Financial Distress and Incentives for Pollution Abatement, Care, and Regulatory Compliance

1. Financial Distress and Incentives for Pollution Abatement, Care, and Regulatory Compliance Mary F. Evans and Scott M. Gilpatric 83284701

2. Theoretical contributions • How does the financial position of a firm (proximity to insolvency) subject to strict liability affect its incentives to exercise care? (Shavell, 1986; Beard, 1990; Larson, 1996; Dari-Mattiaci and De Geest, 2006) • Judgment proofness • Subsidy to care

3. Our contribution • Develop theoretical model of care choice with the following features: • Care affects the distribution of damages • Firm decision maker has a stake in the firm remaining solvent • Loss of reputation from insolvency • Stochastic exogenous profit (coming soon!)

4. Model (fixed profit) • Firm subject to strict liability chooses care expenditures. • Accident occurs with probability p. • Care expenditures, z, affect the distribution of (monetary) damages: • where x is a random variable with distribution on • “Magnitude” model using Dari-Mattiaci and De Geest (2006) classification.

5. Socially optimal level of care • Social cost function: • First order condition:

6. Firm • Firm has assets, A, and profits, . • Firm is insolvent when • Define i as insolvency point, realization of x above which firm is insolvent

7. Firm decision maker • Decision maker owns share of firm • Decision maker faces loss if firm becomes insolvent; decision maker receives V only if the firm remains solvent. • If V = 0 and , then the decision maker seeks to maximize value of firm.

8. Decision maker chooses care, z, to maximize objective function: • First order condition for interior solution: MC of care—accounts for subsidy to care spending from chance of insolvency MB of care—(1) reduction in expected damages; reflects judgment proofness (2) marginal decision maker solvency benefit

9. Comparison to social optimum • z* can be greater or less than z0 • Contradicts Dari-Mattiaci and De Geest (2006) result that z*>z0 occurs only in “probability” models • Why? Model results in care always affecting expected liability at the margin (up to the point where the chance of insolvency has been eliminated). • Comparative static results for fixed profit case • z* increasing in • z* increasing in A (and profit) under reasonable restrictions on F distribution (provided chance of insolvency has not been eliminated)

10. Example with uniform distribution • Assumptions • F is uniform on [0,1000] • p = 0.5 • = 0 or 5

11. Region 2 Region 3 Region 4 Region 1 p = 0.5

12. Additional applications of general model • Abatement choice • Firm chooses level of abatement (unit cost normalized to one), z, and faces per unit penalty, , for emissions that exceed standard, s. • Emissions are where x is a random variable. • Firm is inspected with probability p. • Firm is insolvent for realizations of x > • Objective function:

13. Next steps • Examine effects of stochastic profit • Consider alternative distributions for x • Generalize model

14. Stochastic profit • Firm decision maker faces profit uncertainty and knows only distribution of profit when making care choice. • With sufficiently low profit realizations, firm will be insolvent independent of an accident: • Care spending increases the range of profit realizations for which the firm is insolvent (independent of an accident); this represents additional cost of care to decision maker.

15. Effect on z* of change in is ambiguous. • Intuition: Higher z* increases chance that decision maker will receive , conditional on an accident BUT also increases chance that he will forgo through insolvency independent of an accident. Comparative static depends on which effect dominates.

16. p = 0.05