The link between environmental performance and financial performance at the firm level is an often discussed topic among economists [1
]. Many empirical papers show a positive relation between environmental performance and profitability [5
]. While aggregate profitability measures are used in the empirical implementation, the underlying theoretical argumentation points towards effects of environmental performance on revenues and costs. In the natural-resource-based view, a cost decreasing effect of environmental performance is motivated with the resource efficiency argument [8
]. Following that argument, environmental performance can be increased through more efficient processes, which are accompanied by a reduction in input factors and better waste management [13
]. In addition, better environmental performance can help firms to attract highly skilled employees and increase labor productivity [12
]. Empirical evidence on the environmental performance–cost link is scarce. A number of case studies examine specific companies and generally point to a negative effect of environmental performance on costs [13
]. Christmann [18
] provides survey evidence on firms from the chemical industry. The survey results suggest that the use of pollution prevention technologies is not associated with cost advantages, but the development of proprietary pollution prevention technologies can lead to a cost advantage. Yet, to our knowledge, there is no large sample empirical evidence on the relation between environmental performance and costs. However, this topic is also from a practical perspective of special importance because many executives do not consider the cost decreasing effect of environmental performance improvements in their investment decisions. The McKinsey Global Survey [19
] results reveal that only 26% of the executives name cost cutting as a factor why companies address sustainability. Our findings, however, show that these investments are actually associated with lower operating costs.
We examine the link between environmental performance and operating costs. We split operating costs into overhead costs and direct production costs, and separately investigate both types of costs and their link to environmental performance. We expect a positive relation between environmental performance and overhead costs, for example, due to the installation of environmental managements systems [20
]. In contrast, for direct production costs we hypothesize a negative relation by referring to the resource efficiency argument [13
]. In this line of literature, pollution is seen as an inefficiency in the production process. For example, the use of recycled materials could not only benefit the environment, but also decrease production cost [22
]. Similarly, Christman [18
] points out a reduction in input costs through a more efficient use of resources, which is at the same time associated with the prevention of environmental pollution.
In our empirical analysis, we use the environmental score provided by Asset4. The Asset4 environmental score comprises the three areas emission reduction, product innovation and resource reduction. Our dataset consists of 4493 firm-year observations of large U.S. companies in the time period 2006–2014. We find that firms with a higher level of environmental performance have significantly lower direct production costs. In contrast, for overhead costs, our results show a positive link: better environmental performance is associated with higher overhead costs. The aggregate effect of environmental performance on operating costs is again negative, because direct production costs account for 78% of operating costs.
An important concern in studying the relation between environmental and financial performance is the direction of causality. Potentially, firms, which face lower costs have slack resources to invest in improving their environmental performance [23
]. To interpret the results causally, we use an instrumental variable approach. Di Giuli and Kostovetsky [24
] show that the political environment influences the corporate social responsibility of a firm. We use U.S. election results of the state, where the company’s headquarter is located, as an instrument for the environmental performance of the respective company. The results of the instrumental variable approach confirm our previous findings. Our results are robust to different instrumental variable estimation techniques.
This paper makes three contributions. First, we provide empirical evidence for the theoretical arguments that environmental performance can decrease costs. Second, we document a differential effect on different types of costs: while better environmental performance leads to lower operating costs, it is associated with higher overhead costs. Third, we deal with potential reverse causality problems by using an instrumental variable approach. These insights are not only academically relevant, but also important for managers to reach informed decisions on investments in environmental performance.
In Section 2
, we discuss the theory and derive hypotheses. Section 3
provides details on our measures of environmental performance, operating costs and the control variables. The results of the empirical analysis are shown in Section 4
. Section 5
5. Discussion and Conclusions
The results show that firms with better environmental performance can benefit from lower operating costs. Overhead costs increase slightly, but this effect is more than outweighed by a sizable decrease in costs of goods sold. Importantly, we do not only find these results in a typical regression model, but also in an instrumental variable setting. Thus, we are reasonably confident to conclude that environmental performance leads to lower operating costs and that our findings are unlikely to be affected by reverse causality or other endogeneity problems.
Our findings provide evidence in favor of theoretical arguments made by proponents of the natural-resource-based view, notably Hart [13
] and Russo and Fouts [12
]. One important argument of the natural-resource-based view is that pollution prevention is associated with lower costs [50
]. We contribute to this line of research by providing empirical evidence on the relation between environmental performance and operating costs. Future research can build on our findings and analyze in more detail which factors moderate the relation between cost and environmental performance and how this relation varies across firms. The relation between environmental performance and costs likely depends on complementary assets and capabilities of the firm [18
], and the location of the firm. In her meta-study, Albertini [5
] provides evidence that the relation between environmental performance and aggregate accounting and market-based measures of financial performance varies across countries. This finding might be due to differences in the environmental performance–cost relation across countries; for example, different legal settings, input costs, employee preferences, and firm cultures.
The focus of our study on costs allows us to empirically test one specific line of argumentation of the natural-resource-based view: the relation between environmental performance and cost efficiency. However, this advantage can, at the same time, also be seen as a limitation of our work. We ignore many other aspects of the natural-resource-based view in our analysis. For example, the natural-resource-based view suggests that firms can gain a better reputation from high environmental standards [12
]. This reputation effect might translate into higher revenues as firms attract loyal customers. This mechanism might be another explanation for the often-reported positive relation between profits and environmental performance. Albuquerque et al. [51
] show that product differentiation from high corporate social responsibility standards can lead to customer loyalty and less systematic risk. To our knowledge, there is not yet any work that tests for effects of environmental performance on revenues and the volatility of revenues.
Our study also has important practical contributions. As Dowell and Hart [50
] point out, “Managers that search for opportunities to profit via pollution prevention have the potential to find such opportunities, but their prior expectations about whether such opportunities exist strongly affects their search.” [50
] (p. 1469). We hope that our findings persuade and encourage managers to search for cost advantages from environmental opportunities within their firms. The relatively recent McKinsey survey from 2014 [19
] shows that still nowadays only about one quarter of managers pursue sustainability initiatives with the goal to cut costs. Thus, there seems to be a lot of unused potential that can be realized by convincing managers of the cost advantages from better environmental performance. From a practical perspective, it would be important for future research to provide more detailed guidance for managers on how to identify and implement improvements in environmental performance that reduce operating costs.