lenox M. Sustaining industry self-regulation in the face of free-riding. Working Paper, 2001.

Terlaak A, King A. The effect of ISO 9000 on operational and environmental performance: is there one? University of California-Santa Barbara, Working Paper, 2002.

Terlaak A. Who is influenced by institutional pressures? The effect of organizational size in moderating bandwagon and network effects. University of California?Santa Barbara, Working Paper, 2002.

Presentations:

Radner Roy. A game-theoretic approach to global warming. Presented at Institut Europeen d'Administration des Affaires (INSEAD), May 2001.

Radner Roy. A game-theoretic approach to global warming. Presented at Institut Europeen d'Administration des Affaires (INSEAD), May 2001.

Terlaak A. Contrasting institutional theory and signaling theory to explain the adoption process of an industry standard. Presented at various universities as a job market paper, 2002.

Terlaak A, King A. Do firms get run over by bandwagons? Exploring the effects of early adopters on the diffusion of the ISO 9000 management standard. Presented at the Danish Research Unit for Industrial Dynamics (DRUID) Conference, Aalborg, Denmark, June 12-15, 2001.

Lenox M. Exploring the prospects for industry self-regulation. Presented at the Deans Forum, New York University.

Lenox M. Free riding, adverse selection, and moral hazard in industry self-regulation. Presented at the New York University International Business Seminar, New York University.

Barnett ML. Industry self-regulation and stock price movements. Presented at the Consortium on Competitiveness and Cooperation (CCC) Colloquium, Duke University, Raleigh, NC, April 2001.

Terlaak A. Information asymmetries, imitation, and strategic foresight: a signaling framework to analyze the adoption process of an industry management standard. Presented at the Wharton Mini Technology Conference, University of Pennsylvania, Philadelphia, PA, 2002.

King A. On self-regulation in the United States. Presented at the Environmental Protection Agency, Washington, DC, June 4, 2001.

Terlaak A. The effect of ISO 9000 on operational and environmental performance: is there one? Presented at the University of California-Santa Barbara Ph.D. Seminar, June 5, 2002.

Barnett ML. Unpacking social responsibility: the curvilinear relationship between social and financial performance. Presented at the Academy of Management Conference, Denver, CO, August 11-14, 2002.

Barnett ML. Waves of collectivizing: a dynamic model of competition and cooperation over the life of an industry. Presented at the Academy of Management Conference, Washington, DC, August 3-8, 2001.

King A. Why does it pay to be green? Presented at the Symposium on Sustainability-Profiles in Leadership, Neuberger and Bermann, New York, NY, October 17, 2002.

Proceedings:

King A, Lenox M. Who adopts management standards early? An examination of ISO 14001 certifications. In: Best Paper Proceedings of the Academy of Management Annual Conference.

Project Reports:

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