How to Make Firms Disclose Environmental Violations

April 23, 2018

Professor Peng Sun studies dynamic mechanism design

Professor Peng Sun on firms self-reporting EPA violations

Paying companies to report violations of environmental laws could be more effective and less expensive than inspecting them more frequently, according to research from Duke University’s Fuqua School of Business.

Professor Peng Sun found offering rewards to firms on a decreasing scale between inspections is the most efficient way of uncovering environmental violations. The proposal solves problems with regulatory design that have derailed previous efforts by the Environmental Protection Agency to induce firms to reports spills, leaks and other hazardous incidents.

“The most efficient and least costly way of regulating environmental compliance is inducing people to tell the truth,” Sun said. “The optimal policy is a simple cyclic structure. It’s easy to compute and implement.”

The rewards could be economic subsidies or reduced penalties, depending on the situation. The firm’s responsibility to clean up any damage would not change.

Sun’s theoretical model focuses on environmental hazards that result from random events beyond firms’ control, such as equipment malfunctions or natural causes.

“Even when the violation is not the firm’s fault, they have an economic incentive to continue with business as usual and not tell anyone,” Sun said. “Even delaying just a little while helps the firm economically by delaying any financial penalty or repercussions. But the regulators want to know so they can take actions to mitigate the environmental impact. So it’s a cat-and-mouse game. If a company has an incident that damages the environment but which are hard to see, we need to find the best strategy for regulators to catch them.”

Sun’s research, Inducing Environmental Disclosures: A Dynamic Mechanism Design Approach, was published in the journal Operations Research. Sun worked with Shouqiang Wang of the University of Texas, who earned his Ph.D at Fuqua, and former Fuqua professor Francis de Véricourt of the European School of Management and Technology in Berlin, Germany.

The standard procedure for uncovering environmental violations is to inspect firms and penalize them when violations are found. Prior research into the optimal solution, Sun said, has focused on the frequency and manner of inspections: whether they should be random and unannounced, whether any notice should be given, or if there should be an equal chance firms could be inspected on any given day.

“That’s the stick, but we can also use the carrot,” Sun said. “It’s expensive, and in many cases impossible, to have an inspector watching firms all the time. Frequent inspections are very costly – but the environmental damages are costly too.”

Voluntary disclosure programs exist, usually involving reduced fines for firms that self-report violations. But how to efficiently operationalize the principle of self-reporting remains poorly understood, Sun said. His research focuses on the unknowable element: When violations will occur.

“The key point is timing,” he said. “No one knows when a violation will happen, but when it does, only the firm knows about it at first.”

Sun’s model provides a subsidy that gives firms the incentive to tells regulator sooner when a violation occurs. The amount of the subsidy decreases with each day that passes since the most recent inspection.

 “The solution is to inspect periodically, with a decreasing curve of subsidies between one inspection and the next,” he said. “When a hazard occurs, a firm can wait a few days to report it, but they will receive less subsidy. The decreasing subsidy gives them the incentive to report as soon as possible.”

The subsidy decreases at a rate tied to the amount the firm can benefit from delaying. It hits zero when the next inspection takes place. After the inspection, the subsidy is reset to the highest level.

“There are many inspection programs and self-disclosure programs,” Sun said, “but I haven’t seen them combined in this way.”

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